UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended December 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.)

Two Hopkins Plaza

Baltimore, Maryland 21201

(Address of principal executive offices) (Zip Code)

(410) 237-5900

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Title of each class

 

Name of each exchange on which registered

Common Stock ($2 par value per share)

 

The Nasdaq Stock Market, Inc.

Stock Purchase Rights

 

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes  x    No  o

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes  o    No  x

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  x    No  o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X ]

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 filer” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer  x      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  x

At June 30, 2006, the last business day of registrant’s most recently completed second fiscal quarter, the aggregate market value of shares of common stock held by non-affiliates of registrant (1) (including fiduciary accounts administered by affiliates) was approximately $4.3 billion based on the last sale price on the Nasdaq National Market on June 30, 2006.

As of February 16, 2007, there were 125,730,716 shares of common stock outstanding.


(1) Excludes 2,119,115 shares of common stock held by directors, executive officers, and shares held in fiduciary accounts by the Registrant and subsidiaries of the registrant with discretionary power to vote or dispose of such shares as of June 30, 2006.  Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the registrant, or that such person is controlled by or under common control with the registrant.

 




2006 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

PART I

 

Item 1.

 

Business

 

 

Item 1A.

 

Risk Factors

 

 

Item 1B.

 

Unresolved Staff Comments

 

 

Item 2.

 

Properties

 

 

Item 3.

 

Legal Proceedings

 

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

 

 

 

 

 

 

PART II

 

Item 5.

 

Market for the Registrant’s Common Stock, Related Stockholder Matters

 

 

 

 

and Issuer Purchases of Equity Securities

 

 

Item 6.

 

Selected Financial Data

 

 

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and

 

 

 

 

Results of Operations

 

 

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

 

 

Item 8.

 

Financial Statements and Supplementary Data

 

 

Item 9.

 

Changes in and Disagreements with Accountants on Accounting and

 

 

 

 

Financial Disclosure

 

 

Item 9A.

 

Controls and Procedures

 

 

Item 9B.

 

Other Information

 

 

 

 

 

 

 

PART III

 

Item 10.

 

Directors, Executive Officers and Corporate Governance

 

 

Item 11.

 

Executive Compensation

 

 

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management

 

 

 

 

and Related Stockholder Matters

 

 

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

 

 

Item 14.

 

Principal Accounting Fees and Services

 

 

 

 

 

 

 

PART IV

 

Item 15.

 

Exhibits and Financial Statement Schedules

 

 

 

 

 

 

 

Signatures

 

 

 

 

 




PART I

ITEM 1. BUSINESS.

General

Mercantile Bankshares Corporation, with $17.7 billion in assets at year-end December 31, 2006, is a regional multibank holding company with headquarters in Baltimore, Maryland.  It is comprised of 11 banks (the “Banks”) and a mortgage banking company.  Eight banks are headquartered in Maryland, two are in Virginia and one is in Delaware.  At December 31, 2006, Bankshares’ largest bank, Mercantile-Safe Deposit and Trust Company (“MSD&T”), represented approximately 46% of total assets and operated 36 offices in Maryland, 21 in Virginia, 2 in Washington, D.C. and one in Pennsylvania.  MSD&T provides nearly all of Bankshares substantial wealth management operations and specialized corporate banking services.  Mercantile Bankshares Corporation was incorporated under the laws of Maryland on May 27, 1969.  Mercantile Bankshares Corporation along with its consolidated subsidiaries is referred to in this report as “Bankshares,” “we” or “Registrant.”

On October 8, 2006, Bankshares entered into an Agreement and Plan of Merger with The PNC Financial Services Group, Inc. (“PNC”) pursuant to which Bankshares will merge with and into PNC, with PNC as the surviving corporation in the merger.  When the merger is completed, Bankshares’ stockholders will receive a combination of PNC common stock and cash in exchange for their Bankshares common stock.  Each share of Bankshares common stock will be converted into the right to receive 0.4184 of a share of PNC common stock (including the related preferred stock purchase rights under PNC’s May 2000 Rights Agreement) and $16.45 in cash, without interest.  Under the formula set forth in the merger agreement, an aggregate of up to approximately 54.2 million shares of PNC common stock (and an equal number of related rights) may be issued and $2.13 billion paid in the merger.  This merger was approved by Bankshares’ stockholders on February 27, 2007 and received substantially all of the required regulatory approvals.  The merger is currently expected to close in March of 2007.  Pending the merger, Bankshares must comply with the covenants contained in the merger agreement, but is generally continuing to operate in the ordinary course of business.

Bankshares emphasizes long-term customer relationships founded on value-added service and focuses on those traditional services it performs well.  This emphasis on relationship banking makes moderate-sized and family-owned businesses a particularly important market for Bankshares’ affiliate banks.  Relationship-oriented banking is carried out through all our community banks, each of which has its own name, management, board of directors and historical ties to the families, businesses and institutions that make up its community.  At the same time, community banks, through their association with Bankshares, are able to offer the more sophisticated services and financial strength of a major banking organization, as well as the conveniences of online banking and a large network of banking offices and ATMs.

As a matter of policy, Bankshares’ affiliates lend almost exclusively within their market areas.  Primary corporate objectives are to maintain capital strength, to achieve superior profitability and strong asset quality and to avoid undue risk. We believe that growth is a by-product of meeting these objectives.

On July 17, 2006, Bankshares completed its acquisition of James Monroe Bancorp, Inc. (“James Monroe”), a bank headquartered in Arlington, Virginia.  Subsequent to its acquisition, James Monroe was merged into MSD&T.  James Monroe operated six full-service branches and one loan production office in Northern Virginia and suburban Washington, D.C. at the time of the acquisition.  The total consideration paid to James Monroe shareholders in connection with the acquisition was $71.4 million in cash and 1.8 million shares of Bankshares’ common stock.  The results of James Monroe’s operations have been included in Bankshares’ results subsequent to July 17, 2006.  The assets and liabilities of James Monroe were recorded on the consolidated balance sheet at their respective fair values.  The transaction resulted in an increase in total assets of $552 million, including $414 million in gross loans, and liabilities assumed of $507 million, including $434 million of total deposits.

1




Affiliate Bank Network

Bankshares directly owns all of the outstanding stock of the Banks and directly or indirectly owns all of the outstanding stock of certain other affiliates.  The principal components of our banking and nonbanking network are listed below.

Lead Bank and Affiliates

Mercantile-Safe Deposit and Trust Company

Mercantile Mortgage Corporation (“MMC”)

Mercantile Mortgage, LLC (49.9% owned by MMC)

West River LLC

HarborPoint Capital, GP LLC

HarborPoint Capital LP (74% owned by MMC)

Mercantile Brokerage Services Holdings, LLC

Mercantile Brokerage Services, Inc.

Mercantile Capital Advisors, Inc.

Mercantile/Cleveland, LLC

Boyd Watterson Asset Management, LLC

MBC Agency, Inc.

Mercantile Life Insurance Company

Mercantile Real Estate Advisors, Inc.

Community Banks

 

The Annapolis Banking and Trust Company

 

Annapolis, Maryland

 

The Citizens National Bank

 

Laurel, Maryland

 

Farmers & Mechanics Bank

 

Frederick, Maryland

 

Keller Stonebraker Insurance, Inc.

 

Hagerstown, Maryland

 

Potomac Basin Group Associates, Inc.

 

Beltsville, Maryland

 

Marshall National Bank and Trust Company

 

Marshall, Virginia

 

Mercantile County Bank

 

Elkton, Maryland

 

Mercantile Eastern Shore Bank

 

Chestertown, Maryland

 

Mercantile Peninsula Bank

 

Selbyville, Delaware

 

Mercantile Southern Maryland Bank

 

Leonardtown, Maryland

 

The National Bank of Fredericksburg

 

Fredericksburg, Virginia

 

Westminster Union Bank

 

Westminster, Maryland

 

2




For purposes of segment reporting, two operating components have been identified:  Banking Services and Investment & Wealth Management.  For segment reporting information, see Note No. 16 - Segment Reporting in the Notes to the Consolidated Financial Statements in Item 8 of this Annual Report.  Also, see information under the heading “Segment Reporting” in the sections captioned “Analysis of Operating Results for 2006 to 2005” and “Review of Earnings and Balance Sheet for 2005 to 2004,” in Item 7 of this Annual Report.

Banking Services

Retail Banking

The Banks offer numerous services to meet the checking, savings, invest­ment and credit needs of individuals in their communities.  Retail banking services include checking, savings and money market accounts, Individual Retirement Accounts and time deposits.  The Banks offer home equity loans and lines of credit, installment loans and lines of credit, and equipment and transportation (auto, marine, recreational vehicles, aircraft) loans to meet a variety of borrowing needs.

Through the affiliate bank network, customers have no-fee access to their accounts at 255 Mercantile BANKING TWENTY-FOURSM ATMs, and they can perform many routine transactions at any of the 240 affiliate-banking offices.  For added convenience, substantially all of Bankshares’ affiliates provide customers with toll-free telephone access to a centralized Customer Service Center and a voice-response account information system.  BANKING TWENTY-FOUR ONLINE® enables customers to access their personal accounts online to pay bills, verify account balances, track recent account activity and perform selected transactions.  BANKING TWENTY-FOUR ONLINE offers sole proprietors similar capabilities specifically tailored to meet small business needs.

Small Business Banking

The Banks offer numerous services to meet the deposit, credit and service needs of businesses with annual revenues up to $3.0 million or credit needs up to $750 thousand.  Each Bank works closely with customers to provide cash management services and extend credit for such purposes as receivables and inventory financing, equipment leases and real estate financing.  Where appropriate, the Banks employ government guarantee programs, such as those available from the Small Business Administration.

Commercial Banking

Commercial banking services include commercial deposit, lending and commercial real estate solutions provided to businesses with annual revenues between $4 million and $50 million.

Cash management services help business customers collect, transfer and invest their cash.  Through a variety of electronic payment and account management tools, customers are able to monitor and manage cash flows conveniently and efficiently.

With their local knowledge and focus, our Banks are well suited to meet the traditional credit needs of businesses in their market areas.  Each Bank works closely with customers to extend credit for general business pur­poses, such as working capital, plant expansion or equipment purchases, and for financing industrial and commercial real estate.  When local commercial customers do not qualify for traditional financing, we can help them convert the value of their accounts receivable, inventory and equipment into cash for operations.  Additionally, we can arrange more sophisticated financing in the areas of acquisitions and management buyouts.  We provide land acquisition and development, construction and interim financing to commercial real estate investors and developers.

In addition to extending credit to businesses in its own market area, MSD&T works in collaboration with other bank affiliates when their customers’ credit needs exceed the affiliate bank’s lending limit or when there is a more specialized commercial banking need.  To supplement traditional credit products, the Banks offer capital market products such as municipal bond underwriting, interest rate risk management and financial advisory services through the MSD&T Capital Markets Group.

These services include underwriting and remarketing tax-exempt and taxable municipal variable-rate demand bonds for nonprofit organizations such as senior living and health care providers, private schools, health and social welfare organizations and cultural institutions.  By working directly with borrowers, we can evaluate and recommend financing and interest rate risk- management strategies, which include interest rate swaps, caps and collars.

3




Mortgage Banking

Residential mortgages are provided through Mercantile Mortgage, LLC, a joint venture between Mercantile Mortgage Corporation (“Mercantile Mortgage”), a sub­sidiary of MSD&T, and Wells Fargo Ventures, LLC.  Through Mercantile Mortgage a wide variety of competitively priced fixed and variable-rate products are available, including jumbo loans.  Residential mortgage loans also are available through the Banks.  Mercantile Mortgage also makes loans for land acquisition, development and construction of single-family and multifamily housing.

Risks associated with residential mortgage lending include interest rate risk, which is mitigated through the sale of the majority of all conforming fixed-rate loans, and default risk by the borrower, which is mitigated through underwriting procedures and credit quality standards, among other things.

Permanent financing for multifamily projects nationwide is provided through HarborPoint Capital, LP, a joint venture, the majority of which is owned by Mercantile Mortgage.  HarborPoint Capital, LP, headquartered in Dallas, Texas, is one of the nation’s few Fannie Mae DUS(Delegated Underwriting and Servicing) lenders.

Insurance Products

Keller Stonebraker Insurance, Inc., an independent, wholly owned subsidiary of Farmers & Mechanics Bank, arranges a full line of consumer insurance products through offices in Hagerstown and Cumberland, Maryland, and Keyser, West Virginia.  Consumer insurance products include annuities, homeowners, automobile, life and personal umbrellas.

Potomac Basin Group Associates, Inc. operates as an independent, wholly owned subsidiary of Farmers & Mechanics Bank.  It is an independent insurance agency specializing in corporate employee benefit plans through its offices in Beltsville and Ellicott City, Maryland.  Potomac Basin provides commercial products that include property and casualty packages, workers’ compensation, professional liability and umbrella coverage, bonds and 401(k) and other benefit plans.

MBC Agency, Inc. provides as agent, under group policies, credit life insurance in connection with extensions of credit by the Banks.  Mercantile Life Insurance Company reinsures the insurance provided by MBC Agency, Inc.

Investment and Wealth Management Services

Bankshares offers investment and wealth management services through the Investment & Wealth Management division (“IWM”) of MSD&T.  IWM continues to build on a more than 140-year tradition of providing investment and wealth management services to private individuals, families and institutions.

Today, Bankshares provides a range of wealth management services.  IWM has risk management and asset allocation analyses to complement the investment advice we offer.  An open architecture platform enables Bankshares to offer an array of proprietary investment products and carefully selected outside managers in a range of asset classes, including equity, fixed-income and alternative investment products.  Bankshares’ investment platform provides a range of investment vehicles, from separate account management to mutual funds.  Investment and wealth management services are available through professional advisors at MSD&T, through the affiliate bank network and through Baltimore-based Mercantile Brokerage Services, Inc. (“MBSI”).  Asset allocation and risk management capabilities, coupled with a range of proprietary and nonproprietary investment alternatives and investment vehicles, enable Bankshares to provide high quality, advice-driven, risk-managed solutions to meet clients’ investment objectives.  At December 31, 2006, Bankshares had $21.1 billion of discretionary assets under management and $43.3 billion in assets under administration.

Retail Brokerage Services

Mercantile Brokerage Services, Inc., a general securities broker-dealer, offers full-service, discount and online brokerage capabilities and account services.  Our customers can choose from investments in stocks, bonds, proprietary and nonproprietary mutual funds, and fixed or variable annuities.

4




 

Private Wealth Management Services

When managing a client’s assets as part of an investment management or trustee relationship, Bankshares focuses on consistent investment performance and an asset allocation that is individually designed to meet each client’s risk/return parameters and investment objectives.  Professional advisors, working in partnership with our clients, provide access to proprietary and third-party separate account management, the family of Mercantile Funds, nonproprietary mutual funds and a variety of alternative investments.  In addition, IWM provides a range of sophisticated fiduciary and client administrative services, including trust administration, protection and continuity of trust structures, estate settlement, estate advice and planning, tax advice and planning and charitable giving programs.  IWM also acts in a custodial capacity for its clients, providing safekeeping of assets, transaction execution, income collection, preparation of tax returns and recordkeeping.

IWM also specializes in services designed to meet the unique needs of families with substantial wealth.  We provide a full range of services required to manage seamlessly our client’s complex, multigenerational financial circumstances.  We also provide guidance in more sophisticated investment strategies, incorporating nontraditional asset classes such as private equity, real estate and hedge funds.

Private Banking Services

The Private Banking Group provides one point of contact for its clients’ deposit, investment and credit needs, ensuring that these services are delivered within an overall asset management plan.  Private bankers can coordinate cash flows; arrange investment of short- and long-term funds; and structure credit arrangements to meet short- to long-term needs.

Institutional Investment Management

Bankshares, through IWM and Boyd Watterson Asset Management, LLC, works to provide businesses and charitable organizations with investment management and administrative services for their employee retirement plans, profit sharing plans and endowments.  Clients include state and local government entities, unions, charitable organizations and military institutions.  IWM also can help nonprofit organizations, such as charitable and philanthropic groups, with annual giving and capital campaigns, pooled income funds, gift annuities and charitable remainder trusts.  Bankshares offers corporations 401(k) programs tailored to their specific needs.

Mercantile Funds

We offer a full spectrum of mutual funds - from equity funds designed to grow clients’ money over time, to taxable and tax-exempt bond funds designed to offer regular income payments, to money market funds designed to help clients build a cash reserve.  The Mercantile Funds help clients create well-rounded portfolios around their goals - with the level of risk and potential for return that makes the most sense for them.

Managed by Mercantile Capital Advisors, Inc., an affiliate of MSD&T, Mercantile Funds utilize an investment foundation based on risk management, in-depth fundamental research and a product line designed to meet clients’ needs.

Real Estate

IWM founded Mercantile Real Estate Advisors, Inc. in 2006 to expand its longstanding commercial real estate investment and management services to Taft-Hartley pension funds.  On behalf of its clients, Mercantile directly invests in properties across the country.

Private Equity

Bankshares, in partnership with MSD&T, began a focused private equity investment initiative in 2000 with two objectives: (1) provide an alternative method of funding to develop additional long-term client relationships with emerging companies in Bankshares’ market area and (2) provide an alternative use of capital to generate long-term returns.  The primary investments are private equity limited partnerships located, or seeking investment opportunities, within Bankshares’ geographic trade area and, to a lesser extent, direct investments in privately held companies within the region.  The private equity funds include small- and middle-market buyout funds, mezzanine funds and late-stage venture funds in which the target investments of the funds are or have the potential to become Bankshares’ customers.  For more information on private equity investments, see Notes No. 1, 6 and 10 in Notes to Consolidated Financial Statements.

5




Statistical Information

The statistical information required in this Item 1 is set forth in Items 6, 7 and 8 of this Annual Report on Form 10-K, as follows.

 

 

Disclosure Required by Guide 3

 

Reference to Caption in Item 6 or 7, or Note in Item 8

 

 

 

 

 

(I)

 

Distribution of Assets, Liabilities and
Stockholders Equity; Interest Rates and

 

Analysis of Interest Rates and Interest Differentials (Item 7)

 

 

Interest Differentials

 

Rate/Volume Analysis (Item 7)

 

 

 

 

Nonperforming Assets (Item 7)

 

 

 

 

 

(II)

 

Investment Portfolio

 

Bond Investment Portfolio (Item 7)

 

 

 

 

Notes to Consolidated Financial Statements, Note No. 3 - Investment Securities

 

 

 

 

 

(III)

 

Loan Portfolio

 

Year-End Loan Data (Item 6)

 

 

 

 

Loan Maturity Schedule (Item 7)

 

 

 

 

Interest Rate Risk (Item 7)

 

 

 

 

Nonperforming Assets (Item 7)

 

 

 

 

 

(IV)

 

Summary of Loan Loss Experience

 

Allowance for Loan Losses (Item 7)

 

 

 

 

Credit Risk Analysis (Item 7)

 

 

 

 

Allocation of Allowance for Loan Losses (Item 7)

 

 

 

 

 

(V)

 

Deposits

 

Analysis of Interest Rates and Interest Differentials (Item 7)

 

 

 

 

Notes to Consolidated Financial Statements, Note No. 7 - Deposits

 

 

 

 

 

(VI)

 

Return on Equity and Assets

 

Return on Equity and Assets (Item 6)

(VII)

 

Short-Term Borrowings

 

Notes to Consolidated Financial Statements, Note No. 8 - Short-Term Borrowings

 

Employees

At February 16, 2007, Bankshares and its affiliates had approximately 3,519 employees.

Competition

The banking business is highly competitive.  Within their service areas, the Banks compete with commercial banks (including local banks and branches or affiliates of other larger banks), savings and loan associations and credit unions for loans and deposits, and with insurance companies and other financial institutions for various types of loans.  There is also competition for commercial and retail banking business from banks and financial institutions located outside our service areas.  Interstate banking is an established part of the competitive environment.  Bankshares is a financial holding company and is the largest independent bank holding company headquartered in Maryland.  Measured in terms of assets under management and administration, MSD&T believes it is one of the larger trust institutions in the mid-Atlantic region of the United States.  MSD&T and its subsidiaries (i.e., Boyd Watterson & Mercantile Capital Advisors, Inc.) compete for various classes of fiduciary and investment advisory business with other banks and trust companies, insurance companies, investment counseling firms, mutual funds and others.  Mercantile Mortgage is one of many competitors in its area of activity.  MBC Agency, Inc. is limited to providing life, health and accident insurance in connection with credit extended by the Banks.

The Banks ranged in asset size from approximately $200 million to $8 billion, at December 31, 2006.  They face competition in their own local service areas as well as from the larger competitors mentioned above.

6




Supervision and Regulation

Bankshares and the Banks
Bankshares, as a registered bank holding company, is subject to regulation and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) under the Bank Holding Company Act of 1956, as amended (the “BHC Act”) and is required to file with the Federal Reserve Board quarterly and annual reports and such additional information as the Federal Reserve Board may require pursuant to the BHC Act.  Among other provisions, the BHC Act and regulations promulgated thereunder require prior approval of the Federal Reserve Board of the acquisition by Bankshares of more than five percent of any class of the voting shares of any bank holding company, bank or savings association.

Capital Adequacy.  The Banks include seven banks chartered by the state of Maryland (two of which are members of the Federal Reserve System), a Delaware-chartered bank, and three national banks (additional information about the chartering of the Banks is contained in The Banks, below).  The Federal Reserve Board, regulator of bank holding companies and state-chartered banks that are members of the Federal Reserve System; the Office of the Comptroller of the Currency (the “OCC”), the federal regulator of national banks; and the Federal Deposit Insurance Corporation (the “FDIC”), federal regulator of state-chartered banks that are not members of the Federal Reserve System and insurer of the deposits of all U.S. commercial banks, have issued substantially similar risk-based and leverage capital guidelines applicable to United States banking organizations.  In addition, these regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels, whether because of its financial condition or actual or anticipated growth.

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), among other things, identifies five capital categories for insured depository institutions (well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized) and requires the respective federal regulatory agencies to implement systems for “prompt corrective action” for insured depository institutions that do not meet minimum capital requirements within such categories.  FDICIA imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the category in which an institution is classified.  Failure to meet the capital guidelines could also subject a banking institution to requirements to raise capital.

The various regulatory agencies have adopted substantially similar regulations that define the five capital categories identified by FDICIA, using the total risk-based capital, Tier 1 risk-based capital and leverage capital ratios as the relevant capital measures.  Such regulations establish various degrees of corrective action to be taken when an institution is considered undercapitalized.  Under the regulations, a “well capitalized” institution must have a Tier 1 risk-based capital ratio of at least six percent, a total risk-based capital ratio of at least ten percent and a leverage ratio of at least five percent and not be subject to a capital directive order.  As of December 31, 2006, the most recent notification from the primary regulators for each of Bankshares’ subsidiary banks categorized them as “well capitalized” under the prompt corrective action regulations.

Changes to the risk-based capital regime for banking organizations are proposed or implemented from time to time. The minimum risk-based capital requirements that are currently in effect for U.S. banking organizations follow the Capital Accord issued in 1988 by the Basel Committee on Banking Supervision, which is comprised of bank supervisors and central banks from the major industrialized countries, including the United States.  The Basel Committee issued a proposed replacement for the 1988 Capital Accord in 2001 (“Basel II”), and work has continued on the details of Basel II and the timing of its implementation since that time.  In the United States, the Basel II framework will only apply to the largest financial institutions.  Following the approval of the Accord, non-Basel II institutions expressed concern that the larger banking organizations would gain unfair advantage through the potentially reduced capital requirements that could be possible under the new framework.  In addition, the regulators recognized that the existing capital system applicable to smaller banks could be improved to better differentiate risk within asset classes.  Therefore, in December 2006, the four federal banking agencies designed a proposal known as Basel I-A to address both of these concerns. The final form of Basel I-A, the timing of its implementation and the impact it might have on Bankshares and its subsidiaries cannot be determined at this time.  Additional information regarding capital requirements for bank holding companies and tables reflecting Bankshares’ regulatory capital position at December 31, 2006 is in Note No. 11 - Shareholders’ Equity of Notes to the Consolidated Financial Statements in Item 8 of this Annual Report.

7




The Gramm-Leach-Bliley Act.  The Gramm-Leach-Bliley Act of 1999 (the “GLB Act”) was adopted on November 12, 1999 and amended several of the federal banking laws, including the BHC Act and the Banking Act of 1933 (generally known as “Glass-Steagall”), that affect Bankshares and its subsidiaries.  Prior to the adoption of the GLB Act, the activities of bank holding companies and their subsidiaries were restricted to banking, the business of managing and controlling banks, and other activities that the Federal Reserve Board had determined were so closely related to banking or managing or controlling banks as to be a proper incident thereto.  In particular, Glass-Steagall and the BHC Act imposed important restrictions on the ability of bank holding companies or their subsidiaries to engage in the securities or insurance business.

The GLB Act repealed the provisions of Glass-Steagall and restrictions in the BHC Act that limited affiliations among, and overlapping business activities between the banking business and, respectively, the securities and insurance industries.  With the adoption of the GLB Act, a bank holding company that makes an effective election to become a “financial holding company” may, within a holding company system, (a) engage in banking, or managing or controlling banks; (b) perform certain servicing activities for subsidiaries; and (c) engage in any activity, or acquire and retain the shares of any company engaged in any activity that is either (i) financial in nature or incidental to such financial activity, as determined by the Federal Reserve Board in consultation with the Secretary of the Treasury or (ii) complementary to a financial activity and that does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally, as determined by the Federal Reserve Board.  Activities that are “financial in nature” include activities specified in the GLB Act and those activities that the Federal Reserve Board had determined, by order or regulation in effect prior to enactment of the GLB Act, to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.  Thus, a financial holding company may engage in a full range of banking, securities and insurance activities, including securities and insurance underwriting, as well as, subject to certain restrictions, merchant banking activities.  The election to become a financial holding company is only available to bank holding companies whose bank and thrift subsidiaries are well capitalized, well managed, and have satisfactory Community Reinvestment Act ratings.

With exceptions for insurance underwriting, merchant banking and real estate investment and development, the GLB Act also permits comparable expansion of national bank activities by banks meeting similar criteria, together with certain additional firewalls and other requirements, through “financial subsidiaries” of national banks.  Similarly, as a matter of Federal law, but still subject to State law, the GLB Act expands the potential financial activities of subsidiaries of State banks.  Bankshares filed an election and, on December 20, 2002, became a financial holding company.

The GLB Act also imposed a general scheme of functional regulation with respect to the activities of bank holding companies and their bank and nonbank subsidiaries to ensure that banking activities are regulated by bank regulators, securities activities are regulated by securities regulators, and insurance activities are regulated by insurance regulators, although the Federal Reserve Board retains its role as the umbrella supervisor for bank holding companies.  Consequently, various securities activities of bank subsidiaries of Bankshares are now subject to regulation by the Securities and Exchange Commission and the National Association of Securities Dealers, Inc.

As a result of the functional regulation imposed by the GLB Act, the Banks have moved certain securities activities that have become subject to Securities and Exchange Commission regulation into separate securities subsidiaries or affiliates.  For example, MSD&T has two subsidiaries that engage in securities activities:  Mercantile Capital Advisors, Inc., a registered investment adviser that advises the Mercantile family of mutual funds and certain other institutional accounts; and Mercantile Brokerage Services, Inc., a registered broker-dealer that facilitates the purchase of shares of mutual funds by bank customers and may engage in certain other activities in the future.

The GLB Act also implements a number of requirements designed to protect the privacy of customer information.  A financial institution must inform its customers at the outset of the customer relationship, and at least annually thereafter, of the institution’s privacy policies and procedures with respect to the customer’s nonpublic personal financial information.  With certain exceptions, an institution may not provide any nonpublic personal information to unaffiliated third parties unless the customer has been informed that such information may be so provided and the customer has been given the opportunity to opt out.  Furthermore, the GLB Act limits a financial institution’s use of a customer’s account information for marketing purposes and imposes criminal penalties for the use of fraudulent or deceptive means to obtain personal customer financial information.  The GLB Act permits states to adopt more rigorous laws with respect to privacy of customer information.

8




The Fair Credit Reporting Act and the Fair and Accurate Transactions Act of 2003.  The Fair Credit Reporting Act (“FCRA”), among other provisions, restricts any bank from sharing with its affiliates certain information relating to its individual customers’ creditworthiness and certain other matters with various exceptions.   FCRA preempts state laws that purport to restrict further such information sharing among affiliated institutions.  The Fair and Accurate Transactions Act of 2003 (the “FACT Act”), which was signed into law on December 4, 2003, amended FCRA in various respects, including to enhance the ability of consumers to combat identity theft, increase the accuracy of consumer credit reports, and allow consumers to exercise greater control over the type and amount of marketing solicitations that they receive.  The new marketing restrictions, with some exceptions, would prevent banks from using certain information received from an affiliate for marketing to a consumer unless the consumer was given notice and an opportunity to opt out.  The FACT Act also restricts the sharing of certain types of consumer medical information among affiliates.  These new restrictions on sharing or using information shared among affiliates must be implemented by regulations, which were issued for public comment.  Certain provisions are currently effective while other provisions have been issued, but have not yet been finalized.  More generally, the Federal Reserve Board and the Federal Trade Commission issued joint final rules establishing December 1, 2004 as the effective date for many of the provisions of the FACT.

In December 2004, implementing section 216 of the FACT Act, the federal bank regulatory agencies announced interagency final rules to require financial institutions to adopt measures for properly disposing of “consumer information” derived from credit reports.  Federal banking law requires financial institutions to protect customer information by implementing information security programs.  The rules adopted by the banking agencies require institutions to make certain adjustments to their information security programs to include measures for the proper disposal of consumer information.  The rules define “consumer information” to mean “any record about an individual, whether in paper, electronic, or other form, that is a consumer report or is derived from a consumer report and that is maintained or otherwise possessed by or on behalf of the [institution] for a business purpose,” and include a compilation of such records, but exclude any record that does not identify an individual.  The rules took effect on July 1, 2005.  Federal regulators have pursued enforcement action against U.S. banks and other entities for failing to properly safeguard customers’ information.

The USA PATRIOT ACT.  Congress adopted the USA PATRIOT ACT (the “Patriot Act”) on October 26, 2001 in response to the terrorist attacks that occurred on September 11, 2001.  Under the Patriot Act, banks are required to maintain and prepare additional records and reports that are designed to assist the government’s efforts to combat terrorism.  The Patriot Act includes sweeping anti-money laundering and financial transparency laws and required additional regulations, including, among other things, standards for verifying client identification when opening an account and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.  Specifically, the customer identification program (“CIP”) regulation issued under the Patriot Act requires each bank to implement a written CIP appropriate for its size and type of business that includes certain minimum requirements. The CIP must be incorporated into the bank’s anti-money laundering compliance program, which is subject to approval by the bank’s board of directors.  The regulation applies to all federally regulated banks and savings associations, credit unions, and non-federally regulated private banks, trust companies, and credit unions. All banks were required to comply with the CIP regulation for all accounts established on or after October 1, 2003.

Interstate Banking.   Pursuant to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Banking and Branching Act”), a bank holding company may acquire banks located in states other than its home state without regard to the permissibility of such acquisitions under state law, but subject to any state requirement that the bank has been organized and operating for a minimum period of time, not to exceed five years, and the requirement that the bank holding company, after the proposed acquisition, controls no more than 10%  of the total amount of deposits of insured depository institutions in the United States and no more than 30% or such lesser or greater amount set by state law of such deposits in that state.

Subject to certain restrictions, the Interstate Banking and Branching Act also authorizes banks to merge across state lines to create interstate banks.  The Interstate Banking and Branching Act also permits a bank to open new branches in a state in which it does not already have banking operations if such state enacts a law permitting de novo branching.

9




Other Regulatory Matters.  Bankshares is a separate and distinct legal entity from its subsidiaries.  It receives substantially all of its revenue from dividends from its subsidiaries and interest payments from the Banks on subordinated debt. These dividends are the principal source of funds to pay dividends on Bankshares’ common stock and interest on its debt. The payment of dividends by a bank is subject to federal law restrictions as well as to the laws of its state of incorporation in the case of a state-chartered bank. Also, a parent company’s right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors.  It is Federal Reserve Board policy that a bank holding company should serve as a source of financial and managerial strength for, and commit resources to support each, of its subsidiary banks even in circumstances in which it might not do so (or may not legally be required or financially able to do so) absent such a policy.

In addition to the specific laws and regulations discussed above, there are numerous federal and state laws and regulations which regulate the activities of Bankshares and the Banks, including requirements and limitations relating to reserves, permissible investments and lines of business, transactions with officers, directors and affiliates, loan limits, consumer protection laws, privacy of financial information, predatory lending, fair lending, mergers and acquisitions, issuances of securities, dividend payments, inter-affiliate liabilities, extensions of credit and branch banking.  The BHC Act and the Federal Reserve Board’s regulations limit the ability of bank subsidiaries of bank holding companies to engage in certain tie-in arrangements with bank holding companies and their nonbank subsidiaries in connection with any extension of credit or provision of any property or services, subject to various exceptions.

The laws and regulations to which Bankshares is subject are constantly under review by Congress, regulatory agencies and state legislatures.  The likelihood and timing of any bank-related proposals or legislation and the impact they might have on Bankshares and its subsidiaries cannot be determined at this time.

As a general matter, the recent regulatory environment for banking organizations has included significant enforcement actions by banking regulators and other federal and state agencies, involving such matters as alleged shortcomings in anti-money laundering policies and procedures, inadequate protection of confidential customer information, and violations of securities or other laws.  As a result of this regulatory environment, banking organizations may experience increases in compliance requirements and associated costs.

 

Changes in control of Bankshares and the Banks are regulated under the BHC Act, the Change in Bank Control Act of 1978 and various state laws.

The Banks

All the Banks, with the exception of The Citizens National Bank, The National Bank of Fredericksburg, Marshall National Bank and Trust Company and Mercantile Peninsula Bank are Maryland banks, subject to the banking laws of Maryland and to regulations issued by the Commissioner of Financial Regulation of the Maryland, Department of Labor Licensing and Regulation who is required by statute to make at least one examination in each calendar year (or at 18-month intervals if the Commissioner determines that an examination is unnecessary in a particular calendar year).  Their deposits are insured by, and they are subject to certain provisions of federal law and regulations and examination by, the FDIC.

10




In addition, The Annapolis Banking and Trust Company and Farmers & Mechanics Bank are members of the Federal Reserve System and are thereby subject to regulation by the Federal Reserve Board.

The Citizens National Bank, The National Bank of Fredericksburg and Marshall National Bank and Trust Company are national banks subject to regulation and regular examination by the OCC in addition to regulation and examination by the FDIC, which insures their deposits.

Mercantile Peninsula Bank is a Delaware bank, subject to the banking laws of Delaware and to regulation by the Delaware State Bank Commissioner, who is required by statute to make periodic examinations.  Its deposits are insured by, and it is subject to certain provisions of federal law and regulation and examination by, the FDIC.

Bankshares and its affiliates are subject to the provisions of Section 23A and Section 23B of the Federal Reserve Act and the Federal Reserve Board’s Regulation W, which implements Sections 23A and 23B.  Section 23A, among other things, limits the amount of loans or extensions of credit by the Banks to, and their investments in, Bankshares and the nonbank affiliates of the Banks, while Section 23B generally requires that transactions between the Banks and Bankshares and its nonbank affiliates be on terms and under circumstances that are substantially the same as with non-affiliates.  Under the cross-guarantee provisions of the Federal Deposit Insurance Act, in the event of a loss suffered or anticipated by the FDIC either as a result of default of a bank subsidiary or related to FDIC assistance provided to a bank subsidiary in danger of default the Banks may be assessed for the FDIC’s loss, subject to certain exceptions.

Other Affiliates

As affiliates of Bankshares, the nonbank affiliates are subject to examination by the Federal Reserve Board and, as affiliates of the Banks, they are subject to examination by the FDIC, the Commissioner of Financial Regulation of Maryland and the OCC, as the case may be.  In addition, MBC Agency, Inc. and Mercantile Life Insurance Company are subject to licensing and regulation by state insurance authorities.  Mercantile Capital Advisors, Inc., Boyd Watterson and Mercantile Brokerage Services, Inc. are subject to regulation by the Securities and Exchange Commission and state securities law authorities, and Mercantile Brokerage Services, Inc. is also subject to regulation by the National Association of Securities Dealers, Inc.  Retail sales of insurance and securities products by Mercantile Brokerage Services, Inc. are also subject to the requirements of the Interagency Statement on Retail Sales of Nondeposit Investment Products promulgated in 1994 by the FDIC, the Federal Reserve Board, the Comptroller of the Currency and the Office of Thrift Supervision.

Effects of Monetary Policy

All commercial banking operations are affected by the Federal Reserve System’s conduct of monetary policy and its policies change from time to time based on changing circumstances.  The Federal Reserve Board effectively controls the supply of bank credit in order to achieve economic results it deems appropriate, including efforts to combat unemployment, recession or inflationary pressures.  Among the instruments of monetary policy used to advance these objectives are open market operations in the purchase and sale of U.S. Government securities, changes in the discount rate charged on bank borrowings and changes in reserve requirements against bank deposits.  These means are used in varying combinations to influence the general level of interest rates and the general availability of credit.  More specifically, actions by the Federal Reserve Board influence the levels of interest rates paid on deposits and other bank funding sources and charged on bank loans as well as the availability of bank funds with which loans and investments can be made.

 

11




Cautionary Statement

This Annual Report on Form 10-K contains forward-looking statements, within the meaning of and pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.  A forward-looking statement encompasses any estimate, prediction, opinion or statement of belief contained in this report and the underlying management assumptions.  These “forward-looking statements” include such words as “believes,” “expects,” “anticipates,” “intends,” “outlook,” “estimate,” “forecast,” “project” and similar expressions.  Examples of forward-looking statements in this Annual Report on Form 10-K are statements concerning competitive conditions, effects of monetary policy, the potential impact of legislation, identification of trends, loan growth, customer borrowing trends, anticipated levels of interest rates, business strategies and services, continuation or development of specified lending and other activities, credit quality, predictions or assessments related to the determination and adequacy of loan loss allowances, monitored loans, internal controls, tax accounting, importance and effects of capital levels, effects of asset sensitivity and interest rates, earnings simulation model projections, efforts to mitigate market and liquidity risks, dividend payments and impact of Financial Accounting Standards Board (“FASB”) pronouncements.  These statements are based on current expectations and assessments of potential developments affecting market conditions, interest rates and other economic conditions, and results may ultimately vary from the statements made in this report.  The following factors, among others, could cause actual results to differ materially from the anticipated results or other expectations expressed in the forward-looking statements: (1) the interest rate environment may further compress margins and adversely affect net interest income; (2) results may be adversely affected by continued diversification of assets and adverse changes in credit quality; (3) economic slowdown could adversely affect credit quality and loan originations; (4) loan growth may not improve to a degree that would help offset continuing pressure on net interest margin; (5) adverse governmental or regulatory policies may be enacted; (6) declines in equity and bond markets may adversely affect IWM revenues; (7) the inability to manage adequately the spread between yields on earning assets and cost of funds could adversely affect results; (8) the merger may be more expensive to complete than anticipated, including as a result of unexpected factors or events; and (9) the integration of Bankshares’ business and operations with those of PNC may take longer than anticipated, may be more costly than anticipated and may have unanticipated adverse results relating to Bankshares’ or PNC’s existing businesses.

Website Access to Information

Bankshares’ annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports may be accessed through Bankshares’ website as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission.  Bankshares’ website is www.mercantile.com.

12




ITEM 1A.      RISK FACTORS

The following is a summary of the risk factors that we believe are most relevant to our business.  These are factors that, individually or in the aggregate, we think could cause our actual results to differ significantly from anticipated or historical results.  You should understand that it is not possible to predict or identify all such factors.  Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.  We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events, or otherwise.  You are advised, however, to consult any further disclosure we make on related subjects in our reports on forms 10-Q and 8-K filed with the SEC.

Bankshares is Subject to Interest Rate Risk

Our earnings depend largely on the relationship between the yield on our interest-earning assets and our cost of funds.  This relationship, known as the interest rate spread, is subject to fluctuation and is affected by economic and competitive factors which influence market interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets.  Fluctuations in market interest rates also affect our customers’ demand for our products and services.  See the sections entitled “Net Interest Income and Net Interest Margin” and “Interest Rate Risk” in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located elsewhere in this report for further discussion related to Bankshares’ management of interest rate risk.

Bankshares is Subject to Lending Risk

There are inherent risks associated with Bankshares’ lending activities.  These risks include, among other things, the impact of changes in interest rates and changes in the economic conditions in the markets in which Bankshares operates.  Increases in interest rates and/or weakening economic conditions could adversely affect the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans.  Commercial loans, including commercial real estate loans are typically subject to a higher credit risk than other types of loans, including residential real estate or consumer loans, because they usually involve larger loan balances to a single borrower and are more susceptible to a risk of default during an economic downturn.  Because Bankshares’ loan portfolio contains a significant number of commercial and industrial, construction and commercial real estate loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in nonperforming loans.  These types of loans are also typically larger than residential real estate loans and consumer loans.   An increase in nonperforming loans could result in a net loss of earnings from these loans, an increase in the provision for possible loan losses and an increase in loan charge offs, all of which could have a material adverse effect on Bankshares’ financial condition and results of operations.  See the section captioned “Loans” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to commercial and industrial, construction and commercial real estate loans.

Bankshares’ Allowance for Possible Loan Losses and Reserve for Unfunded Commitments May Be Insufficient

In an attempt to provide for losses inherent in the loan portfolio, we estimate an allowance for loan and lease losses and reserve for unfunded commitments based on, among other things, national and regional economic conditions, historical loss experience and delinquency trends.  However, we cannot predict loan and lease losses with certainty, and we cannot assure you that charge-offs in future periods will not exceed the allowance for loan and lease losses and reserve for unfunded commitments.  If our allowance for loan and lease losses and reserve for unfunded commitments were not sufficient to cover actual loan and lease losses, our earnings would decrease.  In addition, regulatory agencies, as an integral part of their examination process, review our allowance for loan and lease losses and reserve for unfunded commitments and may require additions to the allowance and/or the reserve based on their judgment about information available to them at the time of their examination.  Factors that require an increase in our allowance for loan and lease losses and reserve for unfunded commitments could reduce our earnings.

13




Bankshares Operates in a Highly Competitive Industry and Market Area

Bankshares faces substantial competition in all areas of its operations from a variety of competitors, many of which are larger and may have more financial resources.  Such competitors primarily include national, regional, and community banks within the various markets in which Bankshares operates.  Bankshares also faces competition from many other types of financial institutions, including, without limitation, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, factoring companies and other financial intermediaries.  The financial services industry could become even more competitive resulting from legislative, regulatory and technological changes and continued consolidation.  Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking.  Additionally, technology has lowered barriers to entry and made it possible for nonbanks to offer products and services traditionally provided by banks, such as automatic funds transfer and automatic payment systems.  Many of Bankshares’ competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than Bankshares can. Bankshares’ ability to compete successfully depends on a number of factors, including, among other things:

·                  The ability to develop, maintain and build upon long-term customer relationships based on top quality service, high ethical standards and safe, sound assets.

·                  The ability to expand Bankshares’ market position.

·                  The scope, relevance and pricing of products and services offered to meet customer needs and demands.

·                  The rate at which Bankshares introduces new products and services relative to its competitors.

·                  Customer satisfaction with Bankshares’ level of service.

·                  Industry and general economic trends.

Failure to perform in any of these areas could significantly weaken Bankshares’ competitive position, which could adversely affect Bankshares’ growth and profitability, which, in turn, could have a material adverse effect on Bankshares’ financial condition and results of operations.

Bankshares is Subject to Extensive Government Regulation and Supervision

Financial institution regulation has been the subject of significant legislation in recent years and may be the subject of further significant legislation in the future, none of which is within our control.  Significant new laws or changes in, or repeals of, existing laws, including with respect to federal and state taxation, may cause our results of operations to differ materially.  Further, federal monetary policy, particularly as implemented through the Federal Reserve, significantly affects credit conditions for our affiliated banks, primarily through open market operations in U.S. government securities and the discount rate for bank borrowings and reserve requirements.  A material change in any of these conditions would have a material impact on our results of operations.  Furthermore, failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on Bankshares’ business, financial condition and results of operations.  While Bankshares has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur.  See the section captioned “Supervision and Regulation” in Item 1 “Business” located elsewhere in this report.

Bankshares’ Controls and Procedures May Fail or Be Circumvented

Management regularly reviews and updates Bankshares’ internal controls, disclosure controls and procedures, and corporate governance policies and procedures.  Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system will be met.  Any failure or circumvention of Bankshares’ controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on Bankshares’ business, results of operations and financial condition.

14




Bankshares May Not Be Able To Attract and Retain Skilled People

Bankshares’ success depends, in large part, on its ability to attract and retain key people.  Competition for the best people in the business conducted by Bankshares can be intense and Bankshares may not be able to hire people or to retain them. The unexpected loss of services of one or more of Bankshares’ key personnel could have a material adverse impact on Bankshares’ business because of their skills, knowledge of Bankshares’ market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.

Bankshares’ Information Systems May Experience an Interruption or Breach in Security

Bankshares relies heavily on communications and information systems to conduct its business.  Any failure, interruption or breach in security of these systems could result in failures or disruptions in Bankshares’ customer relationship management, general ledger, deposit, loan and other systems.  While Bankshares has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed.  The occurrence of any failures, interruptions or security breaches of Bankshares’ information systems could damage Bankshares’ reputation, result in a loss of business, subject Bankshares to additional regulatory scrutiny, or expose Bankshares to civil litigation and possible financial liability, any of which could have a material adverse effect on Bankshares’ financial condition and results of operations.

Bankshares Continually Encounters Technological Change

The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology driven products and services.  The effective use of technology increases efficiency and enables financial institutions to serve customers better and to reduce costs.  Bankshares’ future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in Bankshares’ operations.  Many of Bankshares’ competitors have substantially greater resources to invest in technological improvements.  Bankshares may not be able to effectively implement new technology driven products and services or be successful in marketing these products and services to its customers.  Failure to keep pace successfully with technological change affecting the financial services industry could have a material adverse impact on Bankshares’ business and, in turn, Bankshares’ financial condition and results of operations.

Bankshares is Subject to Claims and Litigation Pertaining to Fiduciary Responsibility

From time to time, customers make claims and take legal action pertaining to Bankshares’ performance of its fiduciary responsibilities.  Whether customer claims and legal action related to Bankshares’ performance of its fiduciary responsibilities are founded or unfounded, if such claims and legal actions are not resolved in a manner favorable to Bankshares they may result in significant financial liability and/or adversely affect the market perception of Bankshares and its products and services as well as affect customer demand for those products and services.  Any financial liability or reputation damage could have a material adverse effect on Bankshares’ business, which, in turn, could have a material adverse effect on Bankshares’ financial condition and results of operations.

Bankshares Relies on Dividends from Its Subsidiaries for Most of Its Revenue

We are a financial holding company and a bank holding company and as a result, much of our income consists of dividends received from our affiliated banks.  This means we rely primarily upon dividends from our affiliated banks to pay dividends to Bankshares’ common stockholders.  Federal and state bank regulations restrict the amounts when our affiliated banks pay dividends directly or indirectly to us, when making any extensions of credit to us, when transferring assets to us and when investing in our stock or securities.  These regulations also prevent us from borrowing from our affiliated banks unless the loans are secured by collateral.  In addition, we cannot assure that our affiliated banks will be able to continue to pay dividends to us at past levels, if at all.  If we do not receive sufficient cash dividends or borrowings from our affiliate banks, we may not have sufficient funds to pay dividends on common stock.

15




Bankshares May Not Be Able to Retain Skilled Personnel in Anticipation of the Planned Merger with PNC

Individual employees may experience uncertainty about their post-merger roles with PNC.  Issues relating to the uncertainty and difficulty of integration or a desire not to remain with PNC after the merger may cause them to voluntarily leave Bankshares for other career opportunities.  Loss of significant numbers of employees, or employees in key positions, could have a detrimental impact on Bankshares’ ability to carry on certain routine business activities.  There are no assurances that Bankshares will be able to find adequate replacements if they do depart.

ITEM 1B. UNRESOLVED STAFF COMMENTS.

There were no unresolved staff comments as of December 31, 2006.

ITEM 2. PROPERTIES.

The main offices of Bankshares and MSD&T are located in a 21-story building at Two Hopkins Plaza in Baltimore, Maryland. Pursuant to a lease agreement, effective as of December 13, 2004, MSD&T agreed to lease up to approximately 179,000 square feet of prime office space and approximately 27,000 square feet of back-office and storage space at Two Hopkins Plaza, for a term of ten years.  At December 31, 2006, MSD&T and Bankshares occupied approximately 206,000 square feet.  The lease agreement contains two five-year renewal options.  The lease agreement requires aggregate annual rent of approximately $4.0 million in 2006.  At December 31, 2006, Bankshares also occupied approximately 132,000 square feet of space in a building located in Linthicum, Maryland, in which its operations and certain other departments are located, and a 7,000 square foot call center facility in Federalsburg, Maryland.  The Linthicum and Federalsburg properties are owned by Bankshares.  Of the 240 banking offices, 110 are owned in fee, 33 are owned subject to ground leases and 97 are leased, with aggregate annual rentals, not including the branch located at Two Hopkins Plaza, of approximately $13.9 million as of December 31, 2006.

ITEM 3. LEGAL PROCEEDINGS.

Between 2001 and 2003, on behalf of either individual plaintiffs or a putative class of plaintiffs, eight separate actions were filed in state and federal court against Community Bank of Northern Virginia (“CBNV”) and other defendants challenging the validity of second mortgage loans the defendants made to the plaintiffs.  All of the cases were either filed in, or removed to, the federal district court for the Western District of Pennsylvania.  In June 2003, the parties to the various actions informed the court that they had reached an agreement in principle to settle the various actions.  On July 17, 2003, the court conditionally certified a class for settlement purposes, preliminarily approved the class settlement, and directed the issuance of notice to the class.

Thereafter, certain plaintiffs who had initially opted out of the proposed settlement and other objectors challenged the validity of the settlement in the district court.  The district court denied their arguments and approved the settlement.  These “opt out” plaintiffs and other objectors appealed the district court’s approval of the settlement to the Third Circuit Court of Appeals.

In August 2005, the Third Circuit reversed the district court’s approval of the settlement and remanded the case to the district court with instructions to consider and address certain specific issues when re-evaluating the settlement.  In July 2006, the settling parties modified the original settlement agreement and submitted the modified settlement agreement to the District Court.  See Note No. 10 - Commitments and Contingencies in Notes to the Consolidated Financial Statements.  Certain individuals who were excluded from the settlement class have filed two actions on behalf of a putative class of plaintiffs alleging claims similar to those raised in the initial filing.  These actions were later consolidated in the Western District of Pennsylvania.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

No matter was submitted during the fourth quarter of the fiscal year covered by this Report to a vote of security holders, which is required to be disclosed pursuant to the instructions contained in the form for this Report.

16




PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

For information regarding market prices, dividends on Bankshares common stock, and the number of Bankshares’ stockholders, see the information set forth under the captions “Dividends” and “Recent Common Stock Prices” in Item 7 of this Annual Report.

Comparison of Five-Year Cumulative Total Return
The following line graph compares cumulative total stockholder return on our common stock with the Standard & Poor’s 500 Index and the Standard & Poor’s Banks Composite Index for the period December 31, 2001 through December 31, 2006.  The graph assumes $100 invested at the closing price on December 31, 2001 and the reinvestment of all dividends.

 

 

 

2001

 

2002

 

2003

 

2004

 

2005

 

2006

 

Bankshares

 

$

100.00

 

$

92.37

 

$

112.68

 

$

132.91

 

$

147.78

 

$

188.94

 

S&P 500

 

100.00

 

77.90

 

100.25

 

111.15

 

116.61

 

135.03

 

S&P Banks Composite Index

 

100.00

 

98.97

 

129.45

 

148.81

 

151.11

 

174.74

 

 

 

 

 

 

2002

 

2003

 

2004

 

2005

 

2006

 

Bankshares

 

 

 

-7.63

%

21.99

%

17.95

%

11.19

%

27.85

%

S&P 500

 

 

 

-22.10

%

28.68

%

10.88

%

4.91

%

15.79

%

S&P Banks Composite Index*

 

 

 

-1.03

%

30.80

%

14.95

%

1.55

%

15.64

%

 


*S5CBNK Index TRA on Bloomberg

17




ITEM 6. SELECTED FINANCIAL DATA.

The following selected financial data for 2006, 2005, 2004, 2003 and 2002 is qualified in its entirety by, and should be read in conjunction with the more detailed information contained in, the Consolidated Financial Statements and Notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Annual Report on Form 10-K.

Five-Year Selected Financial Data

Years Ended December 31,

 

 

 

 

 

 

 

 

 

 

 

(Dollars in thousands, except per share data)

 

2006

 

2005

 

2004

 

2003

 

2002

 

OPERATING RESULTS

 

 

 

 

 

 

 

 

 

 

 

Net interest income

 

$

655,787

 

$

617,126

 

$

545,781

 

$

472,349

 

$

441,035

 

Net interest income - taxable equivalent

 

663,158

 

623,973

 

552,525

 

479,109

 

447,228

 

Provision for credit losses

 

 

1,576

 

7,221

 

12,105

 

16,378

 

Noninterest income

 

254,734

 

243,120

 

213,929

 

183,572

 

144,519

 

Noninterest expense

 

457,389

 

420,821

 

391,958

 

337,447

 

272,608

 

Net income

 

288,286

 

276,319

 

229,407

 

196,814

 

190,238

 

 

 

 

 

 

 

 

 

 

 

 

 

PER COMMON SHARE DATA (1)

 

 

 

 

 

 

 

 

 

 

 

Basic net income

 

$

2.32

 

$

2.28

 

$

1.93

 

$

1.80

 

$

1.82

 

Diluted net income

 

2.30

 

2.26

 

1.92

 

1.79

 

1.81

 

Dividends paid

 

1.10

 

0.99

 

0.92

 

0.86

 

0.79

 

Book value at period end

 

19.25

 

17.81

 

16.12

 

15.39

 

12.83

 

Market value at period end

 

46.79

 

37.63

 

34.80

 

30.39

 

25.73

 

Market range:

 

 

 

 

 

 

 

 

 

 

 

High

 

47.39

 

40.09

 

35.39

 

30.63

 

30.24

 

Low

 

34.29

 

32.27

 

26.87

 

20.11

 

21.38

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE SHEET DATA AT PERIOD END

 

 

 

 

 

 

 

 

 

 

 

Total loans

 

$

12,792,733

 

$

11,607,845

 

$

10,228,433

 

$

9,272,160

 

$

7,312,027

 

Total investment securities

 

3,123,552

 

3,106,287

 

2,928,870

 

3,070,645

 

2,550,491

 

Total assets

 

17,716,025

 

16,421,729

 

14,425,690

 

13,695,472

 

10,790,376

 

Total deposits

 

12,773,891

 

12,077,350

 

10,799,199

 

10,262,553

 

8,260,940

 

Shareholders’ equity

 

2,417,166

 

2,194,722

 

1,917,683

 

1,841,441

 

1,324,358

 

 

 

 

 

 

 

 

 

 

 

 

 

PROFITABILITY RATIOS

 

 

 

 

 

 

 

 

 

 

 

Return on average assets

 

1.69

%

1.78

%

1.64

%

1.64

%

1.88

%

Return on average equity

 

12.31

 

13.18

 

12.26

 

13.15

 

15.12

 

Return on average tangible equity

 

18.40

 

19.54

 

18.00

 

16.55

 

16.69

 

Net interest rate spread - taxable equivalent

 

3.48

 

3.88

 

3.99

 

3.92

 

4.05

 

Net interest margin on earning assets - taxable equivalent

 

4.31

 

4.44

 

4.35

 

4.32

 

4.65

 

Efficiency ratio

 

49.83

 

48.53

 

51.14

 

50.92

 

46.07

 

Cash operating efficiency ratio

 

47.32

 

47.61

 

49.63

 

49.52

 

45.80

 

 

 

 

 

 

 

 

 

 

 

 

 

CAPITAL RATIOS

 

 

 

 

 

 

 

 

 

 

 

Average equity to average assets

 

13.75

%

13.51

%

13.38

%

12.51

%

12.43

%

Average tangible equity to average tangible assets

 

9.82

 

9.70

 

9.70

 

10.34

 

11.45

 

Dividend payout ratio (1)

 

47.41

 

43.42

 

47.67

 

47.78

 

43.41

 

Risk-based capital:

 

 

 

 

 

 

 

 

 

 

 

Tier 1 capital ratio

 

12.02

 

11.82

 

12.33

 

12.46

 

15.00

 

Total capital ratio

 

15.31

 

15.37

 

16.23

 

16.63

 

16.29

 

Leverage ratio

 

10.04

 

9.81

 

10.02

 

9.60

 

11.20

 

 

 

 

 

 

 

 

 

 

 

 

 

Bank offices

 

240

 

240

 

226

 

227

 

185

 

Employees

 

3,544

 

3,606

 

3,479

 

3,565

 

2,885

 

 

 

 

 

 

 

 

 

 

 

 

 

CREDIT QUALITY DATA AT PERIOD END

 

 

 

 

 

 

 

 

 

 

 

Net charge-offs

 

$

815

 

$

991

 

$

13,556

 

$

8,574

 

$

19,240

 

Nonaccrual loans

 

30,960

 

22,565

 

30,898

 

50,352

 

33,371

 

Other real estate owned, net

 

1,405

 

667

 

212

 

191

 

132

 

Total nonperforming assets

 

32,365

 

23,232

 

31,110

 

50,543

 

33,503

 

 

 

 

 

 

 

 

 

 

 

 

 

CREDIT QUALITY RATIOS

 

 

 

 

 

 

 

 

 

 

 

Net charge-offs as a percent of period-end loans

 

0.01

%

0.01

%

0.13

%

0.09

%

0.26

%

Allowance for loan losses as a percent of period-end loans

 

1.12

 

1.35

 

1.46

 

1.68

 

1.90

 

Allowance for loan losses as a percent of nonperforming loans

 

461.98

 

694.32

 

482.24

 

308.50

 

415.33

 

Nonperforming assets as a percent of period-end loans and other real estate owned

 

0.25

 

0.20

 

0.30

 

0.55

 

0.46

 


(1)  On January 10, 2006, Bankshares announced a three-for-two stock split on its common stock.  Per share amounts and other applicable information have been adjusted to give effect to the split.

18




Five-Year Summary of Consolidated Income

Years Ended December 31,

 

 

 

 

 

 

 

 

 

 

 

(Dollars in thousands)

 

2006

 

2005

 

2004

 

2003

 

2002

 

INTEREST INCOME

 

 

 

 

 

 

 

 

 

 

 

Interest and fees on loans

 

$

863,563

 

$

700,832

 

$

546,531

 

$

472,943

 

$

468,678

 

Interest on securities

 

132,115

 

112,769

 

111,003

 

113,254

 

112,091

 

Other interest income

 

3,044

 

2,436

 

1,503

 

3,397

 

4,848

 

Total interest income

 

998,722

 

816,037

 

659,037

 

589,594

 

585,617

 

INTEREST EXPENSE

 

 

 

 

 

 

 

 

 

 

 

Interest on deposits

 

251,118

 

139,917

 

83,403

 

93,190

 

122,569

 

Interest on short-term borrowings

 

55,100

 

26,266

 

7,844

 

5,604

 

11,259

 

Interest on long-term debt

 

36,717

 

32,728

 

22,009

 

18,451

 

10,754

 

Total interest expense

 

342,935

 

198,911

 

113,256

 

117,245

 

144,582

 

NET INTEREST INCOME

 

655,787

 

617,126

 

545,781

 

472,349

 

441,035

 

Provision for credit losses

 

 

1,576

 

7,221

 

12,105

 

16,378

 

NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES

 

655,787

 

615,550

 

538,560

 

460,244

 

424,657

 

NONINTEREST INCOME

 

 

 

 

 

 

 

 

 

 

 

Investment and wealth management

 

110,879

 

95,756

 

90,050

 

78,933

 

68,435

 

Service charges on deposit accounts

 

46,339

 

43,885

 

44,263

 

39,194

 

33,539

 

Other income

 

97,516

 

103,479

 

79,616

 

65,445

 

42,545

 

Total noninterest income

 

254,734

 

243,120

 

213,929

 

183,572

 

144,519

 

NONINTEREST EXPENSES

 

 

 

 

 

 

 

 

 

 

 

Salaries and employee benefits

 

261,926

 

246,397

 

232,297

 

198,043

 

165,371

 

Net occupancy and equipment expenses

 

66,228

 

60,255

 

55,746

 

52,366

 

40,368

 

Other expenses

 

129,235

 

114,169

 

103,915

 

87,038

 

66,869

 

Total noninterest expenses

 

457,389

 

420,821

 

391,958

 

337,447

 

272,608

 

Income before income taxes

 

453,132

 

437,849

 

360,531

 

306,369

 

296,568

 

Provision for income taxes

 

164,846

 

161,530

 

131,124

 

109,555

 

106,330

 

NET INCOME

 

$

288,286

 

$

276,319

 

$

229,407

 

$

196,814

 

$

190,238

 

 

19




ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

I. OVERVIEW

Mercantile Bankshares Corporation (“Bankshares”) is a regional multibank holding company headquartered in Baltimore, Maryland.  At December 31, 2006, Bankshares had $17.7 billion in assets, $12.8 billion in loans and $12.8 billion in deposits.  It is the largest bank holding company headquartered in the state of Maryland.  The two principal lines of business are Banking and Investment & Wealth Management (“IWM”), delivered through the lead bank, Mercantile-Safe Deposit and Trust Company (“MSD&T”), and 10 affiliated banks.  See Segment Reporting in “II. ANALYSIS OF OPERATING RESULTS FOR 2006 TO 2005” in this Item 7 for more information.

On October 8, 2006, Bankshares entered into an Agreement and Plan of Merger with The PNC Financial Services Group, Inc. (“PNC”) pursuant to which Bankshares will merge with and into PNC, with PNC as the surviving corporation in the merger.  When the merger is completed, Bankshares’ stockholders will receive a combination of PNC common stock and cash in exchange for their Bankshares common stock.  Each share of Bankshares common stock will be converted into the right to receive 0.4184 of a share of PNC common stock (including the related preferred stock purchase rights under PNC’s May 2000 Rights Agreement) and $16.45 in cash, without interest.  Under the formula set forth in the merger agreement, an aggregate of up to approximately 54.2 million shares of PNC common stock (and an equal number of related rights) may be issued and $2.13 billion paid in the merger.  This merger was approved by Bankshares’ stockholders on February 27, 2007 and received substantially all of the required regulatory approvals.  The merger is currently expected to close in March of 2007.  Pending the merger, Bankshares must comply with the covenants contained in the merger agreement, but is generally continuing to operate in the ordinary course of business.

During the year ended December 31, 2006, Bankshares expensed $13.1 million, or $9.2 million on an after-tax basis, of costs pursuant to the Merger Agreement with PNC.  These expenses were comprised of $6.8 million of investment banker and legal fees and $6.3 million of compensation-related expenses.

On January 10, 2006, Bankshares announced a three-for-two stock split on its common stock, payable in the form of a stock dividend on January 27, 2006 to stockholders of record as of the close of business on January 20, 2006.  Certain share, average share and per share amounts have been adjusted to give effect to the split.

Bankshares recorded its 31st consecutive year of increased net income in 2006.  Net income for Bankshares was $288.3 million for the year ended December 31, 2006, compared with $276.3 million for the year 2005, representing a 4.3% increase.  Diluted net income per common share for 2006 increased by 1.8% to $2.30 compared with $2.26 for 2005.

On July 17, 2006, Bankshares completed its acquisition of James Monroe, a commercial bank headquartered in Arlington, Virginia, which was merged into MSD&T.  The consideration paid to James Monroe shareholders in connection with the acquisition was comprised of $71.4 million in cash and 1.8 million shares of Bankshares’ common stock.  James Monroe transactions have been included in Bankshares’ financial results subsequent to July 17, 2006.  The assets and liabilities of James Monroe were recorded on the consolidated balance sheet at their respective fair values.  The fair values were determined as of July 17, 2006.  The transaction resulted in total assets acquired as of July 17, 2006 of $552 million, including $414 million in loans and liabilities assumed of $507 million, including $434 million in deposits.  Bankshares recorded $95.4 million of goodwill and $7.8 million of core deposit intangible (“CDI”).  CDI is subject to amortization and is being amortized on an accelerated basis.

The Board of Governors of the Federal Reserve System (“Federal Reserve Board”) increased short-term rates by 100 basis points in 2006 and 200 basis points in 2005.  The net interest margin declined 13 basis points to 4.31% for 2006 from 4.44% for 2005, which compares unfavorably with the increase of nine basis points experienced during 2005.  The net interest margin for 2004 was 4.35%.  The 2006 net interest margin decrease was attributable to a 40 basis point decline in the spread between the yield on earnings assets and the cost of interest-bearing liabilities, which was partially offset by a 27 basis point increase in the benefit derived from noninterest-bearing sources of funds.  Competition to gather deposits increased throughout the year and resulted in higher rates paid on these funds and a flat to inverted yield curve adversely affected the net interest spread.  See “Analysis of Interest Rate and Interest Differentials” and the discussions of “Net Interest Income” and “Interest Rate Risk” found in Item 7 of this report.

20




At December 31, 2006, loans outstanding were $12.8 billion, an increase of 10.2% over the $11.6 billion outstanding at December 31, 2005.  Construction loans at December 31, 2006 were $2.0 billion, an increase of 25.1% from $1.6 billion at December 31, 2005.  Commercial real estate loans were $4.2 billion at December 31, 2006, an increase of 14.5% from $3.7 billion at December 31, 2005.  Residential real estate loans grew by 11.7%.

Total deposits outstanding were $12.8 billion at December 31, 2006, up 5.8% from $12.1 billion outstanding at December 31, 2005.  Average deposit growth was driven primarily by increases in time deposits $100,000 and over, money market and other time deposits, which were up 32.2%, 25.8% and 11.5%, respectively, from the year ended December 31, 2005.  The James Monroe acquisition provided approximately 45.2% of the deposit growth from the year ended December 31, 2005.

Nonperforming loans increased from $22.6 million at December 31, 2005 to $31.0 million at December 31, 2006.  Nonperforming loans as a percent of year-end loans were 0.24% at December 31, 2006.  The allowance for loan losses declined by $13.6 million to $143.0 million for the year ended December 31, 2006 due to the reclassification of a portion of the allowance for loan losses to a reserve for unfunded commitments.

Average shareholders’ equity to average assets was 13.75% for 2006, an increase from 13.51% for 2005.

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 and expenses related to the PNC merger) unrelated to Bankshares’ core operations.  We believe these non-GAAP measures provide information useful to investors in understanding our ongoing core business and operational performance trends.  These measures should not be viewed as a substitute for GAAP.  Management believes presentations of financial measures excluding the impact of certain items provide useful supplemental information and better reflect its core operating activities.  In order to arrive at core business operating results, the effects of certain noncore business transactions, such as gains and losses on the sale of securities, amortization of intangibles, restructuring charges and merger-related expenses, have been excluded.  Management reviews these same measures internally.  For instance, the cash operating efficiency ratio, rather than the GAAP basis efficiency ratio, is used to measure management’s success at controlling ongoing, core operating expenses.  We believe these measures are consistent with how investors and analysts typically evaluate our industry and, by providing these measures, we facilitate their analysis.  Cash operating earnings totaled $302.9 million for 2006, an increase of 8.3% over $279.6 million for 2005.

Additionally, management believes that reporting several key measures based on tangible assets (total assets less intangible assets) and tangible equity (total equity less intangible assets) is important, as this more closely approximates the basis for measuring the adequacy of capital for regulatory purposes.  For the year 2006, the return on average tangible assets was 1.81% compared with 1.89% for 2005.  The ratio of average tangible equity to average tangible assets was 9.82% for 2006 and 9.70% for 2005.  See “Reconciliation of Non-GAAP Measures” for the reconciliation of GAAP measures to non-GAAP measures in the section captioned “II. ANALYSIS OF OPERATING RESULTS FOR 2006 TO 2005” in this Item 7.

The remaining sections of Management’s Discussion and Analysis of Financial Condition and Results of Operations will provide a more detailed explanation of the important trends and material changes in components of our consolidated financial statements.  The discussion suggests that sustaining future earnings growth comparable to our experience in past years will require, among other things, efficient generation of loan growth in a competitive market, while maintaining an adequate spread between yields on earning assets and the cost of funds.  Our degree of success in meeting these goals depends on unpredictable factors such as possible changes in prevailing interest rates, the mix of deposits, credit quality and general economic conditions and the impact of the merger with PNC during 2007.  This discussion and analysis should be read in conjunction with the consolidated financial statements and other financial information presented in this Report.

21




 

NET INCOME

 

DILUTED EARNINGS PER SHARE

(Dollars in millions)

 

(In dollars)

Five —Year Compound Growth Rate: 9.7%

 

Five-Year Compound Growth Rate:  6.2%

 

 

 

 

 

 

 

TOTAL ASSETS

 

INTEREST YIELDS AND RATES    

(Dollars in millions) December 31,

 

(Tax-equivalent basis)

Five-Year Compound Growth Rate:  12.3%

 

 

 

 

22




Critical Accounting Policies
Set forth below is a discussion of the accounting policies and related estimates that management believes are the most critical to understanding Bankshares’ consolidated financial statements, financial condition and results of operations, and which require complex management judgments, uncertainties and/or estimates.  Information regarding Bankshares’ other accounting policies is included in Note No. 1 - Significant Accounting Policies in Notes to Consolidated Financial Statements.

Investment Securities
Investment securities classified as “held-to-maturity” are acquired with the intent and ability to hold until maturity and are carried at amortized cost.  Investment securities classified as “available-for-sale” are acquired to be held for indefinite periods and may be sold in response to changes in interest rates and/or prepayment risk or for liquidity management purposes.  These securities are carried at fair value.  Securities may become impaired on an other-than-temporary basis, which involves a degree of judgment.  Therefore, an assessment is made at the end of each quarter to determine whether there have been any events or economic circumstances to indicate that a security is impaired on an other-than-temporary basis.  An other-than-temporary impairment may develop if, based on all available evidence, the carrying amount of the investment is not recoverable within a reasonable period.  Factors considered in making this assessment include among others, the intent and ability to hold the investment for a period sufficient for a recovery in value, external credit ratings and recent downgrades, market price fluctuations due to factors other than interest rates, and the probability of collection of contractual cash flows.  Securities on which there is an unrealized loss deemed to be other-than-temporary are written down to fair value, and the adjustment is recorded as a realized loss.

Allowance for Loan Losses and Reserve for Unfunded Commitments
Arriving at an appropriate level of allowance for loan losses and reserve for unfunded commitments involves a high degree of judgment.  Bankshares’ allowance for loan losses and reserve for unfunded commitments provide for probable losses based on evaluations of inherent risks in the loan portfolio.  The allowance for loan losses and reserve for unfunded commitments are maintained at a level considered by management to be adequate to absorb losses inherent in the loan portfolio as of the date of the consolidated financial statements.  We have developed appropriate policies and procedures for assessing the adequacy of the allowance for loan losses that reflect management’s careful evaluation of credit risk considering all available information.  Management uses historical quantitative information to assess the adequacy of the allowance for loan losses and reserve for unfunded commitments as well as qualitative information about the prevailing economic and business environment, among other things. In developing this assessment, management must rely on estimates and exercise judgment in assigning credit risk.  Depending on changing circumstances, future assessments of credit risk may yield materially different results from the estimates, which may require an increase or decrease in the allowance for loan losses and reserve for unfunded commitments.

We employ modeling and estimation tools in developing the appropriate allowance and reserve for unfunded commitments.  Bankshares’ allowance consists of formula-based components for business and retail loans, an allowance for impaired loans and an unallocated component.  The following provides a description of each of these components of the allowance, the techniques used and the estimates and judgments inherent in each.  In the first quarter of 2006, management refined the methodologies for the formula-based components to align more appropriately the allowance methodology with our current framework for analyzing credit losses.  Formula-based allowance calculations for business and retail components permit us to address specifically the current trends and events affecting the credit risk in the loan portfolio.  The reserve for unfunded commitments is estimated using the same methodology.

Business loans are comprised of commercial, commercial real estate and construction loans, which are evaluated separately for impairment.  For business loans, the formula-based component of the allowance for loan losses is based on statistical migration estimates of the average losses observed for business loans classified by credit grade. Average losses for each credit grade are computed using the annualized historical rate at which loans in each credit grade have defaulted (probability of default rates or “PD”) and the historical average losses realized for defaulted loans (loss-given-default or “LGD”).  We have developed default rates by analyzing four years of our default experience and more than 14 years of comparable external data.  Default rates, which are validated annually, are estimates derived from long-term averages and are not based on short-term economic or environmental factors.  LGD rates have been developed using industry benchmarks.

23




Retail loans are comprised of consumer installment and residential mortgage loans. For retail loans, the formula-based component of the allowance for loan losses is primarily based on the probability of default rates and LGD rates for specific groups of similar loans by product category.  The probability of default rates are based on four years of our default experience and between 14 and 19 years of comparable industry data.  LGD rates were developed using industry benchmarks.

For both business and retail loans, the formula-based components include additional qualitative amounts to establish reasonable ranges that consider observed historical variability in losses.  Factors we may consider in setting these amounts include, but are not limited to, industry-specific data, portfolio specific risks or concentration and macroeconomic conditions. Including these variability components in the model enables us to capture probable incurred losses that are not yet evident in current default grades, delinquencies and other credit-risk measurement tools.

The specific allowance allocation is based on an analysis of the loan portfolio. Each loan with an outstanding balance in excess of a specified threshold that is either in nonaccrual status or on the “Watchlist” is evaluated. The Watchlist includes loans identified and closely followed by management. These loans possess certain qualities or characteristics that may lead to collection and loss issues. The identified loans are evaluated for potential loss by analyzing current collateral values or present value of cash flows, as well as the capacity of the guarantor, as applicable.  This is in accordance with Financial Accounting Standards Board Statement (“SFAS”) No. 114, “Accounting for Creditors for Impairment of a Loan,” and SFAS No. 118, “Accounting for Creditors for Impairment of a Loan — Income Recognition and Disclosure.”

The allowance for loan losses also contains an unallocated component.  The unallocated allowance recognizes the imprecision inherent in estimating and measuring inherent loss when allocating the allowance to individual, or pools of, loans.  It also takes into consideration the allowance level deemed appropriate by each affiliate based on its local knowledge and input from bank regulators and their view from the standpoint of safety and soundness, among other factors.  The amount of this component and its relationship to the total allowance for loan losses may change from one period to another.

In the first quarter of 2006, we reclassified a portion of the allowance for loan losses to a reserve for unfunded commitments, which is included in the other liabilities section of the consolidated balance sheet.  The modeling process used in the first quarter of 2006 for the determination of the reserve for unfunded lending commitments is consistent with the process described above for the formula-based component of the allowance for loan losses, also including as a key factor a benchmark average rate at which unfunded exposures have been funded at the time of default.  The development of this modeling in 2006 enabled Bankshares to evaluate specifically the risk inherent in unfunded commitments and make the reclassification discussed above.  As no model data existed in previous years, prior period data has not been reclassified for comparability.  During the year ended December 31, 2006, Bankshares reclassified $15.8 million of the allowance for loan losses to the reserve for unfunded commitments.

For a full discussion of Bankshares’ methodology for assessing the adequacy of the allowance for loan losses, see “Allowance for Loan Losses” found elsewhere in Item 7 and Note No. 1 - Significant Accounting Policies in Notes to Consolidated Financial Statements and Note No. 4 — Loans and Allowance for Loan Losses and Reserve for Unfunded Commitments.

Loans in Nonaccrual Status or Deemed to Be Impaired
A loan is placed into nonaccrual status when the principal or interest payments on any loan (e.g., commercial, mortgage and construction loans) are past due 90 days or more at the end of a calendar quarter or the payment in full of principal or interest is not expected.  Any accrued but uncollected interest is reversed at that time.  Consumer installment loans are charged off when they become 90 days past due at the end of the quarter.  Additionally, a loan may be put on nonaccrual status sooner than 90 days, if in management’s judgment, the loan or portion thereof is deemed uncollectible.  Bankshares ceases to accrue interest income on such loans. Subsequent receipts on nonaccrual loans are recorded as a reduction of principal, and interest income is recorded only once principal recovery is reasonably assured.  Generally, a loan may be restored to accrual 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.

24




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.  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 impairment of a loan is measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, or the fair value of the collateral if the repayment is expected to be provided predominantly by the underlying collateral.  A majority of Bankshares’ impaired loans are measured by reference to the fair value of the collateral.

Income Taxes
Bankshares recognizes deferred income tax assets and liabilities for the future tax effects of temporary differences, net operating loss carryovers and tax credits.  Deferred tax assets are subject to management’s judgment, based on available evidence, that future realization is more likely than not.  If management determines that Bankshares may be unable to realize all or part of net deferred tax assets in the future, then Bankshares would be required to record a valuation allowance against such deferred tax asset.  In such an event, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount.  For more information regarding Bankshares’ accounting for income taxes, see Note No. 12 - Income Taxes in Notes to Consolidated Financial Statements.

Valuation of Goodwill/Intangible Assets and Analysis for Impairment
Bankshares has increased its market share, in part, through the acquisition of entire financial institutions accounted for under the purchase method of accounting, as well as from the purchase of other financial institutions’ branches (not the entire institution). Bankshares is required to record assets acquired and liabilities assumed at their fair value, which involves an estimate determined by the use of internal or other valuation techniques.  See Note No. 19 - Goodwill and Intangible Assets in Notes to Consolidated Financial Statements for further information on the accounting for goodwill and other intangible assets.

II. ANALYSIS OF OPERATING RESULTS FOR 2006 TO 2005

Segment Reporting

Bankshares reports two distinct business segments, Banking Services and Investment & Wealth Management (“IWM”), for which financial information is segregated for use in assessing performance and allocating resources when reporting to the Board of Directors.  The Banking Services segment consists of the group of 11 affiliate banks and mortgage-banking activities.  A schedule disclosing the details of these operating segments can be found in Note No. 16 - Segment Reporting in Notes to the Consolidated Financial Statements.  Segment financial information is subjective and, unlike financial accounting, is not necessarily based on GAAP.  As a result, 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.

In the fourth quarter of 2005, the Private Banking Group of MSD&T was consolidated into the Private Banking Group of IWM which is reflected in the segment results below.  For loans and deposits included in the IWM segment, a funds transfer-pricing model was utilized to match the duration of the funding and investment of the IWM segment’s assets and liabilities.

25




Banking Services

The Banking Services segment includes the Retail, Small Business, Commercial and Mortgage Banking lines of business.  Banking products include:

·                  Retail Banking:  Checking, savings and money market accounts, time deposits and IRAs, insurance, equity lines and loans, lines of credit, and equipment and transportation (auto, recreational vehicle and marine) loans.

·                  Small Business Banking:  Deposit and credit products and services to businesses with annual revenues up to $3.0 million or credit needs up to $750.0 thousand, including receivables and inventory financing, equipment leases, and real estate financing.

·                  Commercial Banking:  Commercial deposit, lending and commercial real estate solutions to businesses typically with annual revenues between $4.0 million and $50.0 million, and including commercial loans and lines of credit, letters of credit, asset-based lending, commercial real estate, construction loans, capital market products and insurance.

·                  Mortgage Banking:  Commercial, multifamily and residential mortgage loan origination and servicing.

The following table presents selected Banking segment information for the three years ended December 31, 2006.

(Dollars in thousands)

 

2006

 

2005

 

2004

 

Net interest income

 

$

642,835

 

$

609,758

 

$

534,468

 

Provision for loan losses

 

 

(1,576

)

(7,221

)

Noninterest income

 

120,017

 

132,154

 

114,477

 

Noninterest expenses

 

(352,092

)

(341,543

)

(318,706

)

Adjustments

 

25,683

 

17,610

 

18,098

 

Income before income taxes

 

436,443

 

416,403

 

341,116

 

Income tax expense

 

(152,899

)

(145,044

)

(120,253

)

Net income

 

$

283,544

 

$

271,359

 

$

220,863

 

Average loans

 

$

11,975,089

 

$

10,876,592

 

$

9,591,510

 

Average earning assets

 

15,309,149

 

13,917,161

 

12,576,465

 

Average assets

 

16,785,770

 

15,235,634

 

13,413,992

 

Average deposits

 

12,391,585

 

11,444,361

 

10,323,349

 

Average equity

 

2,072,102

 

1,891,834

 

1,449,355

 

 

The Banking Services segment consists of 11 affiliate banks.  Mortgage banking activities are not viewed as a separate business line due to their insignificant impact on the core business of Bankshares and, accordingly, are included in the Banking segment.

In the third quarter of 2006, Bankshares acquired James Monroe and merged it into the Mercantile Potomac Division of MSD&T.  This acquisition increased our presence in the northern Virginia and Washington, D.C. markets.

The Banking Services segment, which contributed 83.8% of total revenue, continued to experience strong loan and deposit growth.  The Banking Services segment was the primary beneficiary of the James Monroe acquisition.  Net income for Banking Services for 2006 increased 4.5% to $283.5 million from $271.4 million for 2005.

The Banking Services segment operating results improved over 2005, with revenue growth of 2.8% and an expense growth of 0.8%.  Net interest income for Banking Services increased 5.4% to $642.8 million for 2006 from $609.8 million for 2005.  The growth in net interest income in 2006 was largely attributable to a 10.1% increase in average loans outstanding.  See the analysis of net interest income included in the section captioned “Net Interest Income and Net Interest Margin” included elsewhere in this document.

The allowance as a percentage of loans was 1.12% at year-end 2006 compared with 1.35% at year-end 2005.  During 2006, we reclassified $15.8 million of the allowance for loan losses to a reserve for unfunded commitments, which is included in the other liabilities section of the consolidated balance sheet.  The development of this modeling in 2006 enabled Bankshares to evaluate specifically the risk inherent in unfunded commitments and make this reclassification discussed above.

26




Average loans outstanding increased $1.1 billion, or 10.1%, to $12.0 billion for 2006.  The James Monroe acquisition accounted for 36.6% of the increase in average loans outstanding.  Construction loans increased 25.7% as compared with the 2005 average, while commercial real estate increased 13.9% and residential real estate loans increased 8.9%.

Average deposits for Banking increased 8.3% to $12.4 billion in 2006. The James Monroe acquisition provided 45.2% of the deposit growth. Year-over-year average deposit growth was driven primarily by increases in money market, time deposits $100,000 and over and other time deposits, which were up 25.8%, 32.2% and 11.5%, respectively.

Noninterest income decreased $12.1 million to $120.0 million from 2005.  Mortgage banking fees were $8.2 million lower than the prior year due principally to the sale of Columbia National Real Estate Finance, LLC.  Furthermore, gains on sales of bank-owned premises declined $2.6 million from the year ended December 31, 2005.

Noninterest expenses increased $10.5 million over 2005 due primarily to operating expenses of $6.2 million from James Monroe and $9.0 million related to a full year of operating expenses from CBNV.  These increases were partially offset by a reduction of $3.3 million in operating expenses resulting from the sale of Columbia National Real Estate Finance, LLC in the third quarter of 2006.

Investment & Wealth Management

IWM includes Retail Brokerage Services, Private Wealth Management, Institutional Investment Management, Private Banking and Mercantile Funds.  IWM provides a full line of investment products and retirement, tax and estate planning services. IWM products include:

·                  Retail Brokerage Services: Stocks, bonds, proprietary and nonproprietary mutual funds, fixed and variable annuities.

·                  Private Wealth Management Services: Proprietary and nonproprietary mutual funds, proprietary and nonproprietary separate account management, customized wealth advisory services, defined benefit and defined contribution retirement services, family office services, individual and institutional trust services and custody services.

·                  Institutional Investment Management:  Sophisticated investment management and administrative services for employee retirement plans, profit-sharing plans and endowments.

·                  Private Banking Services: Deposits, loans, and mortgages.

·                  Mercantile Funds:  Proprietary stock, taxable and nontaxable fixed income, money market mutual funds and registered hedge funds-of-funds.

The following table presents selected IWM segment information for the three years ended December 31, 2006.

(Dollars in thousands)

 

2006

 

2005

 

2004

 

Net interest income

 

$

13,394

 

$

7,819

 

$

10,172

 

Provision for loan losses

 

 

 

 

Noninterest income

 

111,412

 

95,958

 

90,516

 

Noninterest expenses

 

(88,567

)

(72,929

)

(69,575

)

Adjustments

 

(3,616

)

(3,885

)

(3,603

)

Income before income taxes

 

32,623

 

26,963

 

27,510

 

Income tax expense

 

(13,049

)

(10,785

)

(11,004

)

Net income

 

$

19,574

 

$

16,178

 

$

16,506

 

Average loans

 

$

185,642

 

$

152,572

 

$

127,739

 

Average earning assets

 

185,642

 

152,572

 

127,739

 

Average assets

 

186,226

 

152,941

 

127,949

 

Average deposits

 

316,367

 

199,159

 

175,096

 

Average equity

 

38,997

 

34,354

 

31,219

 

 

In the fourth quarter of 2005, the Private Banking Group of MSD&T was consolidated into the Private Banking Group of IWM which is reflected in the segment results above.    Additionally, as loans and deposits are now included in the IWM segment, a funds transfer-pricing model was utilized to match the duration of the funding and investment of the IWM’s segment assets and liabilities.

27




During the second quarter of 2006, Bankshares’ IWM Real Estate Advisory Unit restructured both its Real Estate Advisory Unit and a major advisory relationship within the unit.  As part of the restructuring, a new registered investment advisor (“RIA”) was formed and IWM’s direct real estate management activities were placed in the RIA.

Net income in IWM increased to $19.6 million in 2006 from $16.2 million in 2005 and pre-tax income increased to $32.6 million in 2006 from $27.0 million in 2005.  The increase was due primarily to the restructuring of a major pension advisory relationship in the IWM Real Estate Advisory Unit and growth in average deposits of $117.2 million.  Pre-tax income from the Real Estate Advisory Unit increased $3.0 million over 2005 and net interest income from Private Banking increased $5.6 million over 2005.  Pretax profit margins, prior to corporate overhead allocation, were 29.0% and 29.7% for 2006 and 2005, respectively.

While equity markets rose during 2006, a slump in the second quarter was followed by a strong recovery in the second half of 2006.  The S&P 500 Index ended 2006 at 1,418, up 13.6% from 1,248 at the end of 2005. Between December 31, 2005 and December 31, 2006, the Dow Jones Industrial Average increased 16.3% to 12,463 and the NASDAQ rose 9.5% to 2,415.  The fixed income markets, as measured by the Lehman Brothers US Aggregate Bond Index, were down 1.0% in 2006. Bankshares’ investment asset base is relatively balanced between equities (including real estate) and fixed income, cash and other securities.  As of December 31, 2006, 43.3% of IWM managed assets were invested in equities, including real estate.  Approximately 37.2% were invested in fixed income securities and 19.5% were invested in cash and other.

 

 

As of December 31,

 

Market Indices

 

2006

 

2005

 

2004

 

Dow Jones Industrial Average

 

12,463

 

10,717

 

10,783

 

Year-over-Year % Change

 

16.3

 

-0.6

 

3.1

 

S&P 500 Index-period-end

 

1,418

 

1,248

 

1,214

 

Year-over-Year % Change

 

13.6

 

2.8

 

9.0

 

Nasdaq

 

2,415

 

2,205

 

2,175

 

Year-over-Year % Change

 

9.5

 

1.4

 

8.6

 

Lehman Brothers U.S. Aggregate Bond Index

 

101.0

 

101.9

 

104.6

 

Year-over-Year % Change

 

-1.0

 

-2.5

 

-1.3

 

 

IWM total revenues increased $21.0 million, or 20.3%, to $124.8 million in 2006 from $103.8 million in 2005.  Year-over-year revenue growth exceeded 10.0% in Institutional Management (driven by the restructuring of a major advisory relationship in Bankshares’ IWM Real Estate Advisory Unit), the Private Bank, in Hedge Funds and in Brokerage.

Private Wealth Management benefited from the rise in equity markets during 2006 and a fee increase on some accounts at the beginning of 2006.  Net new business was down from 2005 driven by higher terminations on small accounts due partly to the fee increase.

Institutional Investment Management benefited principally from the restructuring of a major real estate pension advisory relationship.  The impact of this change was to increase revenues $10.2 million year-over-year.  Revenue declined in our Boyd Watterson Asset Management subsidiary primarily due to lower equity assets under management.  Higher terminations in our institutional business continued to impede non-real-estate institutional revenue growth in 2006, evidenced by the loss of a $6.5 billion institutional custody account in the third quarter of 2006.

The Mercantile Funds benefited from higher asset flows into the funds, improved equity markets, and strong performance in the hedge funds-of-funds.  The Mercantile Funds’ assets increased $305 million, or 7.7 %, to $4.3 billion, driven by an 8.7% increase in personal trust assets at December 31, 2006 compared with December 31, 2005.

Brokerage commissions and income benefited from growth in the number of accounts and assets held in accounts. Brokerage assets increased $227 million, or 24%, to $1.2 billion at December 31, 2006 compared with December 31, 2005. In the table on the following page, Mutual Fund assets and Brokerage assets have been allocated to Personal and Institutional.

Private Banking revenues benefited from $33.1 million in loan growth and $117.2 million in deposit growth during 2006.

28




In 2006, noninterest expenses increased 21.4%, or $15.6 million, to $88.6 million, compared with $72.9 million in 2005. The restructuring of a major real estate pension advisory relationship increased expenses by $6.1 million over 2005.

 

 

Year ended December 31,

 

(Dollars in billions)

 

2006

 

2005

 

2004

 

Personal

 

 

 

 

 

 

 

Assets with Investment Responsibility

 

$

9.4

 

$

8.7

 

$

8.7

 

Assets with No Investment Responsibility

 

4.4

 

3.8

 

3.6

 

Total Personal

 

13.8

 

12.5

 

12.3

 

Institutional

 

 

 

 

 

 

 

Assets with Investment Responsibility

 

11.4

 

11.6

 

12.2

 

Assets with No Investment Responsibility

 

17.8

 

22.1

 

23.1

 

Total Institutional

 

29.2

 

33.7

 

35.3

 

Mutual Funds Not included Above

 

0.3

 

0.3

 

0.2

 

Total

 

 

 

 

 

 

 

Assets with Investment Responsibility

 

21.1

 

20.6

 

21.1

 

Assets with No Investment Responsibility

 

22.2

 

25.9

 

26.7

 

Total Assets Under Administration

 

$

43.3

 

$

46.5

 

$

47.8

 

 

At December 31, 2006, assets under administration by IWM were $43.3 billion, a decrease of $3.2 billion, or 6.9%, from the prior year due to the loss of a $6.5 billion institutional custody account in the third quarter of 2006.  Bankshares had investment responsibility for $21.1 billion, an increase of $0.5 billion, or 2.4%, compared with the prior year.

29




Bankshares Earnings Performance

ANALYSIS OF INTEREST RATES AND INTEREST DIFFERENTIALS

The following table presents the distribution of the average consolidated balance sheets, interest income/expense and yields earned and rates paid.

 

 

2006

 

2005

 

(Dollars in thousands)

 

Average
Balance

 

Income (1)
/ Expense

 

Yield (1)
/ Rate

 

Average
Balance

 

Income (1)
/ Expense

 

Yield (1)
/ Rate

 

Earning assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans: (2),(4)

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial

 

$

2,948,882

 

$

221,592

 

7.51

%

$

2,900,598

 

$

186,462

 

6.43

%

Commercial real estate

 

3,922,356

 

277,957

 

7.09

 

3,444,921

 

226,356

 

6.57

 

Construction

 

1,851,632

 

152,667

 

8.24

 

1,473,353

 

102,484

 

6.96

 

Residential real estate

 

1,918,257

 

119,146

 

6.21

 

1,761,955

 

105,312

 

5.98

 

Home equity lines

 

480,747

 

37,349

 

7.77

 

507,153

 

30,692

 

6.05

 

Consumer

 

1,039,138

 

60,254

 

5.80

 

941,571

 

54,283

 

5.77

 

Total loans

 

12,161,012

 

868,965

 

7.15

 

11,029,551

 

705,589

 

6.40

 

Federal funds sold, et al

 

54,274

 

3,041

 

5.60

 

51,826

 

2,434

 

4.70

 

Securities: (3)

 

 

 

 

 

 

 

 

 

 

 

 

 

Taxable securities

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury securities

 

418,560

 

16,718

 

3.99

 

494,763

 

17,906

 

3.62

 

U.S. Government agencies securities

 

963,618

 

36,777

 

3.82

 

922,597

 

30,143

 

3.27

 

Mortgage-backed securities

 

1,659,106

 

72,997

 

4.40

 

1,418,144

 

59,084

 

4.17

 

Other investments

 

63,024

 

2,682

 

4.26

 

63,067

 

2,497

 

3.96

 

Tax-exempt securities

 

 

 

 

 

 

 

 

 

 

 

 

 

States and political subdivisions

 

78,727

 

4,910

 

6.24

 

87,992

 

5,229

 

5.94

 

Total securities

 

3,183,035

 

134,084

 

4.21

 

2,986,563

 

114,859

 

3.85

 

Interest-bearing deposits in other banks

 

200

 

3

 

1.53

 

197

 

2

 

1.21

 

Total earning assets

 

15,398,521

 

1,006,093

 

6.53

 

14,068,137

 

822,884

 

5.85

 

Cash and due from banks

 

310,843

 

 

 

 

 

309,646

 

 

 

 

 

Bank premises and equipment, net

 

140,659

 

 

 

 

 

143,177

 

 

 

 

 

Other assets

 

1,329,592

 

 

 

 

 

1,154,561

 

 

 

 

 

Less: allowance for loan losses

 

(147,352

)

 

 

 

 

(154,502

)

 

 

 

 

Total assets

 

$

17,032,263

 

 

 

 

 

$

15,521,019

 

 

 

 

 

Interest-bearing liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

Savings

 

$

1,246,877

 

6,339

 

0.51

 

$

1,428,445

 

5,545

 

0.39

 

Checking plus interest accounts

 

1,272,953

 

2,655

 

0.21

 

1,399,215

 

2,367

 

0.17

 

Money market

 

2,077,613

 

56,967

 

2.74

 

1,651,513

 

23,036

 

1.39

 

Time deposits $100,000 and over

 

2,150,857

 

97,801

 

4.55

 

1,627,194

 

51,714

 

3.18

 

Other time deposits

 

2,388,767

 

87,356

 

3.66

 

2,142,068

 

57,255

 

2.67

 

Total interest-bearing deposits

 

9,137,067

 

251,118

 

2.75

 

8,248,435

 

139,917

 

1.70

 

Short-term borrowings

 

1,435,082

 

55,100

 

3.84

 

1,105,988

 

26,266

 

2.37

 

Long-term debt

 

682,324

 

36,717

 

5.38

 

749,196

 

32,728

 

4.37

 

Total interest-bearing funds

 

11,254,473

 

342,935

 

3.05

 

10,103,619

 

198,911

 

1.97

 

Noninterest-bearing deposits

 

3,236,404

 

 

 

 

 

3,165,320

 

 

 

 

 

Other liabilities and accrued expenses

 

199,289

 

 

 

 

 

155,663

 

 

 

 

 

Total liabilities

 

14,690,166

 

 

 

 

 

13,424,602

 

 

 

 

 

Shareholders’ equity

 

2,342,097

 

 

 

 

 

2,096,417

 

 

 

 

 

Total liabilities & shareholders’ equity

 

$

17,032,263

 

 

 

 

 

$

15,521,019

 

 

 

 

 

Net interest rate spread

 

 

 

$

663,158

 

3.48

%

 

 

$

623,973

 

3.88

%

Effect of noninterest-bearing funds

 

 

 

 

 

0.83

 

 

 

 

 

0.56

 

Net interest margin on earning assets

 

 

 

 

 

4.31

%

 

 

 

 

4.44

%

Tax-equivalent adjustment included in:

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan income

 

 

 

$

5,402

 

 

 

 

 

$

4,757

 

 

 

Investment securities income

 

 

 

1,969

 

 

 

 

 

2,090

 

 

 

Total

 

 

 

$

7,371

 

 

 

 

 

$

6,847

 

 

 

 

30




 

 

 

2004

 

2003

 

(Dollars in thousands)

 

Average
Balance

 

Income (1)
/ Expense

 

Yield (1)
/ Rate

 

Average
Balance

 

Income (1)
/ Expense

 

Yield (1)
/ Rate

 

Earning assets

 

 

 

 

 

 

 

 

 

 

 

 

 

Loans: (2),(4)

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial

 

$

2,725,452

 

$

145,170

 

5.33

%

$

2,478,707

 

$

135,186

 

5.45

%

Commercial real estate

 

2,927,968

 

173,626

 

5.93

 

2,316,627

 

142,166

 

6.14

 

Construction

 

1,144,044

 

62,508

 

5.46

 

929,939

 

50,324

 

5.41

 

Residential real estate

 

1,643,504

 

98,596

 

6.00

 

1,350,034

 

88,292

 

6.54

 

Home equity lines

 

450,244

 

20,222

 

4.49

 

311,037

 

13,899

 

4.47

 

Consumer

 

828,197

 

50,940

 

6.15

 

702,638

 

47,973

 

6.83

 

Total loans

 

9,719,409

 

551,062

 

5.67

 

8,088,982

 

477,840

 

5.91

 

Federal funds sold, et al

 

59,848

 

1,501

 

2.51

 

250,462

 

3,337

 

1.33

 

Securities: (3)

 

 

 

 

 

 

 

 

 

 

 

 

 

Taxable securities

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Treasury securities

 

741,127

 

28,710

 

3.87

 

1,021,513

 

41,233

 

4.04

 

U.S. Government agencies securities

 

810,014

 

28,554

 

3.53

 

709,519

 

32,399

 

4.57

 

Mortgage-backed securities

 

1,250,947

 

48,159

 

3.85

 

927,235

 

36,135

 

3.90

 

Other investments

 

57,193

 

2,389

 

4.18

 

20,804

 

807

 

3.88

 

Tax-exempt securities

 

 

 

 

 

 

 

 

 

 

 

 

 

States and political subdivisions

 

94,308

 

5,404

 

5.73

 

69,888

 

4,543

 

6.50

 

Total securities

 

2,953,589

 

113,216

 

3.83

 

2,748,959

 

115,117

 

4.19

 

Interest-bearing deposits in other banks

 

158

 

2

 

1.17

 

9,085

 

60

 

0.66

 

Total earning assets

 

12,733,004

 

665,781

 

5.23

 

11,097,488

 

596,354

 

5.37

 

Cash and due from banks

 

291,540

 

 

 

 

 

266,173

 

 

 

 

 

Bank premises and equipment, net

 

141,368

 

 

 

 

 

118,071

 

 

 

 

 

Other assets

 

985,222

 

 

 

 

 

637,461

 

 

 

 

 

Less: allowance for loan losses

 

(158,163

)

 

 

 

 

(147,612

)

 

 

 

 

Total assets

 

$

13,992,971

 

 

 

 

 

$

11,971,581

 

 

 

 

 

Interest-bearing liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

Deposits:

 

 

 

 

 

 

 

 

 

 

 

 

 

Savings

 

$

1,425,423

 

4,197

 

0.29

 

$

1,168,074

 

4,702

 

0.40

 

Checking plus interest accounts

 

1,289,295

 

1,899

 

0.15

 

1,071,877

 

2,061

 

0.19

 

Money market

 

1,571,462

 

9,584

 

0.61

 

1,357,234

 

9,757

 

0.72

 

Time deposits $100,000 and over

 

1,314,423

 

26,101

 

1.99

 

1,272,327

 

29,464

 

2.32

 

Other time deposits

 

1,933,799

 

41,622

 

2.15

 

1,852,622

 

47,206

 

2.55

 

Total interest-bearing deposits

 

7,534,402

 

83,403

 

1.11

 

6,722,134

 

93,190

 

1.39

 

Short-term borrowings

 

932,493

 

7,844

 

0.84

 

851,348

 

5,604

 

0.66

 

Long-term debt

 

645,375

 

22,009

 

3.41

 

517,386

 

18,451

 

3.57

 

Total interest-bearing funds

 

9,112,270

 

113,256

 

1.24

 

8,090,868

 

117,245

 

1.45

 

Noninterest-bearing deposits

 

2,879,290

 

 

 

 

 

2,269,720

 

 

 

 

 

Other liabilities and accrued expenses

 

129,741

 

 

 

 

 

113,848

 

 

 

 

 

Total liabilities

 

12,121,301

 

 

 

 

 

10,474,436

 

 

 

 

 

Shareholders’ equity

 

1,871,670

 

 

 

 

 

1,497,145

 

 

 

 

 

Total liabilities & shareholders’ equity

 

$

13,992,971

 

 

 

 

 

$

11,971,581

 

 

 

 

 

Net interest rate spread

 

 

 

$

552,525

 

3.99

%

 

 

$

479,109

 

3.92

%

Effect of noninterest-bearing funds

 

 

 

 

 

0.36

 

 

 

 

 

0.40

 

Net interest margin on earning assets

 

 

 

 

 

4.35

%

 

 

 

 

4.32

%

Tax-equivalent adjustment included in:

 

 

 

 

 

 

 

 

 

 

 

 

 

Loan income

 

 

 

$

4,531

 

 

 

 

 

$

4,897

 

 

 

Investment securities income

 

 

 

2,213

 

 

 

 

 

1,863

 

 

 

Total

 

 

 

$

6,744