-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, SrHQ0qJI2XhEadbK+M2KZrAZFEutGFnVXzveiuV1XJ5qvsLZyRY+IC6lkbUrp1Kw IPw6OhU1muYb9e8Y/2e8wA== 0000950124-04-000931.txt : 20040315 0000950124-04-000931.hdr.sgml : 20040315 20040315122132 ACCESSION NUMBER: 0000950124-04-000931 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 20031231 FILED AS OF DATE: 20040315 FILER: COMPANY DATA: COMPANY CONFORMED NAME: CITIZENS BANKING CORP CENTRAL INDEX KEY: 0000351077 STANDARD INDUSTRIAL CLASSIFICATION: NATIONAL COMMERCIAL BANKS [6021] IRS NUMBER: 382378932 STATE OF INCORPORATION: MI FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 000-10535 FILM NUMBER: 04668466 BUSINESS ADDRESS: STREET 1: ONE CITIZENS BANKING CTR STREET 2: 328 SOUTH SAGINAW STREET CITY: FLINT STATE: MI ZIP: 48502 BUSINESS PHONE: (989) 776-7568 MAIL ADDRESS: STREET 1: 1 CITIZENS BANKING CENTER STREET 2: 328 SOUTH SAGINAW STREET CITY: FLINT STATE: MI ZIP: 48502 FORMER COMPANY: FORMER CONFORMED NAME: CB WEALTH MANAGEMENT N A DATE OF NAME CHANGE: 20020502 FORMER COMPANY: FORMER CONFORMED NAME: CITIZENS BANKING CORP DATE OF NAME CHANGE: 19920703 10-K 1 k82546e10vk.txt ANNUAL REPORT FOR FISCAL YEAR ENDED 12/31/03 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K |X| Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2003. or | | 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 000-10535 CITIZENS BANKING CORPORATION (Exact name of Registrant as specified in its charter) MICHIGAN 38-2378932 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 328 S. Saginaw Street, Flint, Michigan 48502 (Address of Principal Executive Offices) (ZIP Code)
Registrant's telephone number, including area code: (810) 766-7500 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, NO PAR VALUE PREFERRED STOCK PURCHASE RIGHTS 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 | | 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 an accelerated filer (as defined in Rule 12b-2 of the Act). Yes |X| No | | The aggregate market value of the voting common stock held by non-affiliates of the Registrant as of June 30, 2003 was $1,145,854,413. The number of shares outstanding of the Registrant's no par value Common Stock as of February 27, 2004 was 43,367,509. DOCUMENTS INCORPORATED BY REFERENCE Portions of Citizens Banking Corporation's 2003 Annual Report to Shareholders are incorporated by reference into Part I and II of this Annual Report on Form 10-K. Portions of Citizens Banking Corporation's Proxy Statement for its annual meeting of shareholders to be held April 22, 2004 are incorporated by reference into Part III of this Annual Report on Form 10-K. 1 CITIZENS BANKING CORPORATION 2003 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS
Page ---- PART I Item 1. Business ......................................................................................... 3 Item 2. Properties ....................................................................................... 11 Item 3. Legal Proceedings ................................................................................ 11 Item 4. Submission of Matters to a Vote of Security Holders .............................................. 11 PART II Item 5. Market for the Registrant's Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities............................................................................ 12 Item 6. Selected Financial Data .......................................................................... 13 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ............ 13 Item 7A. Quantitative and Qualitative Disclosures about Market Risk ....................................... 13 Item 8. Financial Statements and Supplementary Data ...................................................... 13 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.............. 13 Item 9A. Controls and Procedures........................................................................... 13 PART III Item 10. Directors and Executive Officers of the Registrant ............................................... 14 Item 11. Executive Compensation ........................................................................... 14 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters......................................................................................... 14 Item 13. Certain Relationships and Related Transactions ................................................... 14 Item 14 Principal Accountant Fees and Services............................................................ 14 PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K ................................. 15 SIGNATURES .................................................................................................. 16 EXHIBIT INDEX.................................................................................................. 18
2 PART I ITEM 1. BUSINESS Unless the context indicates otherwise, all references in this Form 10-K to "Citizens," the "Company," "our," "us" and "we" refer to Citizens Banking Corporation and its subsidiaries. Our common stock is traded on the National Market tier of the Nasdaq Stock Market under the symbol "CBCF." Our principal executive offices are located at 328 South Saginaw Street, Flint, Michigan 48502, and our telephone number is (810) 766-7500. We maintain an internet website at www.citizensonline.com where our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports are available without charge, as soon as reasonably practicable after we file each such report with, or furnish it to, the U.S. Securities and Exchange Commission. The information in our website does not constitute a part of this Form 10-K. GENERAL Citizens Banking Corporation, incorporated in the State of Michigan in 1980, is a diversified banking and financial services company that is registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. We provide a full range of banking and financial services to individuals and businesses through our Citizens Bank and F&M Bank subsidiaries. We also provide wealth management services through Citizens Bank Wealth Management, N.A., and through affiliate trust departments of F&M Bank - Wisconsin and F&M Bank - Iowa. We operate in the following three major business segments: - - Commercial Banking - Commercial Banking provides a full range of credit and related financial services to a wide range of middle-market corporate, small business, government and leasing clients. Products and services offered include commercial loans, commercial mortgages, small business loans, letters of credit, deposit accounts, treasury management and international trade services. We extend credit to clients within the commercial, commercial mortgage, real estate construction and lease financing categories. - - Consumer Banking - Consumer Banking includes consumer lending and deposit gathering, electronic banking and residential mortgage loan origination and servicing. This line of business offers a variety of retail financial products and services including deposit accounts, direct and indirect installment loans, debit and credit cards, home equity lines of credit, residential mortgage loans, fixed and variable annuities and ATM network services. Consumer loans are primarily composed of automobile, personal, marine, recreational vehicle, home equity and credit card loans. - - Wealth Management - Wealth Management provides services to both our business and consumer clients. Wealth Management focuses on high net-worth customers and offers a broad array of asset management, estate settlement and administration, deposit and credit products. Trust and investment services include personal trust and planning services, investment management services, estate settlement and administration services and investment advisory services for the Golden Oak family of mutual funds, which we distribute through our banking offices. Retirement plan services focus on investment management and fiduciary activities with special emphasis on 401(k) plans. The brokerage and insurance businesses deliver retail mutual funds, other securities, variable and fixed annuities, personal disability and life insurance products and discounted brokerage services. In the fourth quarter of 2003, we announced a major expansion in Oakland County, located in Southeast Michigan, one of the wealthiest counties in the nation. We intend to invest up to $35 to $40 million and to open as many as 10 to 14 new branches, including two hub offices over the next 24 months. This initiative will significantly add to the Bank's current Oakland County presence of six branches and four financial centers and increase staff by up to 180 employees. The first hub office, located in Troy, opened in January 2004. As of December 31, 2003, we had 2,342 full-time equivalent employees and conducted our operations through 176 banking offices, 194 ATM locations and 29 brokerage centers located in Michigan, Wisconsin, Iowa and Illinois. In Michigan, the primary market includes much of the lower peninsula of the state. In Wisconsin, the primary market area is the Fox Valley region, extending from Green Bay to Appleton to Oshkosh, as well as northeastern and southwestern Wisconsin. Other market areas are central Iowa and the western suburban market of Chicago, Illinois. Many of our offices are located in small cities and rural areas that have diverse economies and a mix of manufacturing, service, retailing and agricultural businesses. In many of these localities, we are the largest bank, which we believe to be a competitive advantage. 3 At December 31, 2003 we directly or indirectly owned the following subsidiaries:
- -------------------------------------------------------------------------------------------------- Total Date Principal Number of Assets Acquired/ Subsidiary Office Offices (in millions) Established - ------------------------------------- ---------------- --------- ------------- ----------- Citizens Bank (a) Flint, MI 113 $5,476.0 01/01/82 Citizens Bank - Illinois, N.A. Berwyn, IL 3 187.2 05/01/87 F&M Bancorporation, Inc. Kaukauna, WI 11/01/99 F&M Bank - Wisconsin (a) Kaukauna, WI 50 1,638.3 01/03/00 F&M Bank - Iowa (a) Marshalltown, IA 10 460.2 11/01/99 Citizens Bank Wealth Management, N.A. Flint, MI (b) (b) 03/01/02 - --------------------------------------------------------------------------------------------------
(a) Consolidated totals of the Bank include its non-bank subsidiaries. (b) Citizens Bank Wealth Management conducts business at most Citizens Bank locations and had total assets under administration of $2.866 billion at December 31, 2003. Citizens Bank, our principal bank subsidiary, directly owned the following non-bank subsidiaries: - CB Financial Services, Inc. (100% owned) - a seller of life insurance and annuity products to clients subject to certain restrictions, - Citizens Bank Mortgage Company, LLC (99% owned) - a provider of mortgage financing and servicing to individuals and businesses, - Citizens Title Services, Inc. (100% owned) - an issuer of title insurance to buyers and sellers of residential and commercial mortgage properties including those occurring due to loan refinancing, - Citizens Commercial Leasing Corporation (100% owned) - a participant in high quality indirect lease participations, - Citizens Service Company, Inc (100% owned) - a holding company owning 1% of Citizens Bank Consumer Finance, LLC and 1% of Citizens Bank Mortgage Company, LLC., - Citizens Bank Consumer Finance, LLC (99% owned) - a partnership established to provide indirect consumer lending services to clients in Citizens' markets, and - CB Capital Management, Inc. (100% owned) - a registered broker-dealer for our Golden Oak mutual funds. F&M Bank - Wisconsin directly owned Pulaski Capital Corporation, a wholly owned nonbank subsidiary organized and existing under the laws of the State of Nevada that holds and manages the majority of F&M Bank - Wisconsin's investment portfolio. F&M Bank - Iowa directly owned Security Bancservices, Inc, a wholly owned non-bank subsidiary that sells property and casualty insurance to clients in the Wisconsin and Iowa markets. Our loan sales and securitization activities are conducted within our subsidiary banks. Our bank in Michigan has been the bank that has coordinated and executed such transactions on behalf of our other subsidiaries. We sell substantially all of the fixed-rate single-family mortgage loans we originate, including adjustable-rate loans that convert to fixed-rate loans. These sales are accomplished through cash sales to Federal Home Loan Mortgage Corporation ("FHLMC"), Federal National Mortgage Association ("FNMA") and other third-party investors, as well as through securitizations with FHLMC and FNMA. In general, mortgage-backed securities ("MBSs") received from FHMLC or FNMA in exchange for fixed-rate mortgage loans are sold immediately in the securities market. From time to time, we also exchange fixed and variable rate mortgage loans held in portfolio for FHLMC or FNMA MBSs backed by the same loans. The resulting MBSs are sold to third party investors or classified as held for sale in our investment security portfolio. If MBSs are retained in the investment portfolio, any gain or loss at time of sale is recorded as a security gain or loss. All other gains or losses associated with sales of single-family mortgage loans are recorded as a component of mortgage banking revenue. Typically, we do not service the loans after they are sold or exchanged, but sell the mortgage servicing rights, in a separate transaction, before or at the time of the securitization. Sales or securitizations of mortgage loans through FHLMC and FNMA are done under terms that do not provide for any material recourse to us by the investor. We do not retain any interest in these securitized mortgage loans. 4 PRINCIPAL SOURCES OF REVENUE The primary source of our revenue is interest income. The table below shows the amount of our total consolidated revenues resulting from interest and fees on loans, interest and dividends on investment securities and other interest and noninterest income for each of the last three years:
Year Ended December 31, ------------------------------ (in thousands) 2003 2002 2001 - ----------------------------------------------- -------- -------- -------- Interest and fees on loans $323,739 $385,812 $492,437 Interest and dividends on investment securities 82,133 76,748 79,348 Other interest and noninterest income 94,924 102,600 119,255 -------- -------- -------- Total revenues $500,796 $565,160 $691,040 ======== ======== ========
LINES OF BUSINESS Our performance is monitored by an internal profitability measurement system that provides line of business results and key performance measures. We operate along three major business lines: Commercial Banking, Consumer Banking and Wealth Management. Additional information regarding our business lines is incorporated herein by reference from Exhibit 13 on pages 47 and 48, and on pages 96 through 97 of such document under the captions, "Line of Business Results" and "Note 20. Lines of Business", respectively. COMPETITION The financial services industry is highly competitive. Our banking subsidiaries compete with other commercial banks, many of which are subsidiaries of other bank holding companies, for loans, deposits, trust accounts and other business on the basis of interest rates, fees, convenience and quality of service. Major competitors include banking subsidiaries of Bank One Corporation, Comerica Incorporated, National City Corporation, Fifth Third Bancorp, Marshall and Ilsley Corporation and Associated Banc-Corp, among others. They also actively compete with a variety of other financial service organizations including community banks, savings associations, finance companies, mortgage banking companies, brokerage firms, credit unions and other organizations. The non-banking subsidiaries compete with other companies in related industries including other leasing companies, title insurance companies, mortgage banking companies, insurance companies, consumer finance companies and other organizations. Mergers between financial institutions and the expansion of financial institutions both within and outside of our primary Midwest banking markets have provided significant competitive pressure in those markets. In addition, the passage of Federal interstate banking legislation has expanded the banking market and heightened competitive forces. The effect of this legislation is further discussed under the caption "Supervision and Regulation". Many of our offices are located in small cities and rural areas that have diverse economies and a mix of manufacturing, service, retailing and agricultural businesses. In many of these localities, we are the largest bank, which we believe to be a competitive advantage. In other markets our competitors may enjoy a competitive advantage, including greater financial resources, more aggressive marketing campaigns, better brand recognition and more branch locations. Our competitors may also offer higher interest rates than we do, which could decrease the deposits that we attract or require us to increase our rates or attract new deposits. Other factors such as employee relations and environmental laws also impact our competitiveness. We maintain a favorable relationship with our employees and none of our employees are represented by a collective bargaining group. The impact of environmental laws is further discussed in "Item 3. Legal Proceedings" of this document. 5 SUPERVISION AND REGULATION GENERAL We are a bank holding company registered with the Federal Reserve Board and are subject to regulation under the Bank Holding Company Act of 1956, as amended (the "Bank Holding Company Act"). The Bank Holding Company Act requires the Federal Reserve Board's prior approval of an acquisition of assets or of ownership or control of voting shares of any bank or bank holding company if the acquisition would give us more than 5% of the voting shares of that bank or bank holding company. It also imposes restrictions, summarized below, on the assets or voting shares of non-banking companies that we may acquire. Our subsidiary banks are subject to the provisions of the banking laws of their respective states or the National Bank Act. They are under the supervision of, and are subject to periodic examination by, their respective state banking departments (in the case of state-chartered banks) or the Office of the Comptroller of the Currency ("OCC") (in the case of national banks), and are subject to the rules and regulations of the OCC, the Federal Reserve Board and the Federal Deposit Insurance Corporation ("FDIC"). Citizens Bank (our principal bank subsidiary), F&M Bank-Wisconsin and F&M Bank-Iowa are state-chartered banks and are therefore subject to supervision, regulation and examination by the Michigan Office of Financial and Insurance Services, the Wisconsin Department of Financial Institutions and the Iowa Division of Banking, respectively, as well as by the Federal Reserve Board. Citizens Bank-Illinois, N.A., a national bank, and Citizens Bank Wealth Management, N.A., a national non-depository trust bank, are subject to supervision, regulation and examination by the OCC. All of our depository banks are subject to supervision and examination by the FDIC, because the FDIC insures their deposits to the extent provided by law. In addition, all of our banks are members of the Federal Reserve System. Our non-bank subsidiaries are supervised and examined by the Federal Reserve Board and various other federal and state agencies. Consistent with the requirements of the Bank Holding Company Act, our only lines of business consist of providing our customers with banking, trust and other financial services and products. These services include commercial banking through our four subsidiary banks, trust services through Citizens Bank Wealth Management, N.A., mortgage origination and servicing through Citizens Bank Mortgage Company, LLC, equipment leasing through Citizens Commercial Leasing Corporation, brokerage and investment advisory services through CB Capital Management, Inc., property and casualty insurance brokerage services through Security Bancservices, Inc., life insurance and annuity products through CB Financial Services, Inc., title insurance through Citizens Title Services, Inc. and portfolio management services for the majority of F&M Bank - Wisconsin's investment portfolio through Pulaski Capital Corporation. Commercial banking activities account for substantially all of our gross revenues. Regulations governing Citizens and our subsidiary depository institutions restrict extensions of credit by such institutions to Citizens and, with some exceptions, our other affiliates. For these purposes, extensions of credit include loans and advances to and guarantees and letters of credit on behalf of Citizens and such affiliates. These regulations also restrict investments by our depository institution subsidiaries in the stock or other securities of Citizens and the covered affiliates, as well as the acceptance of such stock or other securities as collateral for loans to any borrower, whether or not related to Citizens. Our insured depository institution subsidiaries are subject to comprehensive federal and state regulations dealing with a wide variety of subjects, including capital and reserve requirements, loan limitations, restrictions as to interest rates on loans and deposits, restrictions as to dividend payments, requirements governing the establishment of branches and numerous other aspects of their operations. These regulations generally have been adopted to protect depositors and creditors rather than shareholders or holders of subordinated debt. Information concerning capital adequacy guidelines for Citizens and its banking subsidiaries including our regulatory capital position at December 31, 2003 and maintenance of minimum average reserve balances by the banking subsidiaries with the Federal Reserve Bank are incorporated herein by reference from Exhibit 13 on pages 59 and 62 of such document under the captions, "Capital Resources" and "Liquidity and Debt Capacity," respectively, and pages 98 through 99 of such document under the caption "Note 21 Regulatory Matters." Our insured depository institution subsidiaries are also subject to cross-guaranty liability under federal law. This means that if one FDIC-insured depository institution subsidiary of a multi-institution bank holding company fails or requires FDIC assistance, the FDIC may assess "commonly controlled" depository institutions for the estimated losses suffered by the FDIC. Such liability could have a material adverse effect on the financial condition of any assessed subsidiary institution and on Citizens as the common parent. While the FDIC's cross-guaranty claim is generally junior to the claims of depositors, holders of secured liabilities, general creditors and subordinated creditors, it is generally superior to the claims of shareholders and affiliates. 6 Under Federal Reserve Board policy, a bank holding company is expected to serve as a source of financial strength to each of its subsidiary banks and to stand prepared to commit resources to support each of them. There are no specific quantitative rules on the holding company's potential liability. If one of our subsidiary banks were to encounter financial difficulty, the Federal Reserve Board could invoke the doctrine and require a capital contribution from us. In addition, and as a separate legal matter, a holding company is required to guarantee the capital plan of an undercapitalized subsidiary bank. See "FDICIA" below. PAYMENT OF DIVIDENDS There are various statutory restrictions on the ability of our banking subsidiaries to pay dividends or make other payments to Citizens' parent company. Each of our state-charterd banking subsidiaries is subject to dividend limits under the laws of the state in which it is chartered. In addition, all of our subsidiary banks are member banks of the Federal Reserve System, subject to the dividend limits of the Federal Reserve Board. The Federal Reserve Board allows a member bank to make dividends or other capital distributions in an amount not exceeding the current calendar year's net income, plus retained net income of the preceding two years. Distributions in excess of this limit require prior approval of the Federal Reserve Board. Federal Reserve Board policy provides that, as a matter of prudent banking, a bank holding company generally should not maintain a rate of cash dividends unless its net income available to common shareholders has been sufficient to fully fund the dividends, and the prospective rate of earnings retention appears to be consistent with the holding company's capital needs, asset quality and overall financial condition. Dividends from a national banking association may be declared only from the bank's undivided profits, and until the bank's surplus fund equals its common capital, no dividends may be declared unless at least 10% of the bank's net income for a given time period has been carried to the surplus fund, depending on the frequency of dividend payments in a given year. The OCC's approval is required if the total of all dividends declared in any calendar year exceeds the sum of the association's net income of that year combined with its retained net income of the preceding two years. In each of the years ended December 31, 2003, 2002 and 2001, our subsidiaries paid cash dividends to us of $24.0 million, $90.5 million and $107.4 million, respectively. As of January 1, 2004, Citizens' banking subsidiaries are able to distribute dividends of $36.2 million without further regulatory approval. FDICIA The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") requires federal regulators to take prompt corrective action against any undercapitalized institution. FDICIA establishes five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. "Well capitalized" institutions significantly exceed the required minimum level for each capital measure (currently, risk-based and leverage). "Adequately capitalized" institutions include depository institutions that meet the required minimum level for each capital measure. "Undercapitalized" institutions consist of those that fail to meet the required minimum level for one or more relevant capital measures. "Significantly undercapitalized" characterizes depository institutions with capital levels significantly below the minimum requirements. "Critically undercapitalized" refers to depository institutions with minimal capital and at serious risk for government seizure. Under certain circumstances, a well-capitalized, adequately capitalized or undercapitalized institution may be treated as if the institution were in the next lower capital category. A depository institution is generally prohibited from making capital distributions, including paying dividends, or paying management fees to a holding company if the institution would thereafter be undercapitalized. Institutions that are adequately but not well capitalized cannot accept, renew or rollover brokered deposits except with a waiver from the FDIC and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew or rollover brokered deposits. The banking regulatory agencies are permitted or, in certain cases, required to take certain actions with respect to institutions falling within one of the three undercapitalized categories. Depending on the level of an institution's capital, the agency's corrective powers include, among other things: - - prohibiting the payment of principal and interest on subordinated debt; - - prohibiting the holding company from making distributions without prior regulatory approval; - - placing limits on asset growth and restrictions on activities; - - placing additional restrictions on transactions with affiliates; - - restricting the interest rate the institution may pay on deposits; - - prohibiting the institution from accepting deposits from correspondent banks; and - - in the most severe cases, appointing a conservator or receiver for the institution. 7 A banking institution that is undercapitalized is required to submit a capital restoration plan, and such a plan will not be accepted unless, among other things, the banking institution's holding company guarantees the plan up to a certain specified amount. Any such guarantee from a depository institution's holding company is entitled to a priority of payment in bankruptcy. FDICIA also contains a variety of other provisions that may affect our operations, including reporting requirements, regulatory standards for real estate lending, "truth in savings" provisions, and the requirement that a depository institution give 90 days prior notice to customers and regulatory authorities before closing any branch. At December 31, 2003 and 2002, the most recent notification from the Federal Reserve Board categorized Citizens and all of its depository institution subsidiaries as "well capitalized" under the regulatory framework for prompt corrective action. FDIC INSURANCE ASSESSMENTS The FDIC's deposit insurance assessments currently are calculated under a risk-based system. The risk-based system places a bank in one of nine risk categories, principally on the basis of its capital level and an evaluation of the bank's risk to the relevant deposit insurance fund, and bases premiums on the probability of loss to the FDIC with respect to each individual bank. Under the Federal Deposit Insurance Act, depository institutions such as our subsidiary banks may not pay interest on indebtedness, if such interest is required to be paid out of net profits, or distribute any of its capital assets while it remains in default on any assessment due to the FDIC. The adjusted assessment rates for FDIC-insured institutions currently range from 0.00% to 0.27% depending on the assessment category into which a bank is placed. We did not pay any regular insurance assessments to the FDIC in 2002. However, beginning July 1, 2003, our Wisconsin bank subsidiary was required to pay an annualized assessment rate of .03% to the FDIC for deposit insurance. We do not expect that any other of our bank subsidiaries will pay significant insurance assessments in 2004. However, the FDIC retains the ability to increase regular insurance assessments and to levy special additional assessments. INTERSTATE BANKING Under the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, as amended ("Riegle-Neal Act"), a bank holding company may acquire banks in states other than its home state, 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 not control, prior to or following the proposed acquisition, more than 10% of the total amount of deposits of insured depository institutions nationwide or, unless the acquisition is the bank holding company's initial entry into the state, more than 30% of such deposits in the state, or such lesser or greater amount set by the state. The Riegle-Neal Act also authorizes banks to merge across state lines, thereby creating interstate branches. Banks are also permitted to acquire and to establish de novo branches in other states where authorized under the laws of those states. TRANSACTIONS WITH AFFILIATES Transactions between our subsidiary banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. The affiliates of our banks include Citizens and any entity controlled by Citizens. Generally, Sections 23A and 23B (i) limit the extent to which our subsidiary banks may engage in "covered transactions" with any one affiliate to an amount equal to 10% of our capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of the bank's capital stock and surplus, (ii) require that a bank's extensions of credit to such affiliates be fully collateralized (with 100% to 130% collateral coverage, depending on the type of collateral), (iii) prohibit the bank from purchasing or accepting as collateral from an affiliate any "low quality assets" (including non-performing loans) and (iv) require that all "covered transactions" be on terms substantially the same, or at least as favorable, to the bank or its subsidiary as those provided to a non-affiliate. The term "covered transaction" includes the making of loans, purchase of assets, issuance of a guarantee and other type of similar transactions. 8 LOANS TO INSIDERS The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal stockholders of banks. Under Section 22(h) of the Federal Reserve Act and its implementing regulations, loans to a director, an executive officer and to a principal stockholder of a bank, and some affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the bank's loan-to-one-borrower limit. Loans in the aggregate to insiders and their related interests as a class may not exceed the bank's unimpaired capital and unimpaired surplus. Section 22(h) and its implementing regulations also prohibit loans, above amounts prescribed by the appropriate federal banking agency, to directors, executive officers and principal stockholders of a bank or bank holding company, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the bank with any "interested" director not participating in the voting. Section 22(h) generally requires that loans to directors, executive officers and principal stockholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons. COMMUNITY REINVESTMENT ACT Under the Community Reinvestment Act and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate income areas, consistent with safe and sound banking practice. The Community Reinvestment Act requires the adoption by each institution of a Community Reinvestment Act statement for each of its market areas describing the depository institution's efforts to assist in its community's credit needs. Depository institutions are periodically examined for compliance with the Community Reinvestment Act and are periodically assigned ratings in this regard. Banking regulators consider a depository institution's Community Reinvestment Act rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution. An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a bank holding company or its depository institution subsidiary. FAIR LENDING AND CONSUMER LAWS In addition to the Community Reinvestment Act, other federal and state laws regulate various lending and consumer aspects of the banking business. Governmental agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that in some cases prospective borrowers experience unlawful discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against some depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums, short of a full trial. Recently, these governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act. These factors include evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity. Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of certain loans to customers. GRAMM-LEACH-BLILEY ACT OF 1999 The Gramm-Leach-Bliley Act of 1999 (the "GLBA") was signed into law on November 12, 1999. The GLBA covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies. The following description summarizes some of its significant provisions. The GLBA repeals sections 20 and 32 of the Glass-Steagall Act, thus permitting unrestricted affiliations between banks and securities firms. It also permits bank holding companies to elect to become financial holding companies. A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment, merchant banking, insurance underwriting, sales and brokerage activities. In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed and have at least a satisfactory Community Reinvestment Act rating. We have determined not to become certified as a financial holding company at this time. We may reconsider this determination 9 in the future. The GLBA provides that the states continue to have the authority to regulate insurance activities, but prohibits the states in most instances from preventing or significantly interfering with the ability of a bank, directly or through an affiliate, to engage in insurance sales, solicitations or cross-marketing activities. Although the states generally must regulate bank insurance activities in a nondiscriminatory manner, the states may continue to adopt and enforce rules that specifically regulate bank insurance activities in specific areas identified under the law. Under the new law, the federal bank regulatory agencies adopted insurance consumer protection regulations that apply to sales practices, solicitations, advertising and disclosures. The GLBA repeals the broad exemption of banks from the definitions of "broker" and "dealer" for purposes of the Securities Exchange Act of 1934, as amended. It also identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a "broker," and a set of activities in which a bank may engage without being deemed a "dealer." Additionally, the new law makes conforming changes in the definitions of "broker" and "dealer" for purposes of the Investment Company Act of 1940, as amended, and the Investment Advisers Act of 1940, as amended. The GLBA also contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institution's policies and procedures regarding the handling of customers' nonpublic personal financial information. The new law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to "opt out" of such disclosure. An institution may not disclose to a non-affiliated third party, other than to a consumer reporting agency, customer account numbers or other similar account identifiers for marketing purposes. The GLBA also provides that the states may adopt customer privacy protections that are more strict than those contained in the GLBA. INTERNATIONAL MONEY LAUNDERING ABATEMENT AND FINANCIAL ANTI-TERRORISM ACT OF 2001 The International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (the "IMLAFA") was signed into law in October 2001 as part of the USA Patriot Act of 2001. The IMLAFA substantially broadens existing anti-money laundering legislation, imposes new compliance and due diligence obligations, creates new crimes and penalties, and compels the production of documents located both inside and outside the United States. The U.S. Treasury Department has issued a number of regulations implementing the IMLAFA that apply certain of its requirements to financial institutions such as our banking subsidiaries. The regulations impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing. The Treasury Department is expected to issue a number of additional regulations which will further clarify the IMLAFA's requirements. Pursuant to the IMLAFA and the regulations promulgated under it, we have established anti-money laundering compliance and due diligence programs which include, among other things, the designation of a compliance officer, employee training programs, and an independent audit function to review and test the program. FUTURE LEGISLATION Because federal and state regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal and state regulation of financial institutions may change in the future and impact our operations. Although Congress in recent years has sought to reduce the regulatory burden on financial institutions with respect to the approval of specific transactions, we fully expect that the financial services industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices. ECONOMIC FACTORS AND MONETARY POLICY Our earnings and business are affected by the general economic and political conditions in the United States and abroad and by the monetary and fiscal policies of various federal regulatory authorities, including the Federal Reserve System. Through open market securities transactions, variations in the Federal Funds rate and the establishment of reserve requirements, the Board of Governors of the Federal Reserve System exerts considerable influence on interest rates and the supply of money and credit. The effect of fluctuating economic conditions and federal regulatory policies on our future profitability cannot be predicted with any certainty. The effect of the economy and changes in interest rates on our net interest margin and net interest income in 2003 and 2002 and their potential effect on future periods is discussed in Exhibit 13 on pages 41 through 43 under the caption "Net Interest Income" and is incorporated herein by reference. Our sensitivity to changes in interest 10 rates and the potential affect of changes in interest rates on net interest income is presented in Exhibit 13 on pages 63 through 64 under the captions "Interest Rate Risk" and "Interest Rate Sensitivity" and is incorporated herein by reference. ENVIRONMENTAL MATTERS Our primary exposure to environmental risk is through our trust services and our lending activities. In each instance, we have policies and procedures in place to mitigate our environmental risk exposures. With respect to lending activities, we require environmental site assessments at the time of loan origination to confirm collateral quality on commercial real estate parcels posing higher than normal potential for environmental impact, as determined by reference to present and past uses of the subject property and adjacent sites. Environmental assessments are also mandated prior to any foreclosure activity involving non-residential real estate collateral. In the case of trust services, we utilize various types of environmental transaction screening to identify actual and potential risks arising from any proposed holding of non-residential real estate for trust accounts. Consequently we do not anticipate any material effect on capital expenditures, earnings or the competitive position of Citizens or any of our subsidiaries with regard to compliance with federal, state or local environmental protection laws or regulations. Additional information is provided in "Item 3. Legal Proceedings." ITEM 2. PROPERTIES Our executive offices are located at 328 South Saginaw Street, Flint, Michigan in the main office building of Citizens Bank, our largest bank subsidiary. Our bank subsidiaries operate through 176 branch and financial banking offices. Of these, 41 are leased and the remainder are owned and not subject to any material liens. Rent expense on the leased properties totaled $2,122,728 in 2003. The banking offices are located in various communities throughout the states of Michigan and Wisconsin, in parts of Iowa and in the western suburbs of Chicago, Illinois. At certain Citizens Bank locations a portion of the office buildings are leased to tenants. Additional information related to the property and equipment owned or leased by Citizens and its subsidiaries is incorporated herein by reference from Exhibit 13 on page 81 under the caption "Note 9. Premises and Equipment" of such document. ITEM 3. LEGAL PROCEEDINGS Citizens and its subsidiaries are parties to a number of lawsuits incidental to its business. Although litigation is subject to many uncertainties and the ultimate exposure with respect to many of these matters cannot be ascertained, we do not believe the ultimate outcome of these matters will have a material adverse effect on our financial condition or liquidity. From time to time, certain of our subsidiaries are notified by applicable environmental regulatory agencies, pursuant to State or Federal environmental statutes or regulations, that they may be potentially responsible parties ("PRPs") for environmental contamination on or emanating from properties currently or formerly owned. Typically, exact costs of remediating the contamination cannot be fully determined at the time of initial notification. While, as PRPs, these subsidiaries are potentially liable for the costs of remediation, in most cases, a number of other PRPs have been identified as being jointly and severally liable for remediation costs. Additionally, in certain cases, statutory defenses to liability for remediation costs may be asserted based on the subsidiaries' status as lending institutions that acquired ownership of the contaminated property through foreclosure. We are not presently aware of any environmental liabilities that pose a reasonable possibility of future material impact on Citizens or its earnings. It is our policy to establish and accrue appropriate reserves for all such identified exposures during the accounting period in which a loss is deemed to be probable and the amount is determinable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of 2003 to a vote of security holders through the solicitation of proxies or otherwise. 11 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is traded on the National Market tier of the Nasdaq Stock Market under the symbol "CBCF." Information regarding our stock prices during the last two years is incorporated herein by reference from Exhibit 13 on page 65 under the caption "Table 14. Selected Quarterly Information" of such document. As of December 31, 2003, the approximate number of shareholders of the Registrant's common stock was 15,158. This number includes an estimate for individual participants in the security positions of certain shareholders of record. Actual shareholders of record at December 31, 2003 totaled 6,596. Information regarding cash dividends we have declared during the last two fiscal years is incorporated herein by reference from Exhibit 13 on page 65 under the caption "Table 14. Selected Quarterly Information" of such document. Restrictions on the Registrant's ability to pay dividends are incorporated herein by reference from Exhibit 13 on pages 98 and 99 under the caption "Note 21. Regulatory Matters" of such document. EQUITY COMPENSATION PLAN INFORMATION We have two stock option plans pursuant to which we grant performance-based stock options to employees, officers and directors. Our Stock Compensation Plan (the "2002 Plan") was approved by our shareholders in 2002. Our All-Employee Stock Option Plan (the "All-Employee Plan") was not submitted to our shareholders for approval. The 2002 Plan replaced our Third Amended Stock Option Plan which has expired and our Stock Option Plan for Directors which was terminated. Both of these plans were approved by our shareholders and there continue to be options outstanding that were granted under these plans. The following table sets forth, with respect to all of our option plans, (i) the number of shares of common stock to be issued upon the exercise of outstanding options, (ii) the weighted average exercise price of outstanding options, and (iii) the number of shares remaining available for future issuance, as of December 31, 2003.
Number of shares remaining available for future issuance under Number of shares to be Weighted-average equity compensation plans issued upon exercise of exercise price of (excluding shares Plan Category outstanding options (1) outstanding options reflected in column (a)) - ----------------------------- ----------------------- ------------------- ------------------------- (a) (b) (c) Equity compensation plans approved by shareholders 3,980,283 $26.51 4,883,438 Equity compensation plans not approved by shareholders 164,050 (2) $16.66 0 --------- ------ --------- Total 4,144,333 $26.12 4,883,438
(1) Does not include options for 28,895 shares of our common stock that are outstanding as the result of our assuming obligations under stock option plans of F&M Bancorporation, Inc. ("F&M") in connection with our merger with F&M in 1999. While we assumed the obligations existing under these plans as of the time of the merger, we have not used them to make any further grants. The weighted-average exercise price of these outstanding options is $23.68. (2) Issued under the All-Employee Plan. Under this plan, on May 18, 2000, we granted stock options to all employees who did not receive grants under the then existing but since expired Third Amended Stock Option Plan. Each full-time employee received options for 200 shares of our common stock and each part-time employee received options for 100 shares. The $16.66 exercise price of the grant was the market price of our common stock on the grant date. The options became exercisable three years after the date of grant. The options expire ten years from the date of grant. Options for a total of 550,700 shares were granted of which options for 164,050 shares were outstanding as of December 31, 2003. The plan provides that no further grants may be made under the plan. 12 ITEM 6. SELECTED FINANCIAL DATA The information required by this item is incorporated herein by reference from Exhibit 13 on page 34 under the caption "Table 1. Five Year Summary of Selected Financial Data" of such document. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations required by this item is incorporated herein by reference from Exhibit 13 on pages 34 through 65 of such document. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information required by this item is incorporated by reference from Exhibit 13 on pages 63 through 64 under the caption "Interest Rate Risk" of such document. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Financial Statements are incorporated herein by reference from Exhibit 13 on pages 66 through 103 of such document. Supplementary data of Citizens' quarterly results of operations required by this item are incorporated herein by reference from Exhibit 13 on page 65 of such document under the caption "Table 14. Selected Quarterly Information." ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES The management of Citizens Banking Corporation is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under rule 13a-15 of the Securities Exchange Act of 1934. As of the end of the period covered by this report, we performed an evaluation under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to rule 13a-15 of the Securities Exchange Act of 1934. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to cause the material information required to be disclosed by the Company in the reports it files or submits under the Securities Exchange Act of 1934 to be recorded, processed, summarized, and reported to the extent applicable within the time period required by the Securities and Exchange Commission's rules and forms. There have been no significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to the conclusion of their evaluation. 13 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item appears under the captions "Election of Directors" (excluding the information under the headings "Report of the Audit Committee" and "Compensation of Directors"),"Section 16(a) Beneficial Ownership Reporting Compliance" and "Shareholder Proposals and Nominees - Shareholder Communications with the Board of Directors" in Citizens' proxy statement for its annual meeting of shareholders to be held April 22, 2004 (the "Proxy Statement"). ITEM 11. EXECUTIVE COMPENSATION The information required by this item appears under the caption "Compensation of Directors," and under the caption "Executive Compensation" (excluding the information under the heading "Shareholder Return") of the Proxy Statement, and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item appears under the captions "Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" of the Proxy Statement, and is incorporated herein by reference. In addition, the information under the caption "Equity Compensation Plan Information" under Item 5 of this Report is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item appears under the caption "Executive Compensation - Compensation Committee Interlocks and Certain Transactions and Relationships" of the Proxy Statement, and is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item appears under the caption "Independent Certified Public Accountants" of the Proxy Statement, and is incorporated herein by reference 14 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements: The following Consolidated Financial Statements of Citizens and Report of Ernst & Young LLP, Independent Auditors are incorporated by reference under Item 8 "Financial Statements and Supplementary Data" of this document: Consolidated Balance Sheets Consolidated Statements of Income Consolidated Statements of Changes in Shareholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Report of Ernst & Young LLP, Independent Auditors 2. Financial Statement Schedules: All schedules are omitted - see Item 15(d) below. 3. Exhibits: The exhibits listed on the "Exhibit Index" on pages 18 and 19 of this report are filed herewith and are incorporated herein by reference. (b) Reports on Form 8-K A report on Form 8-K, dated November 26, 2003 and filed on December 2, 2003 announcing Citizens' results of operations for the three and nine month periods ending September 30, 2003 under items 7 and 12. A report on Form 8-K, dated November 26, 2003 and filed on December 2, 2003 regarding the conference call conducted on October 17, 2003 to review Citizens' financial results for the third quarter of 2003 and certain other information, under items 7 and 12. A report on Form 8-K, dated November 24, 2003 and filed on November 25, 2003 announcing Citizens' major expansion in Oakland County, Michigan under items 5 and 7. No financial statements were filed with any of these reports. (c) Exhibits: The "Exhibit Index" is filed herewith on pages 18 and 19 of this report and is incorporated herein by reference. (d) Financial Statement Schedules: All financial statement schedules normally required by Article 9 of Regulation S-X are omitted since they are either not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto. 15 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CITIZENS BANKING CORPORATION (Registrant) by /s/ William R. Hartman Date: March 10, 2004 - ----------------------------------------------- William R. Hartman Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Capacity Date - ------------------------------------- ---------------------------------------- -------------------- /s/ Charles D. Christy Executive Vice President and March 10, 2004 - ------------------------------------- Chief Financial Officer Charles D. Christy (Principal Financial Officer) /s/ Daniel E. Bekemeier Senior Vice President and Chief March 10, 2004 - ------------------------------------- Accounting Officer Daniel E. Bekemeier (Principal Accounting Officer) /s/ William R. Hartman Chairman of the Board, President, March 10, 2004 - ------------------------------------- Chief Executive Officer, and Director William R. Hartman /s/ Edward P. Abbott Director March 10, 2004 - ------------------------------------- Edward P. Abbott /s/ Jonathan E. Burroughs II Director March 10, 2004 - ------------------------------------- Jonathan E. Burroughs II /s/ Joseph P. Day Director March 10, 2004 - ------------------------------------- Joseph P. Day /s/ Richard J. Dolinski Director March 10, 2004 - ------------------------------------- Richard J. Dolinski /s/ Lawrence O. Erickson Director March 10, 2004 - ------------------------------------- Lawrence O. Erickson /s/ Benjamin W. Laird Director March 10, 2004 - ------------------------------------- Benjamin W. Laird
16 SIGNATURES (CONTINUED)
Signature Capacity Date - ------------------------------------- ---------------------------------------- -------------------- /s/ Stephen J. Lazaroff Director March 10, 2004 - ------------------------------------- Stephen J. Lazaroff /s/ William C. Shedd Director March 10, 2004 - ------------------------------------- William C. Shedd /s/ Kendall B. Williams Director March 10, 2004 - ------------------------------------- Kendall B. Williams /s/ James L. Wolohan Director March 10, 2004 - ------------------------------------- James L. Wolohan
17 EXHIBIT INDEX The following documents are filed as part of this report. Those exhibits previously filed and incorporated herein by reference are identified below. Exhibits not required for this report have been omitted. Citizens' Commission file number is 000-10535.
Exhibit No. Exhibit - ---------- ------------------------------------------------------------------------------------------------------------------- 3.1 Restated Articles of Incorporation, as amended. (incorporated by reference from Exhibit 3(a) of Citizens' 2002 Second Quarter Report on Form 10-Q). 3.2 Amended and Restated Bylaws dated March 28, 2003 (incorporated by reference from Exhibit 3.2 of Citizens' December 31, 2002 Annual Report on Form 10-K). 4.1 Rights Agreement, dated May 23, 2000, between Citizens and Citizens Bank, as Rights Agent (incorporated by reference from Exhibit 4.1 of Citizens' Current Report on Form 8-K filed June 8, 2000). 4.2 Indenture, dated as of January 27, 2003 among Citizens Banking Corporation and JP Morgan Chase Bank, as Trustee (filed as Exhibit 4.1 to Citizens Banking Corporation's registration statement on Form S-4, registration no. 333-104472, and incorporated herein by reference). 4.3 Registration Rights Agreement, dated as of January 27, 2003 among Citizens Banking Corporation and Morgan Stanley, Keefe, Bruyette & Woods, Inc., Robert W. Baird & Co., Credit Suisse First Boston, Fahnestock & Co. Inc., Howe Barnes Investments, Inc. and McDonald Investments, as Initial Purchasers (filed as Exhibit 4.2 to Citizens Banking Corporation's registration statement on Form S-4, registration no. 333- 104472, and incorporated herein by reference). 4.4 Floating Rate Junior Subordinated Deferrable Interest Debentures dated as of June 26, 2003 (incorporated by reference from Exhibit 4.1 of Citizens' 2003 Second Quarter Report on Form 10-Q). 10.1* Citizens Banking Corporation Second Amended Stock Option Plan (incorporated by reference from Exhibit 4 of Citizens' registration statement on Form S-8 filed May 5, 1992, Registration No. 33-47686). 10.2* Citizens Banking Corporation Third Amended Stock Option Plan (incorporated by reference from Exhibit 10(r) of Citizens' 1997 Second Quarter Report on Form 10-Q). 10.3* First Amendment to Citizens Banking Corporation Third Amended Stock Option Plan (incorporated by reference from Exhibit 10.2 of Citizens' 2000 Second Quarter Report on Form 10-Q). 10.4* Citizens Banking Corporation All-Employee Stock Option Plan (incorporated by reference from Exhibit 99 of Citizens' registration statement on Form S-8 filed June 26, 2000, Registration No. 333-40100). 10.5* Citizens Banking Corporation Stock Option Plan for Directors (incorporated by reference from Exhibit 99 of Citizens' registration statement on Form S-8 filed July 21, 1995, Registration No. 33-61197). 10.6* First Amendment to Citizens Banking Corporation Stock Option Plan for Directors (incorporated by reference from Exhibit 10.3 of Citizens' 2000 Second Quarter Report on Form 10-Q). 10.7* Citizens Banking Corporation Stock Compensation Plan (incorporated by reference from exhibit 10.13 of Citizens' 2001 Annual Report on Form 10-K). 10.8* Post Effective Amendment No. 1 to Form S-4 on Form S-8 pertaining to "F&M Bancorporation, Inc. 1993 Incentive Stock Option Plan" and "F&M Bancorporation, Inc. 1993 Stock Option Plan for Non-employee Directors" (incorporated by reference to Form S-8 filed December 22, 1999, file number 333-86569).
18 EXHIBIT INDEX (CONTINUED)
Exhibit No. Exhibit - ---------- ------------------------------------------------------------------------------------------------------------------- 10.9* Citizens Banking Corporation Amended and Restated Section 401(k) Plan (incorporated by reference from Exhibit 99.1 of Citizens' registration statement on Form S-8 filed August 2, 1996 - Registration No. 333- 09455). 10.10* Citizens Banking Corporation Management Incentive Compensation Plan (incorporated by reference from Exhibit 10.8 of Citizens' 2001 Annual Report on Form 10-K). 10.11* Citizens Banking Corporation Amended and Restated Director's Deferred Compensation Plan (incorporated by reference from Exhibit 10.11 of Citizens' 2002 Annual Report on Form 10-K). 10.12* Amended and Restated Change in Control Agreement, dated as of November 28, 2000, by and between the Company and Wayne G. Schaeffer (incorporated by reference from Exhibit 10.17 of Citizens' 2000 Annual Report on Form 10-K). 10.13 Amended and Restated Declaration of Trust dated as of June 26, 2003 by and among U.S. Bank National Association, as institutional Trustee, Citizens Banking Corporation, as Sponsor, and William R. Hartman, Charles D. Christy and Thomas W. Gallagher as Administrators (incorporated by reference from Exhibit 10.1 of Citizens' 2003 Second Quarter Report on Form 10-Q). 10.14 Placement Agreement, dated June 16, 2003, between the Company, Citizens Michigan Statutory Trust I, FTN Financial Capital Markets and Keefe Bruyette & Woods, Inc. (incorporated by reference from Exhibit 10.2 of Citizens' 2003 Second Quarter Report on Form 10-Q). 10.15 Guarantee Agreement dated as of June 26, 2003 by and between Citizens Banking Corporation and U.S. Bank National Association (incorporated by reference from Exhibit 10.3 of Citizens' 2003 Second Quarter Report on Form 10-Q). 10.16* Amended and Restated Employment Agreement by and between the Company and William R. Hartman dated as of May 29, 2003 (incorporated by reference from Exhibit 10.4 of Citizens' 2003 Second Quarter Report on Form 10-Q). 10.17* Form of Change in Control Agreement by and between the Company and certain executive officers. 10.18* Change in Control Agreement, dated as of April 7, 2003, by and between the Company and Randall J. Peterson. 13 Citizens Banking Corporation 2003 Annual Report - financial information pages 33 through 103 only (except as to portions expressly incorporated herein, said Annual Report information is included only for the information of the Commission). 21 Subsidiaries of the Registrant 23 Consent of Independent Auditors 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934. 32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) under the Securities Exchange Act of 1934. 32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) under the Securities Exchange Act of 1934.
* Current management contracts or compensatory plans or arrangements. 19 EX-10.17 3 k82546exv10w17.txt FORM OF CHANGE IN CONTROL AGREEMENT Exhibit 10.17 (Form 10-K) CHANGE IN CONTROL AGREEMENT This Change in Control Agreement ("Agreement") is made by and between Citizens Banking Corporation, a Michigan corporation ("Corporation"), and _______________________ ("Executive"). The Corporation anticipates the valuable services that the Executive will render on behalf of the Corporation and its subsidiary banks and is desirous of having some assurance that the Executive will continue as an employee and that, in the event of a possible Change in Control of the Corporation, the Executive will be able to perform his duties without undue concern for the Executive's personal financial well-being; and The Executive is willing to serve as an employee of the Corporation but desires assurance that in the event of a Change in Control of the Corporation, he will continue to have the responsibility and status he has earned. Accordingly, the Corporation and the Executive agree as follows: 1. In order to protect the Executive against the possible consequences of a Change in Control of the Corporation, as defined in paragraph 2 of this Agreement, and thereby to induce the Executive to serve as an officer of the Corporation or a subsidiary bank the Corporation agrees that if (a) there is such a Change in Control of the Corporation and (b) the Executive's employment with the Corporation or a subsidiary bank is terminated under the circumstances described in paragraph 3 of this Agreement, then: A. The Corporation shall pay the Executive a lump sum amount in cash equal to the sum of (i) three times the Executive's annual base salary immediately prior to the Change in Control (or if higher, the annual base salary on the date the Executive's employment is terminated) and (ii) three times the greater of (x) the anticipated bonus amount under the Citizens Banking Corporation Management Incentive Plan to be earned in accordance with the plan in the year in which the termination occurs or (y) the highest bonus paid to the Executive in the last three full calendar years of such employment. The applicable amount shall be payable within 60 days following the date of the Executive's termination of employment. B. The Executive shall continue to be covered, at the Corporation's cost, by the medical, dental and life insurance benefit plans that are in effect on the date of his termination and that cover executive employees, for a period of thirty-six (36) months after his termination of employment; provided, however, that if during such time period the Executive should enter into other employment providing comparable benefits, his participation in such plans of the Corporation shall cease to the extent of his coverage by his new employer's plans. Any such non-cash benefit that is tied to compensation shall be based on the Executive's annual compensation averaged over the same period as applicable under paragraph A of this Agreement. C. If the Executive was furnished with a club membership, that membership will be transferred by the Corporation to the Executive at no cost to the Executive, who immediately following the transfer shall become subject to monthly dues charges of the club. D. All stock options and restricted stock previously granted by the Corporation to the Executive, whether or not then exercisable, shall become immediately vested and exercisable. E. For a period of one year following termination of the Executive's employment, the Executive shall be entitled to outplacement services provided by an outplacement service provider designated by the Corporation. The cost of providing the outplacement services shall be borne solely by the Corporation, and shall be equal to the lesser of (i) 10% of the Executive's annual base salary immediately prior to the Change in Control (or, if higher, the Executive's annual base salary as of the date of termination of the Executive's employment) and (ii) $20,000. F. If the payment of any of the foregoing amounts or benefits (when added to any other payments or benefits provided to the Executive in the nature of compensation) will result in the payment of an excess parachute payment as that term is defined in Section 280G of the Internal Revenue Code of 1986 ("Code"), then in such event, the Corporation shall pay the Executive an additional amount for each calendar year in which an excess parachute payment is received by the Executive (the "Gross-Up Payment"). The Gross-Up Payment is intended to cover the Executive's liability for any parachute tax under Code Section 4999 on such excess parachute payment, as well as federal and state income taxes and parachute tax on the additional amount, and shall be computed as follows: A=Pt/(1 - T - t), where - A is the additional amount for any calendar year; P is the amount of the excess parachute payment for the calendar year in excess of the allocable base amount as defined in Code Section 28OG(b)(3); T is the effective marginal rate of federal and state income tax applicable to the Executive for the calendar year; and t is the rate of parachute tax under Code Section 4999. The effective marginal rate of federal and state income tax shall be computed as follows: T = F + S(l - 0.8F) + m, where - F is the highest marginal rate of federal income tax applicable to the Executive for the calendar year; and S is the highest aggregate marginal rate of state income tax applicable to the Executive for the calendar year in the state or states and municipalities to 2 which he is then required to pay income taxes as a result of his employment by the Corporation; and m is the employee's portion of the Medicare tax, currently 1.45%. Payment of the Gross-Up Payment shall be made to the Executive on or before December 31 of each calendar year for which an excess parachute payment is received by the Executive. G. Subject to the provisions of paragraph G, all determinations required to be made under these paragraphs E, F and G, including whether and when a Gross-Up Payment is required and the amount of such Gross-Up Payment and the assumptions to be utilized in arriving at such determination, shall be made by Ernst & Young, LLP or such other certified public accounting firm reasonably acceptable to the Corporation as may be designated by the Executive (the "Accounting Firm") which shall provide detailed supporting calculations both to the Corporation and the Executive within 15 business days of the receipt of notice from the Executive that there has been an excess parachute payment, or such earlier time as is requested by the Corporation. All fees and expenses of the Accounting Firm shall be borne solely by the Corporation. Any determination by the Accounting Firm shall be binding upon the Corporation and the Executive. As a result of the uncertainty in the application of Section 4999 of the Code at the time of the initial determination by the Accounting Firm hereunder, it is possible that Gross-Up Payments which will not have been made by the Corporation should have been made ("Underpayment"), consistent with the calculations required to be made hereunder. In the event that the Corporation exhausts its remedies pursuant to paragraph G and the Executive thereafter is required to make a payment of any Excise Tax, the Accounting Firm shall determine the amount of the Underpayment that has occurred and any such Underpayment shall be promptly paid by the Corporation to or for the benefit of the Executive. H. The Executive shall notify the Corporation in writing of any claim by the Internal Revenue Service that, if successful, would require the payment by the Corporation of the Gross-Up Payment. Such notification shall be given as soon as practicable but no later than ten business days after the Executive is informed in writing of such claim and shall apprise the Corporation of the nature of such claim and the date on which such claim is requested to be paid. The Executive shall not pay such claim prior to the expiration of the 30-day period following the date on which it gives such notice to the Corporation (or such shorter period ending on the date that any payment of taxes with respect to such claim is due). If the Corporation notifies the Executive in writing prior to the expiration of such period that it desires to contest such claim, the Executive shall: (i) give the Corporation any information reasonably requested by the Corporation relating to such claim, (ii) take such action in connection with contesting such claim as the Corporation shall reasonably request in writing from time to time, including, without limitation, accepting legal representation with respect to such claim by an attorney reasonably selected by the Corporation, (iii) cooperate with the Corporation in good faith in order effectively to contest such claim, and (iv) permit the Corporation to participate in any proceedings relating to such claim; provided, however, that the Corporation shall bear and pay directly all costs and expenses (including additional interest and penalties) incurred in connection with such contest and shall indemnify and hold the Executive harmless, on an after-tax basis, for any Excise Tax or income tax (including interest and penalties with respect thereto) imposed as a result of such 3 representation and payment of costs and expenses. Without limitation on the foregoing provisions of this subparagraph H, the Corporation shall control all proceedings taken in connection with such contest and, at its sole option, may pursue or forgo any and all administrative appeals, proceedings, hearings and conferences with the taxing authority in respect of such claim and may, at its sole option, either direct the Executive to pay the tax claimed and sue for a refund or contest the claim in any permissible manner, and the Executive agrees to prosecute such contest to a determination before any administrative tribunal, in a court of initial jurisdiction and in one or more appellate courts, as the Corporation shall determine; provided, however, that if the Corporation directs the Executive to pay such claim and sue for a refund, the Corporation shall advance the amount of such payment to the Executive, on an interest-free basis, and shall indemnify and hold the Executive harmless, on an after-tax basis, from any Excise Tax and income tax (including interest or penalties with respect thereto) imposed with respect to such advance or with respect to any imputed income with respect to such advance calculated as described in subparagraph F of this section; and further provided that any extension of the statute of limitations relating to payment of taxes for the taxable year of the Executive with respect to which such contested amount is claimed to be due is limited solely to such contested amount. Furthermore, the Corporation's control of the contest shall be limited to issues with respect to which a Gross-Up Payment would be payable hereunder and the Executive shall be entitled to settle or contest, as the case may be, any other issue raised by the Internal Revenue Service or any other taxing authority. If, after the receipt by the Executive of an amount advanced by the Corporation pursuant to this subparagraph H, the Executive becomes entitled to receive any refund with respect to such claim, the Executive shall (subject to the Corporation's complying with the requirements of this subparagraph H) promptly pay to the Corporation the amount of such refund (together with any interest paid or credited thereon after taxes applicable thereto). If, after the receipt by the Executive of an amount advanced by the Corporation pursuant to this subparagraph H, a determination is made that the Executive shall not be entitled to any refund with respect to such claim and the Corporation does not notify the Executive in writing of its intent to contest such denial of refund prior to the expiration of 30 days after such determination, then such advance shall be forgiven and shall not be required to be repaid and the amount of such advance shall offset, to the extent thereof, the amount of Gross-Up Payment required to be paid. 2. For purposes of this Agreement, a "Change in Control" shall mean: A. The acquisition by any individual, entity or group (within the meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) (a "Person") of beneficial ownership (within the meaning of Rule l3d-3 promulgated under the Exchange Act) of 20% or more of either (1) the then outstanding shares of common stock of the Corporation (the "Outstanding Corporation Common Stock") or (2) the combined voting power of the then outstanding voting securities of the Corporation entitled to vote generally in the election of directors (the "Outstanding Corporation Voting Securities"); provided, however, that for purposes of this subparagraph A, the following acquisitions shall not constitute a Change in Control: (i) any acquisition directly from the Corporation, (ii) any acquisition by the Corporation, (iii) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Corporation or any corporation controlled by the Corporation, or (iv) any acquisition by any corporation pursuant to a transaction which complies with clauses (1), (2) and (3) of subparagraph C of this paragraph 2; or 4 B. Individuals who, as of the date hereof, constitute the Board of Directors of the Corporation (the "Incumbent Board") cease for any reason to constitute at least a majority of the Board of Directors; provided, however, that any individual becoming a director subsequent to the date hereof whose election, or nomination for election by the Corporation's shareholders, was approved by a vote of at least a majority of the directors then comprising the Incumbent Board (either by a specific vote or by approval of the proxy statement of the Corporation in which such person is named as a nominee for director, without written objection to such nomination) shall be considered as though such individual were a member of the Incumbent Board, but excluding, for this purpose, any such individual whose initial assumption of office occurs as a result of an actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or contests by or on behalf of a person other than the Board of Directors of the Corporation; or C. Consummation of a reorganization, merger, share exchange or consolidation or sale of other disposition of all or substantially all of the assets of the Corporation (a "Business Combination"), in each case, unless, following such Business Combination: (1) all or substantially all of the individuals and entities who were the beneficial owners, respectively, of the Outstanding Corporation Common Stock and Outstanding Corporation Voting Securities immediately prior to such Business Combination beneficially own, directly or indirectly, more than 65% of, respectively, the then outstanding shares of common stock and the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Corporation or all or substantially all of the Corporation's assets either directly or through one or more subsidiaries) in substantially the same proportions as their ownership, immediately prior to such Business Combination of the Outstanding Corporation Common Stock and Outstanding Corporation Voting Securities, as the case may be; (2) no Person (excluding any corporation resulting from such Business Combination or any employee benefit plan (or related trust) of the Corporation or such corporation resulting from the Business Combination) beneficially owns, directly or indirectly, 20% or more of, respectively, the then outstanding shares of common stock of the corporation resulting from such Business Combination or the combined voting power of the then outstanding voting securities of such corporation except to the extent that such ownership existed prior to the Business Combination; and (3) at least a majority of the members of the board of directors of the corporation resulting from such Business Combination were members of the Incumbent Board immediately prior to the time of the execution of the initial agreement, or of the action of the Board of Directors of the Corporation, providing for such Business Combination; or D. Approval by the stockholders of the Corporation of a complete liquidation or dissolution of the Corporation. 3. Termination of the Executive's employment shall mean the Executive's termination of employment at any time within 3 months prior to, on the date of, or within 24 months after a Change in Control of the Corporation as defined in paragraph 2 of this Agreement either by (a) involuntary dismissal by the Corporation; or (b) the Executive's constructive termination as described in the following sentences of this paragraph 3. If (i) there is a significant reduction in the scope of the Executive's authority or in the extent of his powers, functions, duties or 5 responsibilities, or (ii) the Executive's annual rate of compensation is reduced or fringe benefits, including relocation benefits, are not provided to him on a basis commensurate with other executives of the Corporation and its subsidiary banks, or (iii) there are changes in the Executive's responsibilities for the Corporation which require moving the Executive's job location to a location outside of the lower peninsula of the State of Michigan, then the Executive shall be entitled to give written notice thereof to the Board of Directors of the Corporation. If within 60 days following such notice, the Executive and the Board of Directors of the Corporation do not resolve the Executive's concerns to the satisfaction of the Executive (the Executive's satisfaction or dissatisfaction to be communicated to the Board of Directors of the Corporation in writing within such 60 days), the Executive's employment shall be deemed to be constructively terminated at the end of such 60-day period. 4. The specific arrangements referred to above are not intended to exclude the Executive's participation in other benefits available to executive personnel of the Corporation generally or to preclude other compensation or benefits as may be authorized by the Corporation's Board of Directors from time to time. 5. As partial consideration for the above, the Executive agrees not to disclose any confidential information about the Corporation and its operation to which the Executive was privy during the course of his employment by the Corporation. Further, the Executive agrees not to accept employment or consult for or otherwise assist any competitor of the Corporation for a period of 24 months following his termination of employment. For purposes of the foregoing, "competitor" means any financial institution that conducts business from any location within 50 miles of any location at which the Corporation or any subsidiary bank had an office on the day immediately prior to the day on which the Change of Control of the Corporation occurred. 6 6. This Agreement shall be binding upon and shall inure to the benefit of the respective successors, assigns, legal representatives and heirs to the parties. 7. Any payment or delivery required under this agreement shall be subject to all requirements of the law with regard to withholding, filing, making of reports and the like, and the Corporation shall use its best efforts to satisfy promptly all such requirements. 8. Notwithstanding anything contained herein to the contrary, this Agreement shall be terminated and no benefits to the Executive shall be payable if, at any time, the Executive shall resign voluntarily (other than as provided in Section 3) , retire at or after normal retirement age, become incapacitated, voluntarily take another position requiring a substantial portion of his time, or die. This Agreement also shall terminate upon termination for cause of the Executive's employment as an officer of the Corporation or any subsidiary bank by the Incumbent Board. For purposes of the foregoing, "termination for cause" means termination due to the Executive's conviction of a felony, a determination that the Executive is guilty of sexual harassment of another employee, the Executive's proven embezzlement from the Corporation or a subsidiary bank, the Executive's gross misconduct or incompetence, the Executive's disclosure of confidential information of the Corporation or intentional assistance of a competitor of the Corporation (as defined in paragraph 5), or any other activity of the Executive which has or may have a material adverse effect on the finances or business reputation of the Corporation or a subsidiary bank. 9. Any and all disputes, controversies or claims arising out of or in connection with or relating to this Agreement or any breach or alleged breach thereof shall, upon the request of either party, be submitted to and settled by arbitration in the State of Michigan pursuant to the Voluntary Labor Arbitration Rules, then in effect, of the American Arbitration Association (or at any other place or under any other form of arbitration mutually acceptable to the parties involved). The parties hereto specifically agree to arbitrate with the other party in a proceeding with regard to all issues and disputes, and to permit pre-hearing discovery in the time and manner provided by the then applicable Federal Rules of Civil Procedure. This agreement to arbitrate shall be specifically enforceable under the prevailing arbitration law. Notice of the demand for arbitration shall be filed, in writing, with the other party to this Agreement and with the American Arbitration Association. The demand for arbitration shall be made within a reasonable time after the claim, dispute, or other matter in question arose where the party asserting the claim should reasonably have been aware of the same, but in no event later than the applicable Michigan or federal statute of limitations. The arbitrator shall have no power to add to, subtract from, or alter the terms of this Agreement, and shall render a written decision setting forth findings and conclusions only as to the claims or disputes at issue. Any award by the arbitrator shall be final and conclusive upon the parties, and a judgement thereon may be entered in the highest court for the forum, state or federal, having jurisdiction. All expenses of the arbitration process shall be borne by the Corporation. The Corporation shall reimburse the Executive for the reasonable fees of legal counsel as incurred in connection with arbitrating the enforcement of any of the Executive's rights under this Agreement. However, in no event shall the Executive be entitled to retain any fees so reimbursed if the claim brought by the Executive against the 7 Corporation is in the arbitrator's sole determination frivolous or was brought in bad faith, and the Corporation will be entitled to seek repayment from the Executive for such fees after such determination by the arbitrator. 10. The invalidity or unenforceability of any provision of this Agreement shall not affect the enforceability or validity of any other provision hereof. 11. This Agreement constitutes the entire agreement of the parties with respect to the subject matter addressed in this Agreement. This Agreement may be amended only in a written document signed by both the Corporation and the Executive. 12. This Agreement shall be governed by the laws of the State of Michigan. This Agreement has been executed by the parties effective as of __________________________. CITIZENS BANKING CORPORATION EXECUTIVE By: -------------------------------- ------------------------------ William R. Hartman Chairman, President and Chief Executive Officer Date: Date: ------------------- ------------------- Name, Principal Position of Participants, and Effective Date of Contract: William R. Hartman, Chairman, President and Chief Executive Officer, February 25, 2002. Charles D. Christy, Executive Vice President and Chief Financial Officer, September 3, 2002. John D. Schwab, Executive Vice President and Chief Credit Officer, November 12, 2002. 8 EX-10.18 4 k82546exv10w18.txt CHANGE IN CONTROL AGREEMENT, DATED APRIL 7, 2003 Exhibit 10.18 (Form 10-K) CHANGE IN CONTROL AGREEMENT This Change in Control Agreement ("Agreement") is made by and between Citizens Banking Corporation, a Michigan corporation ("Corporation"), and Randall J. Peterson ("Executive"). The Corporation anticipates the valuable services that the Executive will render on behalf of the Corporation and its subsidiary banks and is desirous of having some assurance that the Executive will continue as an employee and that, in the event of a possible Change in Control of the Corporation, the Executive will be able to perform his duties without undue concern for the Executive's personal financial well-being; and The Executive is willing to serve as an employee of the Corporation but desires assurance that in the event of a Change in Control of the Corporation, he will continue to have the responsibility and status he has earned. Accordingly, the Corporation and the Executive agree as follows: 1. In order to protect the Executive against the possible consequences of a Change in Control of the Corporation, as defined in paragraph 2 of this Agreement, and thereby to induce the Executive to serve as an officer of the Corporation or a subsidiary bank the Corporation agrees that if (a) there is such a Change in Control of the Corporation and (b) the Executive's employment with the Corporation or a subsidiary bank is terminated under the circumstances described in paragraph 3 of this Agreement, then: A. The Corporation shall pay the Executive a lump sum amount in cash equal to the sum of (i) three times the Executive's annual base salary immediately prior to the Change in Control (or if higher, the annual base salary on the date the Executive's employment is terminated) and (ii) three times the greater of (x) the anticipated bonus amount under the Citizens Banking Corporation Management Incentive Plan to be earned in accordance with the plan in the year in which the termination occurs or (y) the highest bonus paid to the Executive in the last three full calendar years of such employment. The applicable amount shall be payable within 60 days following the date of the Executive's termination of employment. B. The Executive shall continue to be covered, at the Corporation's cost, by the medical, dental and life insurance benefit plans that are in effect on the date of his termination and that cover executive employees, for a period of thirty-six (36) months after his termination of employment; provided, however, that if during such time period the Executive should enter into other employment providing comparable benefits, his participation in such plans of the Corporation shall cease to the extent of his coverage by his new employer's plans. Any such non-cash benefit that is tied to compensation shall be based on the Executive's annual compensation averaged over the same period as applicable under paragraph A of this Agreement. C. If the Executive was furnished with a club membership, that membership will be transferred by the Corporation to the Executive at no cost to the Executive, who immediately following the transfer shall become subject to monthly dues charges of the club. D. All stock options and restricted stock previously granted by the Corporation to the Executive, whether or not then exercisable, shall become immediately vested and exercisable. E. For a period of one year following termination of the Executive's employment, the Executive shall be entitled to outplacement services provided by an outplacement service provider designated by the Corporation. The cost of providing the outplacement services shall be borne solely by the Corporation, and shall be equal to the lesser of (i) 10% of the Executive's annual base salary immediately prior to the Change in Control (or, if higher, the Executive's annual base salary as of the date of termination of the Executive's employment) and (ii) $20,000. F. If the payment of any of the foregoing amounts or benefits (when added to any other payments or benefits provided to the Executive in the nature of compensation) will result in the payment of an excess parachute payment as that term is defined in Section 280G of the Internal Revenue Code of 1986 ("Code"), then in such event, the Corporation shall pay the Executive an additional amount for each calendar year in which an excess parachute payment is received by the Executive (the "Gross-Up Payment"). The Gross-Up Payment is intended to cover the Executive's liability for any parachute tax under Code Section 4999 on such excess parachute payment, as well as federal and state income taxes and parachute tax on the additional amount, and shall be computed as follows: A=Pt/(1 - T - t), where - A is the additional amount for any calendar year; P is the amount of the excess parachute payment for the calendar year in excess of the allocable base amount as defined in Code Section 28OG(b)(3); T is the effective marginal rate of federal and state income tax applicable to the Executive for the calendar year; and t is the rate of parachute tax under Code Section 4999. The effective marginal rate of federal and state income tax shall be computed as follows: T = F + S(l - 0.8F) + m, where - F is the highest marginal rate of federal income tax applicable to the Executive for the calendar year; and S is the highest aggregate marginal rate of state income tax applicable to the Executive for the calendar year in the state or states and municipalities to 2 which he is then required to pay income taxes as a result of his employment by the Corporation; and m is the employee's portion of the Medicare tax, currently 1.45%. Payment of the Gross-Up Payment shall be made to the Executive on or before December 31 of each calendar year for which an excess parachute payment is received by the Executive. G. Subject to the provisions of paragraph G, all determinations required to be made under these paragraphs E, F and G, including whether and when a Gross-Up Payment is required and the amount of such Gross-Up Payment and the assumptions to be utilized in arriving at such determination, shall be made by Ernst & Young, LLP or such other certified public accounting firm reasonably acceptable to the Corporation as may be designated by the Executive (the "Accounting Firm") which shall provide detailed supporting calculations both to the Corporation and the Executive within 15 business days of the receipt of notice from the Executive that there has been an excess parachute payment, or such earlier time as is requested by the Corporation. All fees and expenses of the Accounting Firm shall be borne solely by the Corporation. Any determination by the Accounting Firm shall be binding upon the Corporation and the Executive. As a result of the uncertainty in the application of Section 4999 of the Code at the time of the initial determination by the Accounting Firm hereunder, it is possible that Gross-Up Payments which will not have been made by the Corporation should have been made ("Underpayment"), consistent with the calculations required to be made hereunder. In the event that the Corporation exhausts its remedies pursuant to paragraph G and the Executive thereafter is required to make a payment of any Excise Tax, the Accounting Firm shall determine the amount of the Underpayment that has occurred and any such Underpayment shall be promptly paid by the Corporation to or for the benefit of the Executive. H. The Executive shall notify the Corporation in writing of any claim by the Internal Revenue Service that, if successful, would require the payment by the Corporation of the Gross-Up Payment. Such notification shall be given as soon as practicable but no later than ten business days after the Executive is informed in writing of such claim and shall apprise the Corporation of the nature of such claim and the date on which such claim is requested to be paid. The Executive shall not pay such claim prior to the expiration of the 30-day period following the date on which it gives such notice to the Corporation (or such shorter period ending on the date that any payment of taxes with respect to such claim is due). If the Corporation notifies the Executive in writing prior to the expiration of such period that it desires to contest such claim, the Executive shall: (i) give the Corporation any information reasonably requested by the Corporation relating to such claim, (ii) take such action in connection with contesting such claim as the Corporation shall reasonably request in writing from time to time, including, without limitation, accepting legal representation with respect to such claim by an attorney reasonably selected by the Corporation, (iii) cooperate with the Corporation in good faith in order effectively to contest such claim, and (iv) permit the Corporation to participate in any proceedings relating to such claim; provided, however, that the Corporation shall bear and pay directly all costs and expenses (including additional interest and penalties) incurred in connection with such contest and shall indemnify and hold the Executive harmless, on an after-tax basis, for any Excise Tax or income tax (including interest and penalties with respect thereto) imposed as a result of such 3 representation and payment of costs and expenses. Without limitation on the foregoing provisions of this subparagraph H, the Corporation shall control all proceedings taken in connection with such contest and, at its sole option, may pursue or forgo any and all administrative appeals, proceedings, hearings and conferences with the taxing authority in respect of such claim and may, at its sole option, either direct the Executive to pay the tax claimed and sue for a refund or contest the claim in any permissible manner, and the Executive agrees to prosecute such contest to a determination before any administrative tribunal, in a court of initial jurisdiction and in one or more appellate courts, as the Corporation shall determine; provided, however, that if the Corporation directs the Executive to pay such claim and sue for a refund, the Corporation shall advance the amount of such payment to the Executive, on an interest-free basis, and shall indemnify and hold the Executive harmless, on an after-tax basis, from any Excise Tax and income tax (including interest or penalties with respect thereto) imposed with respect to such advance or with respect to any imputed income with respect to such advance calculated as described in subparagraph F of this section; and further provided that any extension of the statute of limitations relating to payment of taxes for the taxable year of the Executive with respect to which such contested amount is claimed to be due is limited solely to such contested amount. Furthermore, the Corporation's control of the contest shall be limited to issues with respect to which a Gross-Up Payment would be payable hereunder and the Executive shall be entitled to settle or contest, as the case may be, any other issue raised by the Internal Revenue Service or any other taxing authority. If, after the receipt by the Executive of an amount advanced by the Corporation pursuant to this subparagraph H, the Executive becomes entitled to receive any refund with respect to such claim, the Executive shall (subject to the Corporation's complying with the requirements of this subparagraph H) promptly pay to the Corporation the amount of such refund (together with any interest paid or credited thereon after taxes applicable thereto). If, after the receipt by the Executive of an amount advanced by the Corporation pursuant to this subparagraph H, a determination is made that the Executive shall not be entitled to any refund with respect to such claim and the Corporation does not notify the Executive in writing of its intent to contest such denial of refund prior to the expiration of 30 days after such determination, then such advance shall be forgiven and shall not be required to be repaid and the amount of such advance shall offset, to the extent thereof, the amount of Gross-Up Payment required to be paid. 2. For purposes of this Agreement, a "Change in Control" shall mean: A. The acquisition by any individual, entity or group (within the meaning of Section 13(d)(3) or 14(d)(2) of the Securities Exchange Act of 1934, as amended (the "Exchange Act")) (a "Person") of beneficial ownership (within the meaning of Rule l3d-3 promulgated under the Exchange Act) of 20% or more of either (1) the then outstanding shares of common stock of the Corporation (the "Outstanding Corporation Common Stock") or (2) the combined voting power of the then outstanding voting securities of the Corporation entitled to vote generally in the election of directors (the "Outstanding Corporation Voting Securities"); provided, however, that for purposes of this subparagraph A, the following acquisitions shall not constitute a Change in Control: (i) any acquisition directly from the Corporation, (ii) any acquisition by the Corporation, (iii) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Corporation or any corporation controlled by the Corporation, or.(iv) any acquisition by any corporation pursuant to a transaction which complies with clauses (1), (2) and (3) of subparagraph C of this paragraph 2; or 4 B. Individuals who, as of the date hereof, constitute the Board of Directors of the Corporation (the "Incumbent Board") cease for any reason to constitute at least a majority of the Board of Directors; provided, however, that any individual becoming a director subsequent to the date hereof whose election, or nomination for election by the Corporation's shareholders, was approved by a vote of at least a majority of the directors then comprising the Incumbent Board (either by a specific vote or by approval of the proxy statement of the Corporation in which such person is named as a nominee for director, without written objection to such nomination) shall be considered as though such individual were a member of the Incumbent Board, but excluding, for this purpose, any such individual whose initial assumption of office occurs as a result of an actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or contests by or on behalf of a person other than the Board of Directors of the Corporation; or C. Consummation of a reorganization, merger, share exchange or consolidation or sale of other disposition of all or substantially all of the assets of the Corporation (a "Business Combination"), in each case, unless, following such Business Combination: (1) all or substantially all of the individuals and entities who were the beneficial owners, respectively, of the Outstanding Corporation Common Stock and Outstanding Corporation Voting Securities immediately prior to such Business Combination beneficially own, directly or indirectly, more than 65% of, respectively, the then outstanding shares of common stock and the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, a corporation which as a result of such transaction owns the Corporation or all or substantially all of the Corporation's assets either directly or through one or more subsidiaries) in substantially the same proportions as their ownership, immediately prior to such Business Combination of the Outstanding Corporation Common Stock and Outstanding Corporation Voting Securities, as the case may be; (2) no Person (excluding any corporation resulting from such Business Combination or any employee benefit plan (or related trust) of the Corporation or such corporation resulting from the Business Combination) beneficially owns, directly or indirectly, 20% or more of, respectively, the then outstanding shares of common stock of the corporation resulting from such Business Combination or the combined voting power of the then outstanding voting securities of such corporation except to the extent that such ownership existed prior to the Business Combination; and (3) at least a majority of the members of the board of directors of the corporation resulting from such Business Combination were members of the Incumbent Board immediately prior to the time of the execution of the initial agreement, or of the action of the Board of Directors of the Corporation, providing for such Business Combination; or D. Approval by the stockholders of the Corporation of a complete liquidation or dissolution of the Corporation. 3. Termination of the Executive's employment shall mean the Executive's termination of employment at any time within 3 months prior to, on the date of, or within 24 months after a Change in Control of the Corporation as defined in paragraph 2 of this Agreement either by (a) involuntary dismissal by the Corporation; or (b) the Executive's constructive termination as described in the following sentences of this paragraph 3. If (i) there is a significant reduction in the scope of the Executive's authority or in the extent of his powers, functions, duties or 5 responsibilities, or (ii) the Executive's annual rate of compensation is reduced or fringe benefits, including relocation benefits, are not provided to him on a basis commensurate with other executives of the Corporation and its subsidiary banks, or (iii) there are changes in the Executive's responsibilities for the Corporation which require moving the Executive's job location to a location outside of the State of Wisconsin, then the Executive shall be entitled to give written notice thereof to the Board of Directors of the Corporation. If within 60 days following such notice, the Executive and the Board of Directors of the Corporation do not resolve the Executive's concerns to the satisfaction of the Executive (the Executive's satisfaction or dissatisfaction to be communicated to the Board of Directors of the Corporation in writing within such 60 days), the Executive's employment shall be deemed to be constructively terminated at the end of such 60-day period. 4. The specific arrangements referred to above are not intended to exclude the Executive's participation in other benefits available to executive personnel of the Corporation generally or to preclude other compensation or benefits as may be authorized by the Corporation's Board of Directors from time to time. 5. As partial consideration for the above, the Executive agrees not to disclose any confidential information about the Corporation and its operation to which the Executive was privy during the course of his employment by the Corporation. Further, the Executive agrees not to accept employment or consult for or otherwise assist any competitor of the Corporation for a period of 24 months following his termination of employment. For purposes of the foregoing, "competitor" means any financial institution that conducts business from any location within 50 miles of any location at which the Corporation or any subsidiary bank had an office on the day immediately prior to the day on which the Change of Control of the Corporation occurred. 6 6. This Agreement shall be binding upon and shall inure to the benefit of the respective successors, assigns, legal representatives and heirs to the parties. 7. Any payment or delivery required under this agreement shall be subject to all requirements of the law with regard to withholding, filing, making of reports and the like, and the Corporation shall use its best efforts to satisfy promptly all such requirements. 8. Notwithstanding anything contained herein to the contrary, this Agreement shall be terminated and no benefits to the Executive shall be payable if, at any time, the Executive shall resign voluntarily (other than as provided in Section 3) , retire at or after normal retirement age, become incapacitated, voluntarily take another position requiring a substantial portion of his time, or die. This Agreement also shall terminate upon termination for cause of the Executive's employment as an officer of the Corporation or any subsidiary bank by the Incumbent Board. For purposes of the foregoing, "termination for cause" means termination due to the Executive's conviction of a felony, a determination that the Executive is guilty of sexual harassment of another employee, the Executive's proven embezzlement from the Corporation or a subsidiary bank, the Executive's gross misconduct or incompetence, the Executive's disclosure of confidential information of the Corporation or intentional assistance of a competitor of the Corporation (as defined in paragraph 5), or any other activity of the Executive which has or may have a material adverse effect on the finances or business reputation of the Corporation or a subsidiary bank. 9. Any and all disputes, controversies or claims arising out of or in connection with or relating to this Agreement or any breach or alleged breach thereof shall, upon the request of either party, be submitted to and settled by arbitration in the State of Michigan pursuant to the Voluntary Labor Arbitration Rules, then in effect, of the American Arbitration Association (or at any other place or under any other form of arbitration mutually acceptable to the parties involved). The parties hereto specifically agree to arbitrate with the other party in a proceeding with regard to all issues and disputes, and to permit pre-hearing discovery in the time and manner provided by the then applicable Federal Rules of Civil Procedure. This agreement to arbitrate shall be specifically enforceable under the prevailing arbitration law. Notice of the demand for arbitration shall be filed, in writing, with the other party to this Agreement and with the American Arbitration Association. The demand for arbitration shall be made within a reasonable time after the claim, dispute, or other matter in question arose where the party asserting the claim should reasonably have been aware of the same, but in no event later than the applicable Michigan or federal statute of limitations. The arbitrator shall have no power to add to, subtract from, or alter the terms of this Agreement, and shall render a written decision setting forth findings and conclusions only as to the claims or disputes at issue. Any award by the arbitrator shall be final and conclusive upon the parties, and a judgement thereon may be entered in the highest court for the forum, state or federal, having jurisdiction. All expenses of the arbitration process shall be borne by the Corporation. The Corporation shall reimburse the Executive for the reasonable fees of legal counsel as incurred in connection with arbitrating the enforcement of any of the Executive's rights under this Agreement. However, in no event shall the Executive be entitled to retain any fees so reimbursed if the claim brought by the Executive against the 7 Corporation is in the arbitrator's sole determination frivolous or was brought in bad faith, and the Corporation will be entitled to seek repayment from the Executive for such fees after such determination by the arbitrator. 10. The invalidity or unenforceability of any provision of this Agreement shall not affect the enforceability or validity of any other provision hereof. 11. This Agreement constitutes the entire agreement of the parties with respect to the subject matter addressed in this Agreement. This Agreement may be amended only in a written document signed by both the Corporation and the Executive. 12. This Agreement shall be governed by the laws of the State of Michigan. This Agreement has been executed by the parties effective as of April 7, 2003. CITIZENS BANKING CORPORATION EXECUTIVE By: ---------------------------- -------------------- William R. Hartman Randall J. Peterson Chairman, President and Chief Executive Officer Date: April 7, 2003 Date: April 7, 2003 8 EX-13 5 k82546exv13.txt 2003 ANNUAL REPORT Exhibit 13 (Form 10-K) CITIZENS BANKING CORPORATION 2003 ANNUAL REPORT INFORMATION CITIZENS BANKING CORPORATION 2003 ANNUAL REPORT INFORMATION This report contains information required to be included in an annual report pursuant to the rules of the Securities and Exchange Commission, including audited financial statements, management's discussion and analysis of financial condition and results of operations and five year selected financial data. Upon request, Citizens Banking Corporation will provide without charge a copy of its annual report on Form 10-K. TABLE OF CONTENTS I. Financial Review including Management's Discussion and Analysis Management's Discussion and Analysis ................................... 34 Five Year Summary of Selected Financial Data ....................... 34 Forward-Looking Statements ......................................... 35 Overview ........................................................... 36 Summary of Financial Results ....................................... 37 Critical Accounting Policies ....................................... 38 Recent Accounting Pronouncements and Recent Developments ........... 39 Results of Operations .............................................. 41 Net Interest Income ............................................ 41 Noninterest Income ............................................. 44 Noninterest Expense ............................................ 45 Federal Income Taxes ........................................... 47 Line of Business Results ....................................... 47 Financial Condition ................................................ 48 Summary ........................................................ 48 Average Total Assets ........................................... 49 Investment Securities and Money Market Investments ............. 49 Loan Portfolio ................................................. 50 Nonperforming Assets ........................................... 56 Deposits ....................................................... 57 Borrowed Funds ................................................. 58 Capital Resources .............................................. 59 Contractural Obligations and Off-Balance Sheet Arrangements .... 59 Liquidity and Debt Capacity ........................................ 62 Interest Rate Risk ................................................. 63 Selected Quarterly Information ..................................... 65 II. Consolidated Financial Statements Consolidated Balance Sheets ............................................ 66 Consolidated Statements of Income ...................................... 67 Consolidated Statements of Changes in Shareholders' Equity ............. 68 Consolidated Statements of Cash Flows .................................. 69 III. Notes to Consolidated Financial Statements ................................. 70 IV. Report of Independent Auditors ............................................. 102 V. Report of Management ....................................................... 103
33 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CITIZENS BANKING CORPORATION AND SUBSIDIARIES
- --------------------------------------------------------------------------------------------------------------------------- TABLE 1. FIVE YEAR SUMMARY OF SELECTED FINANCIAL DATA (in thousands, except per share data) 2003 2002 2001 2000 1999 - ----------------------------------------------------- ----------- ----------- ----------- ----------- ----------- FOR THE YEAR Net interest income $ 286,258 $ 301,782 $ 307,981 $ 314,874 $ 309,642 Provision for loan losses 62,962 120,200 26,407 20,983 24,675 Noninterest income before securities gains (losses) 94,716 99,340 111,286 90,344 85,044 Investment securities gains (losses) 103 2,436 6,195 -- (3,052) Noninterest expense(1) 232,988 259,383 251,183 257,762 276,976 Income tax provision (benefit) 19,176 (1,063) 43,215 35,813 27,989 Net income 65,951 25,038 104,657 90,660 61,994 Cash dividends 49,476 50,659 50,158 48,108 30,035 PER COMMON SHARE DATA Net income: Basic $ 1.52 $ 0.56 $ 2.27 $ 1.92 $ 1.29 Diluted 1.51 0.56 2.25 1.91 1.28 Cash dividends 1.140 1.130 1.085 1.015 0.915 Book value, end of year 14.69 14.88 15.46 14.62 13.32 Market value, end of year 32.72 24.78 32.88 29.06 22.38 AT YEAR END Assets $ 7,711,070 $ 7,524,724 $ 7,682,899 $ 8,409,749 $ 7,900,547 Portfolio Loans (2) 5,245,702 5,432,561 5,771,963 6,422,806 5,917,483 Deposits 5,442,267 5,936,913 5,965,126 6,244,141 6,128,998 Long-term debt 936,859 599,313 629,099 471,117 127,104 Shareholders' equity 635,162 650,469 697,464 679,979 633,669 AVERAGE FOR THE YEAR Assets $ 7,693,931 $ 7,569,341 $ 7,935,843 $ 8,073,021 $ 7,342,167 Earning assets 7,272,887 7,160,596 7,510,332 7,584,932 6,875,643 Portfolio Loans (2) 5,248,922 5,530,790 5,977,744 6,202,157 5,528,963 Deposits 5,665,533 5,924,442 6,008,096 6,121,373 5,906,664 Interest-bearing deposits 4,787,594 5,054,743 5,126,928 5,175,252 5,002,135 Repurchase agreements and other short-term borrowings 458,673 251,315 538,673 920,323 478,920 Long-term debt 861,704 620,913 596,380 303,597 210,289 Shareholders' equity 632,060 691,834 702,381 650,251 672,227 FINANCIAL RATIOS Return on average: Shareholders' equity 10.44% 3.62% 14.90% 13.94% 9.22% Earning assets 0.91 0.35 1.39 1.20 0.90 Assets 0.86 0.33 1.32 1.12 0.84 Average shareholders' equity/avg. assets 8.21 9.14 8.85 8.05 9.16 Dividend payout ratio 75.02 202.33 47.93 53.06 59.13 Net interest margin (FTE) 4.15 4.45 4.32 4.32 4.68 Tier I leverage ratio 7.45 7.18 7.79 7.11 7.21 Tier I risk-based capital ratio 9.80 9.18 9.87 9.05 9.22 Total risk-based capital ratio 13.23 10.43 11.12 10.30 10.47 - ---------------------------------------------------------------------------------------------------------------------------
(1) Citizens recorded special charges of $13,402,000 in 2002, $15,541,000 in 2000 and $40,198,000 in 1999 for mergers, restructurings and other initiatives. Additionally, the year 2003 included a special charge credit of ($691,000). The special charges and the related credit were included in noninterest expense. (2) Excludes mortgage loans held for sale. 34 The following commentary presents management's discussion and analysis of Citizens Banking Corporation's financial condition and results of operations for each of the past three years and should be read in conjunction with the accompanying Consolidated Financial Statements and Notes. Unless the context indicates otherwise, all references in the discussion to "Citizens," the "Company," "our," "us" and "we" refer to Citizens Banking Corporation and its subsidiaries. FORWARD-LOOKING STATEMENTS Discussions in this report that are not statements of historical fact (including statements that include terms such as "may," "should," "believe," "expect," "anticipate," "estimate," "intend," and "plan") are forward-looking statements that involve risks and uncertainties, and our actual future results could materially differ from those discussed. Factors that could cause or contribute to such differences include, without limitation, risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission, as well as the following. - We face the risk that loan losses, including unanticipated loan losses due to changes in our loan portfolios, fraud and economic factors, will exceed our allowance for loan losses and that additional increases in the allowance will be required. Additions to the allowance would cause net income to decline and could have a negative impact on our capital. - While we attempt to manage the risk from changes in market interest rates, interest rate risk management techniques are not exact. In addition, we may not be able to economically hedge our interest rate risk. A rapid or substantial increase or decrease in interest rates could adversely affect our net interest income and results of operations. - An economic downturn, and the negative economic effects caused by terrorist attacks, potential attacks and other destabilizing events, would likely contribute to the deterioration of the quality of our loan portfolio and could reduce our customer base, our level of deposits, and demand for financial products such as loans. - If we are unable to continue to attract core deposits, our cost of funds will increase, adversely affecting our ability to generate the funds necessary for lending operations, reducing our net interest margin and negatively affecting our results of operations. - Increased competition with other financial institutions could reduce our net income by decreasing the number and size of loans that we originate, the interest rates we may charge on these loans and the fees we are able to charge for services to our customers. - The financial services industry is undergoing rapid technological changes. If we are unable to adequately invest in and implement new technology-driven products and services, we may not be able to compete effectively, or our cost to provide products and services may increase significantly. - Our business may be adversely affected by the highly regulated environment in which we operate. Changes in banking or tax laws, regulations and regulatory practices at either the federal or state level may adversely affect us, including our ability to offer new products and services, obtain financing, dividend funds to our parent company, attract deposits, make loans and leases and achieve satisfactory spreads, and may also result in the imposition of additional costs on us. - The products and services offered by the banking industry and customer expectations regarding them are subject to change. We attempt to respond to perceived customer needs and expectations by offering new products and services, such as our new wealth management capabilities, which are often costly to develop and market initially. A lack of market acceptance of these products and services would have a negative effect on our results of operations. - New accounting pronouncements may be issued by the accounting profession, regulators or other government bodies which could change our existing accounting methods. Changes in accounting methods could negatively impact our results of operations and capital. - We could face unanticipated environmental liabilities or costs related to both real property that we own or that we acquire through foreclosure. Compliance with federal, state and local environmental laws and regulations, including those related to investigation and clean-up of contaminated sites, may increase our capital costs and operating expenses. - As a bank holding company that conducts substantially all of its operations through its subsidiaries, the ability of the parent company to pay dividends, repurchase its shares or to repay its indebtedness depends upon the results of operations of its subsidiaries and their ability to pay dividends to the parent company. Dividends paid by these subsidiaries are subject to limits imposed by federal and state law. 35 Other factors not currently anticipated by management may also materially and adversely affect our results of operations. There can be no assurance that future results will meet expectations. While we believe that our forward-looking statements are reasonable, you should not place undue reliance on any forward-looking statement. In addition, these statements speak only as of the date made. We do not undertake, and expressly disclaim any obligation, to update or alter our forward-looking statements whether as a result of new information, future events or otherwise, except as required by applicable law. OVERVIEW OUR BUSINESS We are a diversified banking and financial services company that provides a full range of banking and financial services to individuals and businesses through our Citizens Bank and F&M Bank subsidiaries. We also provide wealth management services through Citizens Bank Wealth Management, N.A., and through trust departments of two of our bank affiliates. We conduct our operations through 176 branch, private banking and financial center locations and 194 ATM locations throughout Michigan, Wisconsin, Iowa and Illinois. We operate primarily in three business lines: commercial banking, consumer banking and wealth management. Our performance is monitored by an internal profitability measurement system that provides line of business results and key performance measures including return on assets, return on equity, net interest margin, allowance for loan losses to portfolio loans, net loans charged off percentage and nonperforming assets as a percent of total assets. These key performance measures for the last five years are presented in Tables 1, 6 and 8 of Management's Discussion and Analysis of Financial Condition and Results of Operations. Our primary source of revenue is net interest income, which is the difference between interest income on earning assets such as loans and securities and interest expense on liabilities, including interest-bearing deposits and borrowings used to fund those assets. Net interest income is affected by fluctuations in the amount and composition of earning assets and funding sources and in the yields earned and rates paid, respectively, on these assets and liabilities. We measure the level of interest income relative to earning assets and interest bearing liabilities through two statistics - interest spread and net interest margin. The interest spread represents the difference between yields on earning assets and the rates paid for interest-bearing liabilities. The net interest margin is expressed as the percentage of net interest income to average earning assets. A low interest rate environment, such as experienced in 2003, has the effect of reducing the interest spread and net interest margin. Our other significant source of revenue is comprised of the fees and charges we collect in connection with our products and services. These fees and charges, which are classified as noninterest income, include service charges on deposit accounts, fees charged for trust services related to personal, institutional and employee benefit products and services, revenue related to loan products including commercial loan fees and mortgage banking revenue, and fees for various other services including brokerage and investment services, ATM network use, and financial services. Our net income can also be significantly affected by additions to our allowance for loan losses. Extending credit to businesses and consumers exposes us to the risk that the principal balance of a loan and any related interest will not be collected. We mitigate this credit risk through portfolio diversification that limits exposure to any single industry or customer and by establishing a comprehensive system of internal controls. The allowance for credit losses represents our estimate of probable losses inherent in our loan portfolio. The allowance is based on ongoing quarterly assessments of historical data and general economic factors, among other things, and is maintained at a level we consider adequate to absorb probable loan losses identified with specific customer relationships and probable losses believed to be inherent in the loan portfolio which have not been specifically identified. Our evaluation process is inherently subjective, as it requires estimates that may be susceptible to significant change and have the potential to materially affect net income. In the event that we overestimate future cash flows or underestimate losses on loan pools, we may be required to increase our provision for loan losses, which would have a negative impact on results of operations in the period in which the increase occurred. Business volumes may be influenced by overall economic factors including market interest rates, business spending, consumer confidence and competitive conditions. During 2003, record low interest rates resulted in increased mortgage origination volume and lifted mortgage income to a new high. The high level of mortgage refinancings had a negative impact on our mortgage-related securities portfolio, as accelerated prepayments depressed interest yields. Rising mortgage interest rates during the third quarter slowed mortgage origination volumes in the fourth quarter and 2004 originations will likely remain well below 2003 levels. Growth in home equity and indirect lending experienced during 2003 is anticipated to continue into 2004. 36 Commercial loan outstandings declined in 2003 as payoffs exceeded new loan volume. High payoffs resulted from low levels of corporate investment spending and our proactive reduction of exposure on credits with the potential to deteriorate. Commercial credit costs remained high in 2003, but recent trends in our nonperforming assets and net charge-offs are encouraging. The provision for loan losses and net charge-offs are expected to decline in 2004. Proper management of the volume and composition of our earning assets and funding sources is essential for ensuring strong and consistent earnings performance, maintaining adequate liquidity and limiting exposure to risks caused by changing market conditions. Our investment securities portfolio is structured to provide a source of liquidity principally through the maturity of the securities held in the portfolio and to generate an income stream with relatively low levels of principal risk. Loans comprise the largest component of earning assets and are our highest yielding assets. Client deposits are the primary source of funding for earning assets while short-term debt and other managed sources of funds are utilized as market conditions and liquidity needs change. We monitor and manage our liquidity position so that funds will be available at a reasonable cost to meet client cash flow needs, while maintaining funds available for loan and investment opportunities as well as to pay dividends to shareholders, service debt, invest in subsidiaries, finance business expansion, and to satisfy other operating requirements and take advantage of unforeseen opportunities. We derive liquidity primarily through core deposit growth, maturity of money market investments, and maturity and sale of investment securities and loans. We also have access to market borrowing sources for both short-term and long-term purposes. SUMMARY OF FINANCIAL RESULTS An analysis of the major components of net income in 2003, 2002 and 2001 is presented below.
Year Ended December 31, --------------------------------- (in thousands) 2003 2002 2001 - --------------------------------------------------------------------------------- --------- --------- --------- Interest income (1) $ 405,977 $ 463,384 $ 573,559 Interest expense 119,719 161,602 265,578 --------- --------- --------- Net interest income 286,258 301,782 307,981 Provision for loan losses 62,962 120,200 26,407 Noninterest income (1) 94,819 101,776 117,481 Noninterest expense (1) 232,988 259,383 251,183 Income tax provision (1) 19,176 (1,063) 43,215 --------- --------- --------- NET INCOME $ 65,951 $ 25,038 $ 104,657 ========= ========= ========= (1) INCLUDES SIGNIFICANT CHARGES AND/OR GAINS AS FOLLOWS: Interest income $ -- $ (701) $ -- --------- --------- --------- Noninterest income Gains from sale of securitized portfolio mortgages -- 2,436 5,372 Gains from sale of merchant business, an equity investment and other assets -- 5,400 14,433 Other charges -- (1,587) -- --------- --------- --------- Total gains and other charges recorded in noninterest income -- 6,249 19,805 --------- --------- --------- Noninterest expense Special charge -- (13,402) -- Other charges -- (7,137) -- --------- --------- --------- Total special and other charges recorded in noninterest expense -- (20,539) -- --------- --------- --------- Tax benefit (expense) -- 5,247 (6,337) --------- --------- --------- NET INCREASE (DECREASE) TO INCOME $ -- $ (9,744) $ 13,468 --------- --------- --------- - ---------------------------------------------------------------------------------------------------------------------
37 For the year ended December 31, 2003, we recorded net income of $66.0 million, or $1.51 per diluted share, compared with $25.0 million, or $0.56 per diluted share for 2002 and $104.7 million, or $2.25, per diluted share in 2001. Returns on average assets and average equity for 2003 were 0.86% and 10.44%, respectively, compared to returns of 0.33% and 3.62%, respectively, in 2002 and returns of 1.32% and 14.90%, respectively, in 2001. Net income increased 163% in 2003 compared to 2002 due largely to actions taken in the third quarter of 2002 to improve our credit quality risk profile, restructure the Company along its three major lines of business, improve client service and reduce future operating costs. The actions taken included a large loan loss provision ($89.3 million compared to previous quarterly provisions of $5.0 to $9.0 million) in the third quarter of 2002 and the special charge of $13.4 million and other charges of $9.4 million, referred to below in "Recent Developments". As a result of these actions in 2002, loan loss provision and noninterest expense were substantially lower in 2003 compared to the prior year, resulting in higher net income in 2003. The increase in net income in 2003 was offset in part by lower net interest income, as a result of a decline in the net interest margin, and lower noninterest income due to gains in 2002 from the sale of securitized portfolio mortgages and the sale of the merchant services business. Net income was down 76% in 2002 compared to 2001 due largely to the previously mentioned higher loan loss provision and special and other charges incurred in the third quarter of 2002. Full year net income for 2002 was also impacted by lower gains on the sale of securitized portfolio mortgages and other assets in 2002 than in 2001 and a decline in net interest income due to a lower volume of earning assets. CRITICAL ACCOUNTING POLICIES Citizens' Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the industry in which we operate. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such, have a greater possibility of producing results that could be materially different than originally reported. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions and estimates underlying those amounts, management has identified the determination of the allowance for loan losses and the benefit obligation and net periodic pension expense for our employee pension and postretirement benefit plans to be the accounting areas that require the most subjective or complex judgments, and, therefore, are the most likely to vary materially as new information becomes available. Our significant accounting policies are more fully described in Note 1 to the Consolidated Financial Statements. The allowance for loan losses represents management's estimate of probable losses inherent in the loan portfolio, the largest asset category on the consolidated balance sheet. Determining the amount of the allowance for loan losses is considered a critical accounting policy because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which are susceptible to significant change. Default frequency, internal risk ratings, expected future cash collections, loss recovery rates, and general economic factors, among other things, are considered in this evaluation, as are the size and diversity of individual large credits. The allowance for loan losses consists of an allocated component and an unallocated component. The components of the allowance for loan losses represent an estimation pursuant to either SFAS 5, Accounting for Contingencies, or SFAS 114, Accounting by Creditors for Impairment of a Loan. The allocated component of the allowance for loan losses reflects expected losses resulting from analysis developed through specific credit allocations for individual loans (the specific allocation allowance) and on historical loss experience for each loan category (the risk allocation allowance). Specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate it is probable that a loss has been incurred. The specific credit allocations are based on a regular analysis of all commercial and commercial mortgage loans over a fixed dollar amount where the internal credit rating is at or below a predetermined classification. The unallocated portion of the allowance reflects management's estimate of inherent but undetected losses within the portfolio due to uncertainties in economic conditions, delays in obtaining information, including unfavorable information about a borrower's financial condition, the difficulty in identifying triggering events that correlate perfectly to subsequent loss rates, and risk factors that have not yet manifested themselves in loss allocation factors. In addition, the unallocated allowance includes a component that explicitly accounts for the inherent imprecision in loan loss projection models. We 38 have grown through acquisition, expanded the geographic footprint in which we operate, and changed our portfolio mix in recent years. As a result, historical loss experience data used to establish allocation estimates may not precisely correspond to the current portfolio. The uncertainty surrounding the strength and timing of economic cycles, including our concerns over the effects of the prolonged economic downturn in the current cycle, also affects the allocation model's estimates of loss. The historical losses used may not be representative of actual losses inherent in the portfolio that have not yet been realized. In the event that we overestimate future cash flows or underestimate losses on loan pools, we may be required to increase our provision for loan losses, which would have a negative impact on results of operations in the period in which the increase occurred. In the third quarter of 2002, we experienced a significant increase in the allowance for loan losses due to elevated past-due and nonperforming loan levels, a weakened economy and enhancements to the loan loss allocation model, including the incorporation of more recent historical loss data in the determination of projected loss rates for pools of loans evaluated collectively and refinements to our internal risk rating system for commercial loans, which led to an increase in risk rating downgrades. Note 1 to the Consolidated Financial Statements describes the methodology used to determine the allowance for loan losses and a discussion of the factors driving changes in the amount of the allowance for loan losses is included under "Provision and Allowance for Loan Losses." Pension liabilities are established and pension costs are charged to current operations based on actuarially determined present value calculations. The valuation of the pension obligation and net periodic pension expense is considered critical as it requires management to make estimates regarding the amount and timing of expected future cash outflows including assumptions about employee mortality, expected employee service periods, rate of employee compensation increases, and the long-term return on plan assets. If we were to determine that more conservative assumptions were necessary, our costs would likely increase and have a negative impact on results of operations in the period in which the increase occurred. Note 13 to the Consolidated Financial Statements provides further discussion on the accounting for Citizens' employee benefit plans and the estimates used in determining the actuarial present value of the benefit obligations and the net periodic pension expense. In 2003, we modified assumptions regarding the expected long-term rate of return and the assumed discount rate under our defined benefit pension plan, which will have a negative impact on future results. For a discussion of these changes and their expected impact on 2004 results, refer to "Noninterest Expense." The expected rate of return was determined using long-term historical returns of the various investment categories weighted by target asset allocations. See Note 13 of the Consolidated Financial Statements. The discount rate was derived from current market yields on long-term corporate bonds. The assumed discount rate is likely to change each year with fluctuations in market yields for long-term corporate bonds, while the expected long-term rate of return will likely exhibit less volatility. RECENT ACCOUNTING PRONOUNCEMENTS Note 2 to the Consolidated Financial Statements discusses new accounting policies adopted by Citizens during 2003 and 2002 and the expected impact of accounting policies recently issued or proposed but not yet required to be adopted. To the extent the adoption of new accounting standards materially affects Citizens' financial condition, results of operations or liquidity, the impact is discussed elsewhere in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and in Notes 1, 2 and 7 to the Consolidated Financial Statements. RECENT DEVELOPMENTS In the fourth quarter of 2003, we announced a major expansion in Oakland County, located in Southeast Michigan, one of the wealthiest counties in the nation. We intend to invest up to $35 to $40 million and to open as many as 10 to 14 new branches, including two hub offices over the next 24 months. This initiative will significantly add to the Bank's current Oakland County presence of six branches and four financial centers and increase staff by up to 180 employees. The first hub office, located in Troy, opened in January 2004. In the second quarter of 2003, Wealth Management formed strategic alliances with SEI Investments and EnvestnetPMC, Inc. These alliances will enable us to offer our wealth management clients a broader range of mutual fund family choices, access to separately managed accounts with specialized portfolio managers, state of the art research capabilities, and sophisticated client profiling and portfolio modeling tools. In addition, in the third quarter of 2003, Wealth Management, through an arrangement with EPIC Advisors, Inc., announced plans to increase and grow its retirement plan business by offering its clients advanced state-of-the-art online employee account access, online retirement plan design and consulting options, and access to industry experts. We successfully completed the conversion of our trust and investment accounting systems and operations with SEI Investments and our retirement plan processing systems with EPIC Advisors, Inc. in the fourth quarter of 2003, see "Noninterest Expense" and "Line of Business Results". 39 During the fourth quarter of 2002 and the first quarter of 2003, we experienced two unanticipated loan losses of $8.5 million and $11.5 million, respectively, resulting from collateral value shortfalls due to falsified borrowing base reports by the borrower. To reduce our risk of further unforeseen losses from similar collateral issues, we hired outside collateral auditors to conduct field audits on all loans in excess of specific dollar thresholds. We have also instituted regular audits of receivable and inventory collateral as a standard practice going forward. Refer to "Credit Risk Management" for further discussion. In 2002, we recorded a special charge of $13.4 million ($8.7 million after-tax) that included restructuring and impairment costs associated with reorganization of our consumer, commercial and wealth management lines of business. The reorganization resulted from a detailed review of our consumer banking, commercial banking and wealth management areas by key members of management with assistance from industry consultants. This review revealed opportunities for process change, staff reassignment, reporting structure changes, branch closures, expense reduction and business growth. As a result of the reorganization, we displaced 134 employees (157 employees less employees subsequently rehired for other available positions). Displaced employees were offered severance packages and outplacement assistance. As part of our restructuring initiatives, we recognized a pension curtailment related to the early termination of certain officers' employment earlier than expected. These pension benefits were provided under unfunded supplemental benefit plans. The curtailment resulted in a charge of $891,870 for the accelerated recognition of their prior service cost bases and was recorded as a component of the $13.4 million special charge. Also, twelve banking offices were closed in the fourth quarter of 2002 and six additional offices were closed during the second quarter of 2003. In the third quarter of 2002, we also charged to earnings $9.4 million ($6.1 million after-tax) of other significant items we considered unusual in nature. Net interest income was charged $701,000, comprised of an adjustment of $668,000 to premium amortization on mortgage-backed securities and a $33,000 write-off of accrued interest on a pool of government subsidized loans. Noninterest income was charged $1.6 million, which included market value adjustments of $662,000 in an equity investment and $650,000 to life insurance cash surrender values, and write-offs of $200,000 for obsolete assets and $75,000 for cash management fees accrued but not collectable. Noninterest expense was charged $7.1 million, comprised of a $3.3 million prepayment penalty on high cost FHLB debt, a $2.0 million contribution to our charitable trust, a $979,000 market valuation adjustment in other real estate, $406,000 in additional depreciation on equipment to be retired early and $452,000 in other items. The aforementioned $668,000 adjustment of our premium amortization on mortgage-backed securities in the third quarter of 2002 was the result of our quarterly review of prepayment assumptions. Low mortgage interest rate levels in 2002 resulted in an increase in prepayments and shortened the expected average life of these securities. Because the increase in prepayments was inconsistent with historical norms, the adjustment was determined to be unusual in nature. The aforementioned equity investment market value writedown in 2002 relates to a venture capital partnership that specializes in financing technology companies. In the third quarter of 2002, we received an accounting from the partnership showing significant writedowns in the carrying value of some of the investments in technology companies within the partnership due to the poor financial performance and the poor prospects of recovering some of these investments given the unfavorable market conditions for technology companies. As a result of these factors, we reduced the book value of our investment in the partnership by $662,000 from $1.1 million to $438,000, and, because of the broad scope and degree of decline in the technology sector, we determined the adjustment to be unusual in nature. The cash surrender value of separate-account life insurance policies is determined based upon the value of the underlying securities held in the policies. During the third quarter of 2002, the value of the underlying securities experienced a swift and significant decline due to the decrease in values in the equity markets. As a result, we reduced the book value on these policies by $650,000 from $2.2 million to $1.55 million, and considered the adjustment unusual due to the sharp and significant amount of the decline as a percent of the total cash surrender value of the policies. In the second quarter of 2002, we realized gains of $5.4 million on the sale of the merchant services business and $2.4 million on the sale of securitized mortgages. Significant gains in 2001 included $5.4 million on the sale of securitized mortgages, $2.6 million from the sale of credit card assets and $11.0 million from the sale of NYCE stock. In November 2001, we also sold F&M Bank-Minnesota with assets of $27.0 million. The bank was our sole location in Minnesota. This divestiture resulted in a pretax gain of $793,000. See "Noninterst Income". 40 RESULTS OF OPERATIONS NET INTEREST INCOME Table 2 presents net interest income, interest spread and net interest margin with average balances and related interest rates for the past three years. TABLE 2. AVERAGE BALANCES/NET INTEREST INCOME/AVERAGE RATES
2003 2002 ---------------------------------- ---------------------------------- Year Ended December 31 AVERAGE AVERAGE Average Average (in millions) BALANCE INTEREST (1) RATE (2) Balance Interest (1) Rate (2) - ---------------------------------------------------- --------- ------------ -------- --------- ------------ --------- EARNING ASSETS Money market investments $ 11.2 $ 0.1 0.94% $ 50.6 $ 0.8 1.61% Investment securities (3): Taxable 1,405.6 61.6 4.38 963.6 55.5 5.75 Tax-exempt 405.4 20.5 7.78 416.6 21.3 7.87 Mortgage loans held for sale 155.4 8.6 5.54 146.4 9.2 6.27 Portfolio Loans (4): Commercial 3,112.3 173.5 5.66 3,343.3 207.8 6.31 Real estate mortgage 527.6 32.3 6.12 686.2 49.8 7.24 Consumer 1,609.0 109.3 6.79 1,501.3 119.0 7.93 --------- ------- --------- ------- Total earning assets (3) 7,226.5 406.0 5.80 7,108.0 463.4 6.72 NONEARNING ASSETS Allowance for loan losses (120.9) (87.6) Investment security fair value adjustment 46.4 52.6 Nonearning assets 541.9 496.3 --------- --------- Total assets $ 7,693.9 $ 7,569.3 ========= ========= INTEREST BEARING LIABILITIES Deposits: Interest-bearing demand $ 1,319.9 11.7 0.89 $ 1,148.0 18.0 1.57 Savings 1,329.6 8.9 0.67 1,363.5 15.5 1.14 Time 2,138.1 62.8 2.94 2,543.3 94.4 3.71 Short-term borrowings 458.7 5.0 1.08 251.3 4.0 1.60 Long-term debt 861.7 31.3 3.63 620.9 29.7 4.79 --------- ------- --------- ------- Total interest bearing liabilities 6,108.0 119.7 1.96 5,927.0 161.6 2.73 NONINTEREST BEARING LIABILITIES AND SHAREHOLDERS' EQUITY Noninterest-bearing demand 877.9 869.7 Other liabilities 75.9 80.8 Shareholders' equity 632.1 691.8 --------- --------- Total liabilities and shareholders' equity $ 7,693.9 $ 7,569.3 --------- --------- NET INTEREST INCOME $ 286.3 $ 301.8 ======= ======= INTEREST SPREAD (5) 3.84% 3.99% Contribution of noninterest-bearing sources of funds 0.31 0.46 ---- ---- NET INTEREST MARGIN (5)(6) 4.15% 4.45% ==== ==== 2001 -------------------------------- Year Ended December 31 Average Average (in millions) Balance Interest(1) Rate(2) - ---------------------------------------------------- --------- ----------- -------- EARNING ASSETS Money market investments $ 46.9 $ 1.8 3.75% Investment securities (3): Taxable 896.1 57.6 6.43 Tax-exempt 419.2 21.7 7.97 Mortgage loans held for sale 131.3 9.0 6.85 Portfolio Loans (4): Commercial 3,440.8 269.7 7.93 Real estate mortgage 1,001.8 76.9 7.67 Consumer 1,535.2 136.9 8.91 --------- ------- Total earning assets (3) 7,471.3 573.6 7.87 NONEARNING ASSETS Allowance for loan losses (81.2) Investment security fair value adjustment 39.0 Nonearning assets 506.7 --------- Total assets $ 7,935.8 ========= INTEREST BEARING LIABILITIES Deposits: Interest-bearing demand $ 744.8 14.0 1.88 Savings 1,474.5 34.8 2.36 Time 2,907.6 156.1 5.37 Short-term borrowings 538.7 27.5 5.09 Long-term debt 596.4 33.2 5.57 --------- ------- Total interest bearing liabilities 6,262.0 265.6 4.24 NONINTEREST BEARING LIABILITIES AND SHAREHOLDERS' EQUITY Noninterest-bearing demand 881.2 Other liabilities 90.3 Shareholders' equity 702.4 --------- Total liabilities and shareholders' equity $ 7,935.8 --------- NET INTEREST INCOME $ 308.0 ======= INTEREST SPREAD (5) 3.63% Contribution of noninterest-bearing sources of funds 0.69 ---- NET INTEREST MARGIN (5)(6) 4.32% ====
(1) Interest income is shown on an unadjusted basis and therefore does not include taxable equivalent adjustments. (2) Average rates include taxable equivalent adjustments to interest income of $13,508,000, $14,470,000, and $14,835,000 for the years ended December 31, 2003, 2002, and 2001, respectively, based on a 35% tax rate. (3) For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts. (4) Nonaccrual loans are included in average balances. (5) The interest spread and net interest margin are presented on a tax-equivalent basis. (6) Because noninterest-bearing funding sources, demand deposits, other liabilities and shareholders' equity also support earning assets, the net interest margin exceeds the interest spread. 41 Net interest income, was $286.3 million in 2003, down from $301.8 million in 2002 and $308.0 million in 2001. The decline in net interest income in 2003 was attributable to a 30 basis point decline in the net interest margin to 4.15% in 2003 compared with 4.45% in 2002 partially offset by a $112.3 million increase in average earning assets. The net interest margin declined due to the combined effects of the continued low interest rate environment and accelerated prepayments in both the fixed rate commercial loan portfolio and the mortgage-related securities portfolio. Net premium amortization on investment securities totaled $10.0 million in 2003 compared with $1.9 million in 2002. The increase in 2003 is the result of accelerated premium amortization due to prepayments on the existing mortgage-related securities portfolio and additional on-going premium amortization on new purchases of mortgage-related securities. The decline in the net interest margin was also due, in part, to the expansion of the investment portfolio beginning near the end of the first quarter and continuing into the second quarter of 2003. Citizens expanded the investment portfolio by approximately $500 million in the first half of 2003, as we sought to offset the effects of weak loan demand and the prospect of net interest margin pressure from continued low interest rates on our net interest income. Citizens purchased mortgage backed securities and collateralized mortgage obligations with average lives of three to five years and an average duration of two to four years, resulting in interest spreads of up to 250 basis points over funding sources. As this expansion generated a 250 basis point spread to funding costs, it had a dilutive effect on our net interest margin. The decline in net interest income in 2002 was attributable to a lower level of earning assets partially offset by a more favorable asset mix and reduced reliance on short-term wholesale funding. During 2002 we took several steps to improve our earning asset mix and increase our net interest margin. In 2002, we sold 81% of our new mortgage loan production into the secondary market for $1.024 billion and securitized an additional $28.6 million, or 2%, of new mortgage loan production which we transferred to our investment portfolio. Additionally, $114.3 million of fixed and variable rate, seasoned mortgage loans previously held within our mortgage portfolio were securitized through the Federal National Mortgage Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC"). During 2002, we also refinanced $75 million of high cost Federal Home Loan Bank advances, reducing the interest rate on these funds by 486 basis points. Table 3 below shows changes in interest income, interest expense and net interest income due to volume and rate variances for major categories of earning assets and interest-bearing liabilities. TABLE 3. ANALYSIS OF CHANGES IN INTEREST INCOME AND INTEREST EXPENSE
2003 COMPARED TO 2002 2002 Compared to 2001 --------------------------------- --------------------------------- INCREASE (DECREASE) Increase (Decrease) DUE TO CHANGE IN Due to Change in Year Ended December 31 NET --------------------- Net -------------------- (in thousands) CHANGE(1) RATE(2) VOLUME(2) Change(1) Rate(2) Volume(2) - ------------------------------ ---------- --------- ---------- ---------- --------- --------- INTEREST INCOME: Money market investments $ (719) $ (248) $ (471) $ (950) $ (1,077) $ 127 Investment securities: Taxable 6,184 (15,621) 21,805 (2,186) (6,332) 4,146 Tax-exempt (799) (233) (566) (414) (280) (134) Mortgage loans held for sale (562) (2,435) 1,873 172 (810) 982 Loans: Commercial (34,297) (22,408) (11,889) (61,821) (54,922) (6,899) Real estate (17,452) (5,936) (11,516) (27,164) (4,079) (23,085) Consumer (9,762) (14,637) 4,875 (17,812) (13,436) (4,376) --------- --------- --------- ---------- --------- --------- Total (57,407) (61,518) 4,111 (110,175) (80,936) (29,239) --------- --------- --------- ---------- --------- --------- INTEREST EXPENSE: Deposits: Demand (6,305) (8,703) 2,398 4,042 (2,573) 6,615 Savings (6,590) (6,168) (422) (19,298) (15,985) (3,313) Time (31,505) (17,969) (13,536) (61,824) (44,609) (17,215) Short-term borrowings 927 (1,622) 2,549 (23,425) (13,171) (10,254) Long-term debt 1,590 (8,223) 9,813 (3,471) (4,794) 1,323 --------- --------- --------- ---------- --------- --------- Total (41,883) (42,685) 802 (103,976) (81,132) (22,844) --------- --------- --------- ---------- --------- --------- NET INTEREST INCOME $ (15,524) $ (18,833) $ 3,309 $ (6,199) $ 196 $ (6,395) ========= ========= ========= ========== ========= =========
(1) Changes are based on actual interest income and do not reflect taxable equivalent adjustments. (2) The change in interest not solely due to changes in volume or rates has been allocated in proportion to the absolute dollar amounts of the change in each. 42 Interest income declined $57.4 million in 2003 compared with 2002 due to lower yields on all asset categories. Yields declined due to the overall lower interest rate environment in 2003. Declining interest rates had a particularly significant impact on the yields on short-term and variable rate assets. In addition, accelerated prepayments in both the fixed-rate commercial and mortgage loan portfolios and the mortgage-related securities portfolio, as well as normal loan repayments and new origination in the lower interest rate environment, also led to the decline in earning asset yields. The unfavorable rate-related variances in interest income were partially offset by net favorable volume-related variances. The expansion of the taxable investment portfolio in the first half of 2003, growth in the consumer loan portfolio, particularly home equity loans, and higher average mortgage loans held for sale offset significant declines in the commercial and real estate loan portfolios and led to the favorable volume-related variances in 2003. Interest income declined $110.2 million in 2002 due primarily to unfavorable rate-related variances in the lower interest rate environment, and to a lesser extent, unfavorable volume-related variances due to lower average balances in all loan portfolios. Yields on commercial loans and certain consumer home equity loans were particularly impacted as many of these loans are tied to the prime interest rate, which declined 475 basis points during 2001 and another 50 basis points in November 2002. The largest volume-related decline in interest income occurred within the real estate loan portfolio due to the restructuring of our mortgage loan portfolio in 2002 and 2001. Interest expense decreased $41.9 million in 2003 due to favorable rate-related variances as the cost of all categories of interest bearing liabilities declined in 2003 compared with 2002, due to the continued low interest rate environment. Net unfavorable volume-related variances of $0.8 million partially offset the favorable rate-related variances. Average time deposits declined $405.2 million in 2003 from the prior year as a result of less aggressive pricing and concentrated efforts to grow core demand deposits. Higher average balances for interest bearing demand deposits, short term borrowings and long term debt offset the decline in time deposits. The increase in short-term borrowings and long term debt funded the aforementioned growth in the investment portfolio and offset the decline in time deposits. The increase in long term debt also resulted from the issuance of $125 million of subordinated debt in January 2003 and the issuance of approximately $25 million of trust preferred securities in June 2003 to provide liquidity and increase capital levels at the parent company. Interest expense declined $104.0 million in 2002 reflecting a lower cost of funds on all categories of interest bearing liabilities and less reliance on wholesale funding due to the balance sheet restructuring in 2002 and 2001. Average deposits decreased $83.7 million in 2002, as growth in core deposits was more than offset by declines in higher cost brokered and large denomination time deposits, which reduced funding costs and minimized our reliance on purchased deposits. Net interest margin declined during the first three quarters of 2003 before stabilizing at 4.07% in the fourth quarter of 2003. We expect net interest margin in the first quarter of 2004 to be slightly lower than the fourth quarter 2003 level. We also expect the full year 2004 net interest margin to be lower than the fourth quarter 2003 level. In addition, due to the anticipated lower net interest margin in 2004 than the full year 2003, net interest income is expected to be lower in 2004 than in 2003. 43 NONINTEREST INCOME An analysis of the components of noninterest income is presented in the table below. To provide more meaningful trend analysis certain significant transactions not normally incurred are presented separately.
Year Ended December 31, $ Change % Change ------------------------------------ ---------------------- ---------------------- (dollars in thousands) 2003 2002 2001 2003-2002 2002-2001 2003-2002 2002-2001 - ---------------------- --------- --------- --------- --------- --------- --------- --------- Service charges on deposit accounts $ 29,916 $ 26,456 $ 27,773 $ 3,460 $ (1,317) 13.08% (4.74)% Trust fees 17,527 18,956 21,028 (1,429) (2,072) (7.5) (9.9) Mortgage and other loan income 18,046 16,845 13,159 1,201 3,686 7.1 28.0 Bankcard fees 3,042 6,142 11,799 (3,100) (5,657) (50.5) (47.9) Brokerage and investment fees 7,720 9,502 8,157 (1,782) 1,345 (18.8) 16.5 ATM network user fees 3,533 3,658 3,448 (125) 210 (3.4) 6.1 Financial services 2,479 2,888 3,134 (409) (246) (14.2) (7.8) Security gains: Sale of investment securities 103 -- 823 103 (823) 100.0 (100.0) Sale of securitized mortgages -- 2,436 5,372 (2,436) (2,936) (100.0) (54.7) Gain on sale of merchant business -- 5,400 -- (5,400) 5,400 (100.0) -- Gain on sale of credit card portfolio -- -- 2,623 -- (2,623) -- (100.0) Gain on sale of F&M Bank Minnesota -- -- 793 -- (793) -- (100.0) Gain on sale of equity investment -- -- 11,017 -- (11,017) -- (100.0) Other charges -- (1,587) -- 1,587 (1,587) -- -- Other 12,453 11,080 8,355 1,373 2,725 12.4 32.6 --------- --------- --------- --------- --------- TOTAL NONINTEREST INCOME $ 94,819 $ 101,776 $ 117,481 $ (6,957) $ (15,705) (6.8) (13.4) ========= ========= ========= ========= =========
2003 COMPARED TO 2002 As shown in the table, the decline in noninterest income in 2003 was due mostly to gains of $7.8 million recorded in 2002 from the sale of securitized mortgages and the sale of our merchant services business, partially offset by $1.6 million of other charges recorded in 2002 and described above under the caption "Recent Developments". The securitized mortgage sales were part of our strategy to restructure the balance sheet to decrease reliance on wholesale funding and minimize interest rate risk. The remainder of the decline in 2003 was due to decreases in bankcard fees, trust fees and brokerage and investment fees, which were nearly offset by increases in deposit service charges, mortgage banking revenue and other revenue. Bankcard fees declined in 2003 due to the sale of our merchant services business in the second quarter of 2002. Brokerage and investment fees declined in 2003 due to slower retail sales of fixed annuity products. Trust fees declined in 2003 due to lower average asset levels resulting from the decline in the financial markets during the latter half of 2002 and the first quarter of 2003 and from client attrition. Recent operational changes, system and technology upgrades and new product offerings at our trust bank resulting from strategic alliances with three third party vendors that began in 2003 are expected to accelerate new business growth and reduce client attrition. Total assets under administration were $2.866 billion at December 31, 2003 compared to $2.555 billion at December 31, 2002. The average assets under administration during 2003 were $2.597 billion, down 5.9% or $164 million, from $2.761 billion in 2002. We made a number of changes in our service charge policies in 2003 that resulted in additional overdraft fees, a new overdraft monitoring system and fewer waived fees. The increase in mortgage and other loan income in 2003 reflected higher mortgage banking revenue from higher gains on sales of mortgages and the related servicing rights, as well as higher commercial line of credit fees and new home equity prepayment fee income. Other noninterest income increased in 2003 due to a $2.2 million increase in life insurance income, partially offset by a decrease of $0.6 million in gains recorded on the sale of branches and equipment. The increase in life insurance income resulted from increases in policy cash surrender values as the equity markets improved in the second half of 2003 and from the purchase of $78 million of separate account, bank owned life insurance in the third quarter of 2002. The policies, on which Citizens is the beneficiary, insure the lives of our officers and are designed as a funding source for our payment of employee benefits and deferred compensation. We typically sell our mortgage servicing rights concurrently with the sale of the underlying mortgage loan. Falling interest rates coupled with appreciating home values helped create a strong mortgage origination market in both 2003 and 2002. Mortgage originations reached $1.44 billion in 2003, up from $1.27 billion in 2002 and $1.1 billion in 2001. Over 80% of all new mortgage loan originations in 2003 and 2002 were sold in the secondary market. 44 2002 COMPARED TO 2001 The decrease in noninterest income in 2002 resulted from fewer gains from sales of assets and investment securities of $12.8 million, the aforementioned other charges of $1.6 million and lower bankcard, deposit service charges and trust fees. These items were offset, in part, by higher mortgage banking revenue and brokerage and investment fees. In 2001, gains on sales of assets and investment securities included gains of $5.4 million from sales of securitized mortgages, $2.6 million from the sale of credit card assets, $793,000 from the sale of F&M Bank - Minnesota, and $11.0 million from the sale of NYCE stock. NYCE Corporation is an ATM network provider in which we held an equity position. Bankcard fees declined significantly in 2002 due to the sale of our $30 million Michigan-based credit card portfolio in the second quarter of 2001. Service charges on deposit accounts decreased in 2002 due to a decline in NSF and overdraft fees partially offset by higher commercial checking account service charges. Trust fees declined in 2002, principally due to the decline in the equity markets, which reduced the value of assets under administration. At December 31, 2002, we had total assets under administration of $2.555 billion at December 31, 2002 compared to $3.162 billion at December 31, 2001. The increase in mortgage banking fees in 2002 was due to higher gains on sales of mortgages and the related servicing rights. In 2002, brokerage and investment fees benefited from increased fixed annuity product sales driven by clients' preference for this product over certificates of deposit or equity investments and more emphasis on selling this product through the retail branch network. Other noninterest income increased in 2002 due to higher revenue from the sale of checks, the sale of four branch properties in the fourth quarter of 2002 and an increase in life insurance income due, in part, to our purchase of bank-owned life insurance in the third quarter of 2002. We anticipate noninterest income levels in 2004 to be slightly higher than 2003 levels due in large part, to higher deposit service charges from fee changes implemented in 2003. NONINTEREST EXPENSE An analysis of the components of noninterest expense is presented in the table below. In order to provide more meaningful trend analysis, special and certain other significant charges are presented separately.
Year Ended December 31, $ Change % Change ------------------------------------- ------------------------ --------------------- (dollars in thousands) 2003 2002 2001 2003-2002 2002-2001 2003-2002 2002-2001 - ---------------------- --------- --------- --------- --------- --------- --------- --------- Salaries and employee benefits $ 122,322 $ 126,847 $ 126,278 $ (4,525) $ 569 (3.6)% 0.5% Occupancy 18,449 17,855 17,713 594 142 3.3 0.8 Equipment 16,087 19,869 19,317 (3,782) 552 (19.0) 2.9 Professional services 17,815 14,790 12,277 3,025 2,513 20.5 20.5 Data processing services 12,744 12,641 13,101 103 (460) 0.8 (3.5) Postage and delivery 6,896 7,120 7,746 (224) (626) (3.1) (8.1) Advertising and public relations 5,786 5,112 5,219 674 (107) 13.2 (2.1) Telephone 4,793 5,279 5,556 (486) (277) (9.2) (5.0) Stationery and supplies 3,935 4,032 4,426 (97) (394) (2.4) (8.9) Intangible asset amortization 2,899 2,899 10,115 -- (7,216) -- (71.3) Bankcard fees 378 3,879 9,308 (3,501) (5,429) (90.3) (58.3) Special charge (691) 13,402 -- (14,093) 13,402 -- -- Prepayment penalty on FHLB advances -- 3,300 -- (3,300) 3,300 -- -- Contribution to charitable trust -- 2,000 -- (2,000) 2,000 -- -- Other 21,575 20,358 20,127 1,217 231 6.0 1.1 --------- --------- --------- --------- --------- TOTAL NONINTEREST EXPENSE $ 232,988 $ 259,383 $ 251,183 $ (26,395) $ 8,200 (10.2) 3.3 ========= ========= ========= ========= =========
2003 COMPARED TO 2002 Noninterest expense decreased $26.4 million, or 10.2%, in 2003, primarily as a result of the special charge of $13.4 million recorded in the second half of 2002 to restructure our three major lines of business and $7.1 million of other charges recorded in the third quarter of 2002. These charges are described under "Recent Developments." Also contributing to the decline were reductions in salaries and employee benefits, equipment expense and bankcard expense. These reductions were partially offset by increases in professional services, advertising and public relations costs, occupancy costs and system implementation and severance costs. 45 Salaries decreased $1.7 million and employee benefits expense decreased $2.8 million in 2003 due to lower staffing levels resulting from the third quarter of 2002 restructuring initiatives, normal attrition and lower pension costs. The number of full-time equivalent employees declined 7.1% during 2003. The defined benefit pension plan for our Michigan and Illinois employees was amended, effective January 1, 2002, to provide a cash balance pension benefit. The amendment increased the projected benefit obligation of the plan by $1.1 million and increased pension expense by approximately $450,000 annually. Staff reductions tied to our 2002 restructuring initiatives reduced future pension expense by approximately $200,000 annually. The higher pension costs in 2002 substantially offset lower salary costs in 2002 due to the restructuring initiatives. Pension expense for 2004 is expected to increase by approximately $2.4 million from 2003 levels. The increase reflects changes for 2004 in the assumptions used to determine our net periodic pension expense, amortization in 2004 of unrecognized losses and a lower market related value of plan assets at January 1, 2004 than at January 1, 2003. For 2004, we reduced the assumed rate of return on plan assets to 8.75% from 9.25% and the discount rate to 6.25% from 6.50%. Both changes have the effect of increasing pension expense. The reduction in the market related value of plan assets reflects the large market asset losses experienced during 2001 and 2002, which are being phased into the market related value of plan assets over a three year period. A lower market related value of plan assets reduces plan earnings and therefore increases pension expense. Equipment expenses decreased in 2003 due to lower depreciation and improved pricing from new or renegotiated maintenance contracts. A $0.4 million charge in the third quarter of 2002 to record additional depreciation on assets, primarily personal computer equipment, to be retired early also contributed to the decrease. Bankcard fee expense has declined since 2001 due to the sale of our merchant services business in the second quarter of 2002 and the sale of our Michigan credit card portfolio in the second quarter of 2001. Professional services increased in 2003 due to higher legal costs related to loan collection efforts, increased executive recruiting and relocation costs, implementation costs for Citizens' new INEA Performance Management software and costs incurred in 2003 for the collateral field audit initiative which began in March. In addition, ongoing costs for banking industry consultants assisting us in completing the reorganization of our major business lines and identifying new revenue and cost saving opportunities, also contributed to higher professional services in 2003. Advertising and public relations expenses increased in 2003 due to our recently announced expansion into Oakland County, Michigan and several new home equity and checking account promotions during the year. These additional promotion costs were offset, in part, by a more focused marketing strategy, seeking higher promotional exposure at lower costs. Occupancy expense increased in 2003 reflecting higher maintenance costs and approximately $0.2 million of additional expense related to a fourth quarter 2003 capital investment of $1.7 million in branch renovations. Additional expense resulted from a recent change in our capitalization policy to incorporate higher capitalization thresholds on new expenditures. Partially offsetting the increased occupancy costs were the favorable effects of fewer branch locations as a result of the third quarter 2002 restructuring. Other expenses increased in 2003 due to operational and system implementation costs associated with Citizens Bank Wealth's strategic alliances with SEI Investments, EnvestnetPMC, Inc., and EPIC Advisors, Inc., which commenced in 2003. Higher state taxes and other real estate expenses also contributed to the increase, offset in part, by lower mortgage servicing rights amortization and other charges of $1.4 million recorded in the third quarter of 2002. Capitalized mortgage servicing rights associated with our serviced loan portfolio were fully amortized in June 2003. 2002 COMPARED TO 2001 In 2002, noninterest expense increased $8.2 million, or 3.3%. The increase reflected the aforementioned special and other charges of $20.5 million and an increase in professional services. These increases were partially offset by lower intangible asset amortization and bankcard fees. Professional services expenses increased in 2002 due to the costs associated with our engagement of banking industry consultants to assist us in defining our new business model and reorganizing our consumer, commercial and wealth management lines of business. Intangible asset amortization decreased $7.2 million in 2002 due to the adoption on January 1, 2002 of Statement of Financial Accounting Standards 142 that eliminated goodwill amortization. Refer to Notes 1, 2 and 7 to the Consolidated Financial Statements. Bankcard fee expense declined in 2002 because of the sale of our merchant services business in the second quarter of 2002 and the sale of our Michigan credit card portfolio in the second quarter of 2001. 46 FEDERAL INCOME TAXES Citizens recorded an income tax expense of $19.2 million in 2003 as compared to an income tax benefit of $1.1 million in 2002 and income tax expense of $43.2 million in 2001. The effective tax rate, computed by dividing the provision for income taxes by income before taxes, was 22.5% in 2003, compared to a negative 4.4% in 2002 and 29.2% in 2001. The effective tax rate is lower than the statutory tax rate due to tax-exempt interest income (see note (2) to Table 2) and to a lesser extent other permanent income tax differences. Citizens' effective tax rate increased in 2003 compared with 2002 due to higher pre-tax earnings in 2003 resulting from a large loan loss provision and special and other significant charges recorded in the third quarter of 2002. LINE OF BUSINESS RESULTS Net income by line of business is presented in the table below. A description of each business line, important financial performance data and the methodologies used to measure financial performance are presented in Note 20 to the Consolidated Financial Statements.
Net Income ----------------------------------- (in thousands) 2003 2002 2001 -------- -------- -------- Commercial Banking $ 18,561 $(12,648) $ 46,501 Consumer Banking 38,549 37,200 47,553 Wealth Management 626 4,284 6,148 Other 8,215 (3,798) 4,455 -------- -------- -------- Total $ 65,951 $ 25,038 $104,657 ======== ======== ========
2003 COMPARED TO 2002 Commercial Banking net income increased $31.2 million to $18.6 million in 2003 compared to a net loss of $12.6 million in 2002. The increase in net income was due to a significantly lower loan loss provision and lower noninterest expense, partially offset by lower net interest income. The loan loss provision decreased by $60.7 million in 2003 as a result of lower net charge-offs, fewer commercial loan risk-rating downgrades and improving nonperforming asset levels. Noninterest expense decreased $6.5 million primarily due to lower staff compensation costs as a result of the 2002 line of business restructuring and lower processing costs due to the decline in commercial loan volumes. Higher legal expenses due to loan collection activity partially offset the decline in noninterest expense. Taxable equivalent net interest income decreased by $16.6 million as a result of a decline in commercial loan balances and lower yields due to fixed rate loan refinancing, loan repayments and new origination of commercial loans in the lower interest rate environment. Consumer Banking net income increased $1.3 million to $38.5 million in 2003 compared to $37.2 million in the prior year. The increase in Consumer Banking net income was attributable to a $7.5 million decrease in noninterest expense, partially offset by lower noninterest income of $5.2 million. Noninterest expense declined as a result of lower salaries and equipment expenses due to our restructuring of the branch delivery system and the decline in bankcard expense due to the June 2002 sale of the merchant services business. Noninterest income decreased $5.2 million due to the prior year $5.4 million gain on sale of the merchant services business and the related $3.1 million decline in bankcard revenue in 2003. These changes were partially offset by $3.4 million improvement in deposit service charge revenue due to higher overdraft fee income and by reduced fee waivers. The increase in Consumer Banking net income is also attributable in part to an increase in net interest income of $1.8 million as a result of improving spreads on loans and to favorable changes in the deposit mix from high cost time deposits to lower cost core deposits, offsetting the effect of lower average mortgage loan balances. Consumer Banking net income in 2003 was also affected by an increase in the provision for loan losses of $2.0 million to $15.6 million, as a result of a higher provision for losses on wholesale mortgage loans. Wealth Management net income declined $3.7 million to $0.6 million in 2003 from $4.3 million in the prior year. The decline in net income was due to a decrease in noninterest income and an increase in noninterest expense. Noninterest income declined as a result of lower trust and brokerage and investment fees. The decline in trust fees was primarily due to lower average trust assets resulting from the decline in the financial markets during the latter half of 2002 and the first quarter of 2003 and, to a lesser extent, to client attrition. The decline in brokerage and investment fees reflects slower retail sales of fixed annuity products. Noninterest expense increased due to severance and implementation costs associated with our strategic alliances with SEI Investments, EnvestnetPMC, Inc., and EPIC Advisors, Inc. and $0.3 million of additional trust litigation and account losses. 47 The Other business line recorded net income of $8.2 million in 2003 compared with a net loss of $3.8 million in 2002. The improvement in net income was the result of higher noninterest income and lower noninterest expense, partially offset by lower net interest income and higher income tax expense. The increase in noninterest income resulted from higher insurance income due to the full year effect in 2003 of our purchase of $78 million of bank-owned life insurance in the third quarter of 2002, and the prior year charges attributable to noninterest income totaling $1.3 million for valuation adjustments to an equity investment and life insurance cash surrender values. Noninterest expense declined due to the prior year special and other charges of $19.1 million included in noninterest expense, partially offset by higher professional fees in 2003 for industry consultants assisting in the business line restructuring and for field collateral audits. 2002 COMPARED TO 2001 Commercial Banking recorded a net loss of $12.6 million in 2002 compared with net income of $46.5 million in 2001, due to a significantly higher loan loss provision and, to a lesser extent, increased operating expenses. The loan loss provision increased by $90.6 million in 2002 from the prior year, attributable to increased charge-offs and nonperforming loans in the commercial loan portfolio. Taxable equivalent net interest income increased $1.2 million as net interest spreads on commercial loans improved while average loan balances declined. Noninterest expense increased $2.3 million due to higher other real estate and loan collection costs. Consumer Banking net income declined $10.4 million to $37.2 million in 2002 compared to $47.6 million in the prior year. The decrease in Consumer Banking net income was attributable to lower net interest income, a higher provision for loan losses and lower noninterest income, partially offset by lower noninterest expense. Net interest income declined due to lower average loan balances and narrower interest spreads on deposits. Loan balances declined due to the sale of the majority of new mortgage loan production, the current and prior year securitization of new and portfolio mortgage loans, the June 2001 sale of the Michigan credit card portfolio and a decline in indirect loans. The higher loan loss provision was attributable to increased charge-offs in the direct and indirect loan portfolios. Noninterest expense declined $6.5 million, of which $5.4 million was attributable to lower bankcard expense due to the sale of the merchant services business in June 2002. Wealth Management net income declined $1.8 million to $4.3 million in 2002 from $6.1 million in the prior year. The decrease in Wealth Management net income is attributable to a decline in trust fees, lower net interest income and higher noninterest expenses. Trust fees declined due to a lower level of assets under administration resulting primarily from weak equity markets and, to a lesser extent, net account attrition. Noninterest expense increased due to higher salaries, benefits and other expenses. The Other business line recorded a net loss of $3.8 million in 2002 compared with net income of $4.5 million in 2001, due to lower noninterest income and higher noninterest expenses. Noninterest income decreased $11.5 million due to lower gains on sales of assets. Noninterest expense increased due to the special and other charges resulting from the third quarter 2002 restructuring actions. Combined special and other charges of $21.1 million were attributed to the Other business line. Noninterest expense was charged $19.1 million, noninterest income was charged $1.3 million and net interest income was charged $0.7 million. Partially offsetting the increase in noninterest expense is reduced goodwill amortization costs of $7.2 million, resulting from the implementation of SFAS No. 142. See Note 7 to the Consolidated Financial Statements for additional information. FINANCIAL CONDITION SUMMARY The following table summarizes various indicators of our financial condition for 2003, 2002 and 2001.
2003 2002 2001 -------- -------- -------- Average total assets (in millions) $ 7,694 $ 7,569 $ 7,936 Average short term borrowings (in millions) 458.7 251.3 538.7 Average long term debt (in millions) 861.7 620.9 596.4 Average earning assets as a percent of average assets 94.5% 94.6% 94.6% Average investment securities and money market investments as a percent of average earning assets 25.7 20.7 18.7 Average loans (including mortgage loans held for sale) as a percent of average earning assets 74.3 79.3 81.3 Interest-bearing deposits as a percent of average interest-bearing liabilities 78.4 85.3 81.9 Ratio of average noninterest bearing deposits to average deposits 15.5 14.7 14.7
48 These items are discussed in more detail below. AVERAGE TOTAL ASSETS Average total assets increased $125 million, or 1.7%, in 2003 to $7.694 billion due to the expansion of the investment portfolio beginning near the end of the first quarter of 2003, offset in part by a decrease in commercial and real estate mortgage loans. INVESTMENT SECURITIES AND MONEY MARKET INVESTMENTS Objectives in managing the securities portfolio are driven by the dynamics of the balance sheet, including growth, maturity, management of interest-rate risk and maximizing return. Securities classified as available for sale comprised 99% of the total portfolio. A summary of investment securities balances at December 31, 2003, 2002 and 2001 is provided below. INVESTMENT SECURITIES
December 31 (in thousands) 2003 2002 2001 - -------------------------- ---------- ---------- ---------- AVAILABLE FOR SALE: U.S. Treasury $ -- $ 6,135 $ 8,163 Federal agencies Mortgage-backed 1,180,493 787,821 565,393 Other agencies 272,089 148,687 166,236 State and municipal: Taxable 7,948 9,338 10,776 Tax-exempt 429,055 435,613 433,180 Mortgage and asset-backed 4,135 6,452 10,558 Other securities 71,481 63,235 65,200 ---------- ---------- ---------- Total $1,965,201 $1,457,281 $1,259,506 ========== ========== ========== HELD TO MATURITY: State and municipal - tax exempt $ 19,857 $ -- $ -- ========== ========== ==========
Total agency-issued securities increased $516.1 million or 55.1% in 2003 after increasing $204.9 million or 28.0% in 2002. Agency issued mortgage-backed securities increased $392.7 million or 49.8% in 2003 compared to an increase of $222.4 million or 39.3% in 2002. Other agency issued securities increased $123.4 million or 83.0% after decreasing in 2002. The overall increase in 2003 was due to our strategy of expanding the investment securities portfolio by approximately $500 million in the first half of 2003 to increase net interest income. The portfolio expansion was funded with cash-flow from loan pay-offs and short and medium term funding discussed under "Borrowed Funds." In 2002, mortgage-backed securities increased as proceeds from Treasury and Other Agency securities were reinvested in more attractive mortgage-backed securities and due to the retention of securities created from mortgage loan securitizations. State and municipal securities were purchased in 2003 and 2002 due to their higher tax equivalent yields. Purchases of these securities remain dependent on our capacity to effectively utilize tax-exempt income. Other securities, consisting of Federal Reserve stock, Federal Home Loan Bank stock and money market funds, totaled 3.6% of total investment securities at December 31, 2003, compared with 4.3% at year end 2002. Money market investments comprised of federal funds sold and government money market investments averaged $11.2 million for 2003 compared with $50.6 million in 2002. The amount of funds invested in these assets is adjusted from time to time based on the present and anticipated interest rate environment, liquidity needs and other economic factors. 49 Maturities and average yields of investment securities at December 31, 2003 are presented in Table 4 below. TABLE 4. MATURITIES AND AVERAGE YIELDS OF SECURITIES AT DECEMBER 31, 2003
U.S. Treasury and Federal Agency(1) State and Municipal (1),(2) ----------------------------- ----------------------------- Amortized Fair Amortized Fair (in millions) Cost Value Yield Cost Value Yield - ----------------------- --------- --------- ----- --------- --------- ----- AVAILABLE FOR SALE: Due within one year $ 244.8 $ 249.8 5.21% $ 14.2 $ 14.0 8.11% One to five years 918.1 917.4 3.69 92.4 98.3 7.40 Five to ten years 266.9 267.6 4.13 185.0 200.0 7.36 After ten years 17.8 17.8 4.28 116.0 124.7 7.11 --------- --------- --------- --------- $ 1,447.6 $ 1,452.6 4.04 $ 407.6 $ 437.0 7.32 ========= ========= ========= ========= Average maturity (3) 3.43 yrs. 6.93 yrs. HELD TO MATURITY: Due within one year $ -- $ -- One to five years 3.7 3.6 5.73 Five to ten years 12.9 13.0 6.46 After ten years 3.3 3.3 6.59 --------- --------- $ 19.9 $ 19.9 6.35 ========= ========= Average maturity (3) 9.10 yrs.
Other(1) Total ----------------------------- ----------------------------- Amortized Fair Amortized Fair (in millions) Cost Value Yield Cost Value Yield - ----------------------- --------- --------- ----- --------- --------- ----- AVAILABLE FOR SALE: Due within one year $ 3.8 $ 3.9 5.49% $ 262.8 $ 267.7 5.37% One to five years 5.5 5.6 3.15 1,016.0 1,021.3 4.03 Five to ten years 0.1 0.1 3.30 452.0 467.7 5.45 After ten years 66.0 66.0 5.36 199.8 208.5 6.28 --------- --------- --------- --------- $ 75.4 $ 75.6 4.95 $ 1,930.6 $ 1,965.2 4.78 ========= ========= ========= ========= Average maturity (3) 3.14 yrs. 4.19 yrs. HELD TO MATURITY: Due within one year $ -- $ -- One to five years 3.7 3.6 5.73 Five to ten years 12.9 13.0 6.46 After ten years 3.3 3.3 6.59 --------- --------- $ 19.9 $ 19.9 6.35 ========= ========= Average maturity (3) 9.10 yrs.
(1) Maturities for Federal agency, collateralized mortgage obligations and asset-backed securities are based upon projections of independent cash flow models. Maturities for state and municipal securities incorporate early call features, if applicable. (2) Yields for state and municipal securities are calculated on a tax equivalent basis using a 35% tax rate. (3) Average maturity information excludes Federal Reserve and Federal Home Loan Bank stocks with no stated maturity. As of December 31, 2003, the estimated aggregate fair value of our investment securities portfolio was $34.6 million above amortized cost, consisting of gross unrealized gains of $48.2 million and gross unrealized losses of $13.6 million. A summary of estimated fair values and unrealized gains and losses for the major components of the investment securities portfolio is provided in Note 5 to the Consolidated Financial Statements. Our present policies with respect to the classification of investments in debt and equity securities are discussed in Note 1 to the Consolidated Financial Statements. LOAN PORTFOLIO We extend credit primarily within the local markets of our banking subsidiaries located in Michigan, Wisconsin, Iowa and Illinois. We generally lend to consumers and small to mid-sized businesses and, consistent with our emphasis on relationship banking, most of these credits represent core, multi-relationship customers who also maintain deposit relationships and utilize other banking services such as cash management. Our loan portfolio is diversified by borrower and industry with no concentration within a single industry that exceeds 10% of total loans. We do not have any loans to foreign debtors and do not purchase nationally syndicated loans or participate in highly leveraged transactions. We seek to limit our credit risk by establishing guidelines to review the aggregate outstanding commitments and loans to particular borrowers, industries, and geographic areas. We obtain collateral based on the nature of the credit and our credit assessment of the customer. PORTFOLIO LOANS Loan balances by category at December 31 and an analysis of the maturity and interest rate sensitivity of commercial and real estate construction loans are presented below. 50 TABLE 5. PORTFOLIO LOANS (1)
(in millions) 2003 2002 2001 2000 1999 - ------------------------------------------ -------- -------- -------- -------- -------- PORTFOLIO LOANS OUTSTANDING AT DECEMBER 31 Commercial $1,521.9 $1,784.7 $1,923.4 $2,127.2 $1,822.4 Commercial real estate 1,364.0 1,326.5 1,323.0 1,205.0 1,053.0 Real estate construction 192.7 262.4 216.0 235.1 185.4 Real estate mortgage 402.9 545.8 821.1 1,282.8 1,440.1 Consumer 1,764.2 1,513.2 1,488.5 1,572.7 1,416.6 -------- -------- -------- -------- -------- Total $5,245.7 $5,432.6 $5,772.0 $6,422.8 $5,917.5 ======== ======== ======== ======== ========
PORTFOLIO LOAN MATURITIES AND INTEREST RATE SENSITIVITY AT DECEMBER 31, 2003
One to After Within Five Five One Year Years Years Total -------- -------- -------- -------- Commercial and commercial real estate $1,212.3 $1,513.7 $ 159.9 $2,885.9 Real estate construction 192.7 -- -- 192.7 -------- -------- -------- -------- Total $1,405.0 $1,513.7 $ 159.9 $3,078.6 ======== ======== ======== ======== Loans above: With floating interest rates $ 976.3 $ 620.0 $ 78.7 $1,675.0 With predetermined interest rates 428.7 893.7 81.2 1,403.6 -------- -------- -------- -------- Total $1,405.0 $1,513.7 $ 159.9 $3,078.6 ======== ======== ======== ========
(1) Excludes mortgage loans held for sale The decreases in total portfolio loans in 2003 and 2002 reflect declining commercial loan and residential mortgage loan balances, partially offset by growth in consumer loans. On an average basis, portfolio loans comprised 72.2% of total average earning assets during 2003, compared to 77.2% in 2002. COMMERCIAL. The commercial loan category includes mostly in-market small (less than $500,000) and lower-middle market ($500,000 to $2 million) business loans to a wide variety of businesses across many industries. Commercial loans are evaluated for adequacy of repayment sources at the time of approval and are regularly reviewed for any possible deterioration in the ability of the borrower to repay the loan. In certain instances, collateral is required to provide us with an additional source of repayment in the event of default by a commercial borrower. Credit risk for commercial loans arises when borrowers are unwilling or unable to repay the loan and, in the case of secured loans, when the collateral value is less than the outstanding loan balance. Commercial loans declined $262.8 million, or 14.7% in 2003, to $1.522 billion at December 31, 2003 after decreasing $138.7 million or 7.2% in 2002. The decrease in 2003 resulted from increased activity in fixed-rate loan refinancing and paydowns, lower demand for commercial credit and identification and reduction of exposure on credits with the potential to deteriorate. The decline occurred in most of our markets, with the exception of Southeast Michigan, including Oakland County, which experienced modest growth. COMMERCIAL REAL ESTATE. The commercial real estate category includes mortgage loans to developers and owners of commercial real estate and multi-unit residential properties. Approximately two-thirds of these loans are secured by mortgages on owner-occupied properties. Commercial real estate loans are governed by the same lending policies and subject to substantially the same credit risks as commercial loans. Commercial real-estate balances increased 2.8% in 2003 to $1.364 billion at December 31, 2003 due to growth in certain Michigan markets including Southeast Michigan and Oakland County. Commercial real estate balances were essentially unchanged in 2002 as growth in the Michigan market was offset by a decrease in the Wisconsin market due to stricter credit standards and de-emphasis of certain types of commercial real estate lending. REAL ESTATE CONSTRUCTION. Real estate construction loans consist primarily of single family and multi-family residential projects made to builders or developers of real estate properties. These loans are typically refinanced at completion, becoming either income-producing or owner-occupied properties. Real estate construction loans are governed by the same lending policies and subject to substantially the same credit risks as commercial loans. Real estate construction loans decreased 26.6% to $192.7 million at December 31, 2003, following an increase of 21.5% in 2002. The decrease in 2003 was a result of lower origination volume due to higher interest rates and decreased product emphasis. 51 RESIDENTIAL REAL ESTATE. The residential real estate category is comprised predominately of owner-occupied residential properties. Residential real estate loans are evaluated for the adequacy of these repayment sources at the time of approval, including credit scores, debt-to-income ratios and collateral values. They are predominately originated in accordance with underwriting standards set forth by the government-sponsored entities, FNMA, FHLMC and the Government National Mortgage Association (GNMA), who serve as the primary purchasers of loans sold in the secondary market by mortgage lenders. These underwriting standards generally require that the loans be collateralized by one-to-four family residential real estate, have loan-to-collateral value ratios of 80% or less and are made to borrowers in good credit standing. Our wholly-owned subsidiary, Citizens Bank Mortgage Company LLC, originates mortgage loans through our banking offices and a wholesale network of brokers and mortgage originators. Substantially all of our residential mortgage loans are sold in the secondary mortgage market. The right to service the loans and receive servicing fee income is typically sold along with the underlying mortgages. Credit risks for residential real estate loans are similar to those arising from commercial loans. In 2003, residential mortgage loans declined $142.9 million, or 26.2% to $402.9 million at December 31, 2003 following a decrease of $275.3 million or 33.5% in 2002. The decline in 2003 and 2002 reflects higher payoffs, resulting from increased refinance activity due to historically low mortgage interest rates, and the sale of most new mortgage loan originations. In addition, in 2002 we securitized $28.6 million of new mortgage loan production and $114.3 million of loans previously held within our mortgage loan portfolio. CONSUMER. The consumer loan category primarily includes home equity loans, and direct and indirect installment loans used by customers to purchase boats, recreational vehicles and autos. Home equity loans consist mainly of revolving lines of credit to consumers that are secured by residential real estate. These loans are originated through our banking offices with loan-to-value ratios generally limited to 90% of collateral value. The same lending policies as described above for residential real estate loans generally govern consumer loans. Credit risk in the consumer loan portfolio arises from borrowers lacking the ability or willingness to repay the loan, and in the case of secured loans, by a shortfall in the collateral value in relation to the outstanding loan balance in the event of default and subsequent liquidation of collateral. In 2003, consumer loans increased $251.0 million, or 16.6%, to $1.764 billion at December 31, 2003 after increasing $24.7 million, or 1.7%, in 2002. The increase in consumer loans in 2003 reflects higher home equity loan balances and indirect loan balances, partially offset by a decline in other direct consumer products. In 2003, home equity loans increased $196.5 million or 35.6% to $749.2 million at December 31, 2003, as a result of successful targeted sales and marketing efforts. MORTGAGE LOANS HELD FOR SALE Mortgage loans held for sale were $44.7 million at December 31, 2003, a decrease of $116.0 million from $160.7 million at December 31, 2002. The decrease was primarily due to a decrease in residential mortgage loan closings during the fourth quarter of 2003 of $158.2 million compared to $467.7 million closed during fourth quarter of 2002, as loans closed generally remain in loans held for sale for 30 to 60 days after closing. In addition, $16.9 million of mortgage loan closings during the fourth quarter 2003 were portfolio loan closings compared to $23.6 million during the fourth quarter of 2002. Mortgage loans held for sale at December 31, 2002 reflect an increase of $10.3 million, or 6.8%, from $150.4 million at December 31, 2001. The increase in 2002 reflects a higher volume of residential mortgage loans originated in the fourth quarter of 2002 compared to the fourth quarter of 2001 due to the low interest rate environment. CREDIT RISK MANAGEMENT Extending credit to businesses and consumers exposes us to credit risk -- the risk that the principal balance of a loan and any related interest will not be collected due to the inability or unwillingness of the borrower to repay the loan. Credit risk is mitigated through portfolio diversification that limits exposure to any single industry or customer. Similarly, credit risk is also mitigated through the establishment of a comprehensive system of internal controls, which includes standard lending policies and procedures, underwriting criteria, collateral safeguards, and surveillance and evaluation by an independent internal loan review staff of the quality, trends, collectibility and collateral protection within the loan portfolio. Lending policies and procedures are reviewed and modified on an ongoing basis as conditions change and new credit products are offered. Our commercial and commercial real estate credit administration policies include a loan rating system that is validated by the internal loan review staff who verify credit ratings by sampling loans based upon select criteria, including loan size, delinquency status, loan officer coverage and other factors. Furthermore, account officers are vested with the responsibility of monitoring their customer relationships and act as the first line of defense in determining changes in the loan ratings on credits for which they are responsible. In an ongoing effort to strengthen and monitor loan structuring and collateral position, collateral field audits are performed on those credits that have a significant reliance on accounts receivable and inventory. Loans that have migrated within the loan rating system to a level that requires remediation are actively reviewed by senior management at regularly scheduled quarterly meetings with the credit administration staff and the account officers. At these meetings, action plans are developed to either remediate any emerging problem loans or develop a specific plan for removing such loans from the portfolio within a short time frame. 52 During the fourth quarter of 2002 and the first quarter of 2003, we experienced two unanticipated loan losses resulting from collateral value shortfalls due to falsified borrowing base reports by the borrower. To reduce our risk of further unforeseen losses from similar collateral issues and to supplement our normal credit review procedures, we hired outside collateral auditors in March 2003 to conduct field audits on all loans in excess of $5 million and risk-selected loans in excess of $1 million in which the primary collateral consists of accounts receivable and inventory. A field audit focuses on the value of the collateral and validates the borrower's reporting processes. Based upon results of these audits, there have been no additional reserves or charge-offs, although a small number of commercial customers have been requested to seek alternative financing because they were unwilling or unable to accommodate our reporting requests. We have instituted regular audits of receivable and inventory collateral as standard practice going forward. PROVISION AND ALLOWANCE FOR LOAN LOSSES The provision for loan losses represents a charge against income and a corresponding increase in the allowance for loan losses. Credit losses are charged and recoveries are credited to the allowance for loan losses. The amount of the allowance for loan losses is based on our review of the historical credit loss experience and such factors that, in our judgment, deserve consideration under existing economic conditions in estimating probable credit losses. While we consider the allowance for loan losses to be adequate based on information currently available, future adjustments to the allowance may be necessary due to changes in economic conditions, delinquencies or loss rates. See "Critical Accounting Policies." A summary of our loan loss experience for the past five years appears in Table 6. TABLE 6. SUMMARY OF LOAN LOSS EXPERIENCE
Year Ended December 31 (dollars in thousands) 2003 2002 2001 2000 1999 - ----------------------------------------------- ----------- ----------- ----------- ----------- ----------- Allowance for loan losses - January 1 $ 106,777 $ 76,275 $ 75,413 $ 75,207 $ 69,740 Allowance of acquired (sold) banks and branches -- -- (240) -- 2,400 Transfer to reserve for commitments -- 1,334 633 (3,467) (1,190) Provision for loan losses 62,962 120,200 26,407 20,983 24,675 CHARGE-OFFS: Commercial 49,091 83,503 18,265 10,920 8,675 Real estate 1,234 2,027 189 169 436 Consumer 15,738 16,174 14,278 14,359 17,751 ---------- ----------- ----------- ----------- ----------- Total charge-offs 66,063 101,704 32,732 25,448 26,862 ---------- ---------- ---------- ---------- ---------- RECOVERIES: Commercial 14,850 5,860 1,950 3,577 2,483 Real estate 36 11 47 45 149 Consumer 4,983 4,801 4,797 4,516 3,812 ---------- ---------- ---------- ---------- ---------- Total recoveries 19,869 10,672 6,794 8,138 6,444 ---------- ---------- ---------- ---------- ---------- Net charge-offs 46,194 91,032 25,938 17,310 20,418 ----------- ----------- ----------- ----------- ----------- Allowance for loan losses - December 31 $ 123,545 $ 106,777 $ 76,275 $ 75,413 $ 75,207 =========== =========== =========== =========== =========== Allowance for losses on lending-related commitments - December 31 $ 2,690 $ 2,690 $ 4,024 $ 4,657 $ 1,190 =========== =========== =========== =========== =========== Portfolio loans outstanding at year-end (1) $ 5,245,702 $ 5,432,561 $ 5,771,963 $ 6,422,806 $ 5,917,483 Average portfolio loans outstanding (1) 5,248,922 5,530,790 5,977,744 6,202,157 5,528,963 Ratio of allowance for loan losses to portfolio loans outstanding at year-end 2.36% 1.97% 1.32% 1.17% 1.27% Ratio of net loans charged off as a percentage of average portfolio loans outstanding 0.88 1.65 0.43 0.28 0.37
(1) Balances exclude mortgage loans held for sale. (2) During the fourth quarter of 2003, Citizens reclassified $2.7 million from the allowance for loan losses related to unfunded loan commitments to other liabilities. Prior period amounts were restated to conform to the new presentation. 53 The lower loan loss provision in 2003 resulted from a decline in nonperforming assets, lower net charge-offs and fewer risk rating downgrades within the commercial loan portfolio. Additionally, enhancements to the loan loss allocation model resulted in relatively higher loan loss allocations in 2002. These enhancements included the incorporation of more recent historical loss data in the determination of projected loss rates for pools of loans evaluated collectively and refinements to our internal risk rating system for our commercial loans, which initially led to an increase in downgrades. The decrease in net charge-offs in 2003 occurred primarily in the commercial loan portfolio. Commercial net charge-offs totaled $34.2 million in 2003, compared with $77.6 million in 2002. Mortgage and consumer loans net charge-offs also decreased, but by lesser amounts. Eight customers comprised $24.5 million or 50% of the gross commercial charge-offs during 2003. On a comparative basis, $45.5 million or nearly 55% of the loans charged off in 2002 related to eight customers. The commercial loans charge-offs in 2003 were from a variety of industries, including steel products manufacturing, heavy construction, industrial supply, electric power distribution, retail grocery, and agriculture. Many of our commercial clients have been negatively affected by a weak economy that has only recently begun to show varying signs of recovery. Net residential mortgage loan charge-offs aggregated $1.2 million in 2003, driven in part by the discount of $0.6 million on the March 2003 sale of $2.8 million of non-performing loans. Based on the current economic climate and the trend that began in the second half of 2003, we expect net charge-offs and the provision for loan losses to be lower in 2004 than in 2003. The allowance for credit losses represents our estimate of probable losses inherent in the loan portfolio. The allowance is based on ongoing quarterly assessments and is maintained at a level we consider adequate to absorb probable loan losses identified with specific customer relationships and probable losses believed to be inherent in the loan portfolio which have not been specifically identified. Our evaluation process is inherently subjective, as it requires estimates that may be susceptible to significant change and have the potential to materially affect net income. Default frequency, internal risk ratings, expected future cash collections, loss recovery rates, and general economic factors, among other things, are considered in this evaluation, as are the size and diversity of individual large credits. We have not substantively changed our overall approach in the determination of the allowance for loan losses in 2003 from 2002 and the allocation methods used at December 31, 2003 and December 31, 2002 were consistent. Our methodology for measuring the adequacy of the allowance relies on several key elements, which include specific allowances for identified problem loans, a formula-based risk-allocated allowance for the remainder of the portfolio and an unallocated allowance. Management may also consider overall portfolio indicators, including trends in historical charge-offs, a review of industry, geographic and portfolio performance, and other qualitative factors. This methodology is discussed in Note 1 to the Consolidated Financial Statements. Internal risk ratings are assigned to each commercial and commercial mortgage loan at the time of approval and are subject to subsequent periodic reviews by senior management. These ratings encompass ten categories that define a borrower's estimated ability to repay their loan obligations. In the third quarter of 2002, we added a new 6 minus subcategory to our ten point rating system and incorporated a new scoring methodology for certain larger balance watch list commercial credits that lowered the number of factors considered from eight to five and gave additional weight toward discounted service ability (cash flow capacity), financial condition and capitalization of the borrower, and less from collateral coverage and prior relationship history. As a result of these changes, a number of commercial credits were downgraded to higher risk ratings resulting in higher loss rates being applied to the same dollar of exposure. Generally, we had used a historical three-year rolling average of net charge-offs as the base for developing loss factors for commercial credits. Beginning in the third quarter of 2002, in order to emphasize more recent loss trends in our methodology, we utilized an eighteen-month rolling average of net charge-offs. The loss rates were more heavily weighted toward more current loss experience as we view the most recent loss history as more representative of the current economic conditions inherent in our loan portfolio. These changes did not affect the level of net charge-offs or the calculation of the specific allowances, but increased the risk allocation allowance by approximately $23 million at December 31, 2002, and to a lesser extent at December 31, 2003. 54 Table 7 below summarizes the allocation of the allowance for loan losses for risk allocated, specific allocated and unallocated allowances by loan type and the percentage of each loan type of total portfolio loans. TABLE 7. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES(1)
2003 2002 2001 2000 1999 --------------- --------------- --------------- --------------- --------------- % OF % of % of % of % of December 31 TOTAL Total Total Total Total (dollars in millions) AMOUNT LOANS Amount Loans Amount Loans Amount Loans Amount Loans - ----------------------------- ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Specific allocated allowance: Commercial(2) $ 18.3 $ 18.7 $ 9.5 $ 5.5 $ -- Risk allocated allowances: Commercial(2) 68.6 55.0% 62.2 57.3% 29.3 56.2% 26.4 51.9% 21.2 48.6% Real estate construction 1.1 3.7 1.0 4.8 0.5 3.7 1.1 3.7 0.8 3.2 Real estate mortgage 4.7 7.7 2.3 10.0 3.3 14.2 5.7 20.0 5.9 24.3 Consumer 15.1 33.6 15.2 27.9 15.6 25.9 15.3 24.4 22.5 23.9 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Total risk allocated allowance 89.5 80.7 48.7 48.5 50.4 ------ ------ ------ ------ ------ Total allocated 107.8 100.0% 99.4 100.0% 58.2 100.0% 54.0 100.0% 50.4 100.0% ====== ====== ====== ====== ====== Unallocated 15.7 7.4 18.1 21.4 24.8 ------ ------ ------ ------ ------ Total $123.5 $106.8 $ 76.3 $ 75.4 $ 75.2 ====== ====== ====== ====== ======
(1) The allocation of the allowance for loan losses in the above table is based upon ranges of estimates and is not intended to imply either limitations on the usage of the allowance or precision of the specific amounts. Citizens and its subsidiaries do not view the allowance for loan losses as being divisible among the various categories of loans. The entire allowance is available to absorb any future losses without regard to the category or categories in which the charged-off loans are classified. (2) The commercial category includes both commercial and commercial real estate loans SPECIFIC ALLOCATED ALLOWANCE. Classified credits, which include "doubtful", "substandard" and "special mention" and are subject to specific reserves, decreased to $66.7 million at December 31, 2003 from $90.4 million at December 31, 2002. The amount of the specific allowance however, as a percent of outstanding loan balances subject to such specific reserves, increased to 27.5% at December 31, 2003 from 20.7% at December 31, 2002 as more substandard credits were assigned a specific reserve. Credits classified as "doubtful" have critical weaknesses that make full collection improbable. "Substandard" credits have well-defined weaknesses which, if not corrected, could jeopardize the full satisfaction of the debt. "Special mention" credits are potentially weak, as the borrower has begun to exhibit deteriorating trends that, if not corrected, could jeopardize repayment of the loan and result in further downgrade. RISK ALLOCATED ALLOWANCE. The amount allocated to commercial and commercial real estate loans increased in 2003, reflecting our review of additional loans in 2003 using the new scoring methodology, a migration of loans to higher risk ratings and assessment of current economic conditions within our local markets. The increase in 2003 in the real estate mortgage risk allocated allowance was attributable to an increased allocation for wholesale-originated mortgage loans, partially offset by lower balances and a reduction in nonaccrual loans. The reduction in nonaccrual real estate loans was attributable in part to the March 2003 sale of $2.8 million of nonperforming mortgage loans. UNALLOCATED ALLOWANCE. The increase in the unallocated allowance reflects continued uncertainty regarding general economic conditions in the near term, and the lingering effects of the weak economy over the past several years on our commercial loan portfolio, especially in the manufacturing and agricultural sectors. Although most observable credit quality indicators have improved, the manufacturing sector in our markets remains weak as evidenced by continued high unemployment. The agricultural sector, although improving, is emerging from a period of prolonged low producer prices and weakness. Additionally, uncertainty regarding the economy is evidenced by conflicting reports on economic growth, job creation, the volatility of long term interest rates, budget shortfalls at the state, local and federal government levels and slow demand for capital investments. These factors, coupled with an increase at December 31, 2003 in other credits that are current in terms of principal and interest payments, but which may deteriorate in quality if economic conditions change, indicate that additional undetected losses exist in the loan portfolios. Based on these factors and the possible imprecision in our loan loss allocation models, management believes that the unallocated allowance at December 31, 2003 appropriately reflects probable inherent but undetected losses in the portfolio. 55 NONPERFORMING ASSETS Nonperforming assets are comprised of nonaccrual loans, restructured loans and repossessed assets. Although these assets have more than a normal risk of loss, they will not necessarily result in a higher level of losses in the future. A five-year history of nonperforming assets is presented in Table 8. TABLE 8. NONPERFORMING ASSETS AND PAST DUE LOANS
December 31 (in thousands) 2003 2002 2001 2000 1999 - ---------------------------------------------------- ------- ------- ------- ------- ------- NONPERFORMING LOANS(1),(2) Nonaccrual Less than 30 days past due $ 7,721 $15,869 $ 6,528 $ 7,237 $ 1,661 From 30 to 89 days past due 4,474 23,210 5,218 7,297 772 90 or more days past due 56,549 47,638 57,047 44,881 26,498 ------- ------- ------- ------- ------- Total 68,744 86,717 68,793 59,415 28,931 90 days past due and still accruing 345 860 4,168 889 2,139 Restuctured (1) -- -- 337 1,068 9 ------- ------- ------- ------- ------- Total nonperforming loans 69,089 87,577 73,298 61,372 31,079 OTHER REPOSSESSED ASSETS ACQUIRED 7,943 8,094 5,947 4,917 4,039 ------- ------- ------- ------- ------- Total nonperforming assets $77,032 $95,671 $79,245 $66,289 $35,118 ======= ======= ======= ======= ======= Nonperforming assets as a percent of portfolio loans plus other repossessed assets acquired 1.47% 1.76% 1.37% 1.03% 0.59% Nonperforming assets as a percent of total assets 1.00 1.27 1.03 0.79 0.45 NONPERFORMING LOANS BY TYPE Commercial $38,774 $51,745 $36,926 $24,758 $11,920 Commercial real estate 16,385 19,301 11,052 12,471 6,085 Real estate mortgage 9,161 10,865 17,304 17,057 7,366 Consumer 4,424 5,666 8,016 7,086 5,708 ------- ------- ------- ------- ------- Total $68,744 $87,577 $73,298 $61,372 $31,079 ======= ======= ======= ======= =======
(1) Nonperforming loans include loans on which interest is being recognized only upon receipt (nonaccrual), those on which interest has been renegotiated to lower than market rates because of the financial condition of the borrowers (restructured), and loans 90 days past due and still accruing. (2) Gross interest income that would have been recorded in 2003 for nonaccrual and restructured loans, as of December 31, 2003, assuming interest had been accrued throughout the year in accordance with original terms was $6.261 million. The comparable 2002 and 2001 totals were $7.721 million, and $6.392 million, respectively. Interest collected on these loans and included in income was $4.011 million in 2003, $4.685 million in 2002 and $3.344 million in 2001. Therefore, on a net basis, total income foregone due to these loans was $2.250 million in 2003, $3.036 million in 2002 and $3.048 million in 2001. The decrease in nonperforming commercial and commercial real estate loans was the result of aggressive collection efforts and, to a lesser extent, continued charge-off of nonperforming loans. In addition, the decrease was attributable to a reduction of the inflow of new nonperforming loans, particularly in the second half of 2003, due to proactive management and reduction of exposure on credits with the potential to deteriorate. We believe the risk of loss for commercial real estate nonperforming loans is significantly less than the total principal balance, due to the nature of the underlying collateral and the value of such collateral in relation to the total credit exposure. These loans are generally for owner-occupied properties and the sources of repayment are not dependent on the performance of the real estate market. Nonperforming loans in both the residential mortgage and consumer loan portfolios decreased at December 31, 2003 compared with December 31, 2002. In the consumer portfolio, a change in asset mix, which included strong growth in home equity loans, has helped reduce nonperforming levels. Residential mortgage nonperforming loans declined due to the March 2003 sale of $2.8 million of nonperforming mortgage loans. Nonperforming assets, charge-offs and provisions for loan losses tend to decline in a strong economy and increase in a weak economy, potentially impacting our results. In addition to loans classified as nonperforming, we carefully monitor other credits that are current in terms of principal and interest payments but which we believe may deteriorate in quality if economic conditions change. As of December 31, 2003, such loans amounted to $189.8 million or 3.6% of total portfolio 56 loans compared with $134.6 million or 2.5% of total portfolio loans as of December 31, 2002. These loans are commercial and commercial real estate loans made in the normal course of business and do not represent a concentration in any one industry or geographic location. Under our credit policies and practices, a loan is placed on nonaccrual status when there is doubt regarding collection of principal or interest, or when principal or interest is past due 90 days or more and the loan is not well secured and in the process of collection. Interest accrued but not collected is reversed and charged against income when the loan is placed on nonaccrual status. A loan is considered impaired when we determine that it is probable that all the principal and interest due under the loan may not be collected. In most instances, impairment is measured based on the fair value of the underlying collateral. Impairment may also be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate. We maintain a valuation allowance for impaired loans. Cash collected on impaired nonaccrual loans is applied to outstanding principal. Interest income on all other impaired loans is recorded on an accrual basis. Certain of our nonperforming loans included in Table 8 are considered to be impaired. We measure impairment on all large balance nonaccrual commercial and commercial real estate loans. Certain large balance accruing loans rated substandard or lower are also measured for impairment. Impairment losses are included in the provision for loan losses. The policy does not apply to large groups of smaller balance homogeneous loans that are collectively evaluated for impairment, except for those loans restructured under a troubled debt restructuring. Loans collectively evaluated for impairment include certain smaller balance commercial loans, consumer loans, and residential real estate loans, and are not included in the impaired loan data. Total loans considered impaired and their related reserve balances at December 31, 2003 and 2002, as well as their effect on net income in 2003 and 2002, are set forth in the following table.
IMPAIRED LOAN INFORMATION Valuation Reserve ----------------- (in thousands) 2003 2002 2003 2002 - ----------------------------------------------- ------- ------- ------- ------- Balances - December 31 Impaired loans with valuation reserve $36,603 $41,240 $12,449 $13,338 Impaired loans with no valuation reserve 35,155 35,272 -- -- ------- ------- ------- ------- Total impaired loans $71,758 $76,512 $12,449 $13,338 ======= ======= ======= ======= Impaired loans on nonaccrual basis $55,159 $70,345 $ 3,913 $ 8,690 Impaired loans on accrual basis 16,599 6,167 8,536 4,648 ------- ------- ------- ------- Total impaired loans $71,758 $76,512 $12,449 $13,338 ======= ======= ======= ======= Average balance for the year $84,077 $80,487 Interest income recognized for the year 854 1,376 Cash collected applied to outstanding principal 3,758 4,415
DEPOSITS Table 9 below provides a year-to-year comparison of our average deposit balances over the last three years. Average, rather than period-end, balances are more meaningful in analyzing our deposit funding sources because of inherent fluctuations that occur on a monthly basis with most deposit categories. TABLE 9. AVERAGE DEPOSITS
2003 2002 2001 ------------------ ------------------ ------------------ Year Ended December 31 AVERAGE AVERAGE Average Average Average Average (dollars in millions) BALANCE RATE Balance Rate Balance Rate - -------------------------- -------- ------- -------- ------- -------- ------- Noninterest-bearing demand $ 877.9 --% $ 869.7 --% $ 881.2 --% Interest-bearing demand 1,319.9 0.89 1,148.0 1.57 744.8 1.88 Savings 1,329.6 0.67 1,363.5 1.14 1,474.5 2.36 Time 2,138.1 2.94 2,543.3 3.71 2,907.6 5.37 -------- -------- -------- Total $5,665.5 1.47 $5,924.5 2.16 $6,008.1 3.41 ======== ======== ========
57 Total average deposits declined 4.4% in 2003. Average noninterest bearing and interest bearing demand balances increased 0.9% and 15.0%, respectively, in 2003 as a result of deposit campaigns focused on growing core checking deposits. These increases were more than offset by a 16% decrease in average time deposits in 2003 a result of less aggressive pricing and efforts to migrate deposits towards core deposit products. The decline in the average cost for the deposit portfolio was a result of the lower rate environment and a shift in the deposit mix from higher cost time deposits to lower cost interest-bearing or noninterest-bearing demand accounts. As of December 31, 2003, certificates of deposit of $100,000 or more accounted for approximately 11.4% of total deposits. The maturities of these deposits are summarized below in Table 10. TABLE 10. MATURITY OF TIME CERTIFICATES OF DEPOSIT OF $100,000 OR MORE
December 31, (in thousands) 2003 - ---------------------------------- ------------ Three months or less $ 154,914 After three but within six months 103,652 After six but within twelve months 143,272 After twelve months 217,119 ------------ Total $ 618,957 ============
We gather deposits primarily from the local markets of our banking subsidiaries and have used purchased deposits from time to time when cost effective. Brokered deposits and time deposits greater than $100,000 declined by $58.7 million at December 31, 2003 from the prior year-end due to less aggressive pricing of such deposits and the reduced need for such funding. We will continue to evaluate the use of alternative funding sources such as brokered deposits as funding needs change. We continue to promote relationship driven core deposit growth and stability through focused marketing efforts and competitive pricing strategies. BORROWED FUNDS Short-term borrowings are comprised of Federal funds purchased, securities sold under agreements to repurchase, other bank borrowings, and Treasury Tax and Loan notes. Total short-term borrowings averaged $458.7 million in 2003, or 7.5%, of total average interest-bearing liabilities, compared with $251.3 million, or 4.2%, during 2002. The increase in short-term borrowings was due to the expansion of the investment portfolio and increased need for wholesale funding. See Note 11 to the Consolidated Financial Statements for additional information on short-term borrowings. Long-term debt, comprised of FHLB notes, subordinated notes and other long-term debt, accounted for $861.7 million, or 14.1%, of average interest-bearing funds during 2003, increasing from $620.9 million or 10.5% during 2002. On January 27, 2003, we issued $125 million of 5.75% subordinated notes due in 2013. The notes qualify as Tier 2 capital for regulatory risk-based capital purposes and were issued to provide funding to support cash flow requirements at our parent company and to improve our risk-based capital ratios. In June 2003, we issued approximately $25 million of floating rate 30 year trust preferred securities through a special purpose trust with an initial interest rate of 4.16%. Interest only payments are due quarterly and full payment of the principal is due in June 2033. These securities qualify as Tier 1 capital for regulatory risk-based capital purposes and were issued to improve liquidity and risk-based capital ratios. FHLB advances increased $188.8 million to $787.9 million at December 31, 2003. The increase reflects our need for additional wholesale funding to support the expansion of the investment portfolio and the decline in time deposits during 2003. A summary of long-term debt balances as of December 31, 2003 and 2002 appears in Note 12 to the Consolidated Financial Statements. Borrowed funds are expected to remain an important, reliable and cost-effective funding vehicle for us. During 2002, we prepaid $75 million in high cost FHLB debt with a remaining maturity of approximately one year to improve balance sheet flexibility, further reduce our funding costs and adjust our interest rate sensitivity. New FHLB borrowings with contractual maturity of greater than one year replaced a major portion of the prepaid debt. 58 CAPITAL RESOURCES We continue to maintain a strong capital position which supports our current needs and provides a sound foundation to support further expansion. Our regulatory capital ratios are consistently at or above the "well-capitalized" standards and all our bank subsidiaries have sufficient capital to maintain a well-capitalized designation. Our capital ratios for the past three years are presented below.
Regulatory Minimum ----------------------- December 31, "Well- -------------------------- Required Capitalized" 2003 2002 2001 -------- ------------ ------ ------ ------ Risk based: Tier 1 capital 4.00% 6.00% 9.80% 9.18% 9.87% Total capital 8.00 10.00 13.23 10.43 11.12 Tier 1 leverage 4.00 5.00 7.45 7.18 7.79
Average shareholders equity was $632.1 million, or 8.22% of average assets for 2003 compared with $691.8 million, or 9.14%, for 2002 and $702.4 million, or 8.85% for 2001. At December 31, 2003, shareholders' equity was $635.2 million, compared with $650.5 million at December 31, 2002. Book value per common share at December 31, 2003 and 2002 was $14.69 and $14.88, respectively. We declared and paid cash dividends of $1.14 per share in 2003, up from $1.13 per share in 2002 and $1.085 per share in 2001. Shareholders' equity declined in 2003 as net income was more than offset by cash dividends and capital used in our share repurchase program. Shareholders equity also declined in 2003 due to a decrease in other comprehensive net income as the net unrealized gain on available-for-sale securities decreased. In October 2001, our board of directors approved a plan to repurchase up to 3,000,000 shares of Citizens' common stock for general corporate purposes. At December 31, 2003, 2,745,400 shares of common stock had been repurchased under this plan at an average price of $28.28, including 810,800 shares purchased during 2003 at an average price of $26.30. In October 2003, our board of directors approved a new plan to repurchase an additional 3,000,000 shares of common stock. These shares are in addition to the 254,600 shares authorized to be repurchased under the plan approved in October 2001. The repurchase of our shares is subject to limitations that may be imposed by applicable securities laws and regulations and the rules of the Nasdaq Stock Market. The timing of the repurchases and the number of shares to be bought at any one time depend on market conditions and our capital requirements. There can be no assurance that we will repurchase the remaining shares authorized to be repurchased, or that any additional repurchases will be authorized by our board of directors. CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS CONTRACTUAL OBLIGATIONS In the ordinary course of its business, we enter into certain contractual arrangements that require future cash payments and may impact liquidity. These obligations include issuance of debt to fund operations, purchase obligations to acquire goods or services, and property leases. The table below summarizes our non-cancelable contractual obligations and future required minimum payments at December 31, 2003. Refer to Notes 9 and 12 to the Consolidated Financial Statements for a further discussion of these contractual obligations. TABLE 11. CONTRACTUAL OBLIGATIONS
Minimum Payments Due by Period ---------------------------------------------------- Less More than 1-3 4-5 than (in thousands) Total 1 year years years 5 years - --------------------------------------------- -------- -------- -------- -------- -------- Federal Home Loan Bank borrowings $787,930 $ 85,200 $320,200 $ 95,204 $287,326 Subordinated debt 148,835 -- -- -- 148,835 Capital lease/mortgage debt 94 56 38 -- -- Purchase obligations 37,784 11,899 21,874 4,011 -- Operating leases and non-cancelable contracts 14,447 3,126 4,835 2,645 3,841 -------- -------- -------- -------- -------- Total $989,090 $100,281 $346,947 $101,860 $440,002 ======== ======== ======== ======== ========
We are also contractually obligated to certain derivative instruments. Refer to Note 18 to the Consolidated Financial Statements for further discussion of these contractual obligations. 59 OFF-BALANCE SHEET ARRANGEMENTS In the normal course of business, in order to meet the financing needs of our customers and to manage our own exposure to interest rate risk, we become a party to transactions involving financial instruments with off-balance sheet risk. These financial instruments which are not reflected in the Consolidated Financial Statements include commitments to extend credit, standby letters of credit, forward commitments to sell mortgage loans and interest rate swaps. The contractual amounts of these instruments express the extent of our involvement in these transactions as of the balance sheet date. These instruments involve, to varying degrees, elements of credit risk, market risk and liquidity risk in excess of the amount recognized in the consolidated balance sheets. However, they do not represent unusual risks for us and we do not anticipate any significant losses to arise from these transactions. Commitments to extend credit are legally binding agreements to lend cash to a customer as long as there is no breach of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require the payment of a fee. Commitments to fund loan applications with agreed-upon rates subject us to market risk due to fluctuations in interest rates. Standby letters of credit guarantee the performance of a customer to a third party. We issue these guarantees primarily to support public and private borrowing arrangements, real estate construction projects, bond financing and similar transactions. The credit risk associated with commitments to extend credit and standby letters of credit is essentially the same as that involved with direct lending. Therefore, these instruments are subject to our loan review and approval procedures and credit policies. Based upon management's credit evaluation of the counter-party, we may require the counter-party to provide collateral as security for the agreement, including real estate, accounts receivable, inventories, and investment securities. The maximum credit risk associated with these instruments equals their contractual amounts and assumes that the counter-party defaults and the collateral proves to be worthless. The total contractual amounts of commitments to extend credit and standby letters of credit do not necessarily represent future cash requirements, since many of these agreements may expire without being drawn upon. At December 31, 2003 and 2002, we had recorded a liability of $2.7 million for possible losses with commitments to extend credit and, in accordance with FIN 45, a liability of $0.8 million representing the value of the guarantee obligations associated with certain standby letters of credit. The guarantee obligation liability will be amortized into income over the life of the commitments. At December 31, 2003, we had outstanding $14.7 million of commitments to fund residential real estate loan applications with agreed-upon rates ("Interest Rate Lock Commitments"). Interest Rate Lock Commitments and holding residential mortgage loans for sale to the secondary market exposes us to interest rate risk during the period from application to when the loan is sold to the investors. To minimize this exposure to interest rate risk, we enter into firm commitments to sell such mortgage loans at specified future dates to various third parties. At December 31, 2003, we had outstanding mandatory forward commitments to sell $29.0 million of residential mortgage loans. These mandatory forward commitments covered $23.0 million of mortgage loans held for sale and $6.0 million of Interest Rate Lock Commitments. These outstanding forward commitments to sell mortgage loans are expected to settle in the first quarter of 2004 without producing any material gains or losses. We implemented SFAS 133, as amended which provides accounting guidance for derivative investments and hedging activities effective January 1, 2001. See Note 1 to the Consolidated Financial Statements for further explanation. For the year ended December 31, 2003, the impact of SFAS 133 on net income was immaterial. At December 31, 2003, we had interest rate swaps with a notional amount of $190 million with a fixed receive rate of 4.78% and a variable pay rate of 1.62%. Notional amounts of $165 million and $25 million have variable pay rates based on LIBOR and prime, respectively. 60 The following table presents the total notional amounts and expected maturity of our off-balance sheet financial instruments outstanding at December 31, 2003 and the notional amounts outstanding at December 31, 2002. TABLE 12. OFF BALANCE SHEET FINANCIAL INSTRUMENTS
Expected Expiration Dates by Period ---------------------------------------------------------- Total Less than More than December 31, (in thousands) 2003 1 year 1-3 years 4-5 years 5 years 2002 - --------------------------------------------------------- ---------- ---------- ---------- ---------- ---------- ------------ FINANCIAL INSTRUMENTS WHOSE CONTRACT AMOUNTS REPRESENT CREDIT RISK: Loan commitments to extend credit $1,593,426 $1,202,613 $ 101,390 $ 15,971 $ 273,452 $ 1,739,091 Standby letters of credit 48,868 39,116 8,115 1,637 -- 36,396 Commercial letters of credit 183,665 40,690 22,151 103,581 17,243 138,679 FINANCIAL INSTRUMENTS SUBJECT TO INTEREST RATE RISK: Interest rate swaps 190,000 -- 25,000 -- 165,000 -- Residential mortgage loan applications with agreed-upon rates 14,683 14,683 -- -- -- 66,787 Forward commitments to sell residential mortgage loans 29,000 29,000 -- -- -- 175,537 ---------- ---------- ---------- ---------- ---------- ------------ Total $2,059,642 $1,326,102 $ 156,656 $ 121,189 $ 455,695 $ 2,156,490 ========== ========== ========== ========== ========== ============
During the ordinary course of business, we also engage in other financial transactions that are not recorded on our consolidated balance sheets or are recorded on an equity or cost basis rather than being consolidated. Such transactions serve a variety of purposes including management of our liquidity, optimization of capital utilization, meeting the financial needs of our customers and fulfilling Community Reinvestment Act obligations in the markets that we serve. Late in the second quarter of 2003, we issued to institutional investors approximately $25 million of floating rate trust preferred securities through a special purpose trust which qualifies as a variable interest entity ("VIE") under applicable accounting rules. Since we are not the primary beneficiary of the VIE, consolidation is not required under the terms of Financial Accounting Standards Board Interpretation 46 "Consolidation of Variable Interest Entities" ("FIN 46"). As a result, the trust preferred securities were not recorded in our Consolidated Balance Sheets. Instead we recorded a floating rate junior subordinated deferrable interest debenture (the "Debenture") issued by Citizens to the VIE for the gross issuance proceeds. The Debenture is the sole asset of the trust and Citizens has guaranteed that interest payments on the Debenture made to the trust will be distributed by the trust to the holders of the trust preferred securities. The Debenture matures in thirty years, is callable at par after five years and bears interest at an annual rate equal to the three-month LIBOR plus 3.10%, payable quarterly. The trust preferred securities issued by the trust have financial terms that are comparable to the Debenture. We have non-marketable equity investments that have not been consolidated in our Consolidated Financial Statements. At December 31, 2003, these investments included $1.0 million in limited partnerships, including a venture capital fund and an affordable housing tax credit fund that were reported under the equity method. Not included in the carrying amount were commitments to fund an additional $2.9 million at some future date. Consolidation of these investments will not be required pursuant to FIN 46 since we are not the primary beneficiary in the investments. The maximum exposure to loss for all non-marketable equity investments is the sum of the carrying amounts plus additional commitments. We originate residential mortgage loans that we sell to the secondary market. Typically we sell the right to service the loans that are sold. As of December 31, 2003, the unpaid principal balance of mortgage loans serviced for others was $58.8 million. These loans are not recorded on our books. Capitalized servicing rights relating to the serviced loans were fully amortized in June 2003 and were $0.4 million at December 31, 2002. We hold assets in a fiduciary or agency capacity that are not included in the Consolidated Financial Statements because they are not assets of Citizens. The total assets managed or administered by Citizens at December 31, 2003, in its fiduciary or agency capacity, were $2.866 billion. 61 LIQUIDITY AND DEBT CAPACITY We monitor and manage our liquidity position so that funds will be available at a reasonable cost to meet financial commitments, to finance business expansion and to take advantage of unforeseen opportunities. We manage the liquidity of our parent company to pay dividends to shareholders, service debt, invest in subsidiaries and to satisfy other operating requirements. We manage the liquidity of our subsidiary banks to meet client cash flow needs while maintaining funds available for loan and investment opportunities. Our subsidiary banks derive liquidity primarily through core deposit growth, maturity of money market investments, and maturity and sale of investment securities and loans. Additionally, our subsidiary banks have access to market borrowing sources on an unsecured, as well as a collateralized basis, for both short-term and long-term purposes including, but not limited to, the Federal Reserve and Federal Home Loan Banks where the subsidiary banks are members. The primary sources of liquidity for the parent company are dividends from and returns on investment in its subsidiaries. Each of our banking subsidiaries is subject to dividend limits under the laws of the state in which it is chartered and, as member banks of the Federal Reserve System, is subject to the dividend limits of the Federal Reserve Board. The Federal Reserve Board allows a member bank to make dividends or other capital distributions in an amount not exceeding the current calendar year's net income, plus retained net income of the preceding two years. Distributions in excess of this limit require prior approval of the Federal Reserve Board. During 2003, our parent company received $24.0 million in dividends from subsidiaries and paid $49.5 million in dividends to its shareholders. As discussed in Note 21 to the Consolidated Financial Statements, as of January 1, 2004, our banking subsidiaries are able to pay dividends of $36.2 million to our parent company without further regulatory approval. An additional source of liquidity is the ability of our parent company to borrow funds on both a short-term and long-term basis. Downgrades in the first quarter of 2003 by FitchRatings and Standard & Poor's Rating Service of our long-term credit rating to BBB from BBB+ due to asset quality deterioration during 2002 did not materially affect our liquidity position. Our short-term credit ratings from FitchRatings and Standard & Poor's remained unchanged at F2 and A-2, respectively. Separately, in the second quarter of 2003, Moody's Investors Service affirmed our outstanding ratings of Baa-1 (long term) and P-2 (short term), after their review for a possible downgrade. We believe that our capital position provides enough financial flexibility to deal with a degree of additional credit deterioration, if such were to occur. Our parent company also maintains a $50 million short-term revolving credit facility with two unaffiliated banks. As of December 31, 2003, we had no outstanding balance on this credit facility. The current facility will mature in August 2004 and is expected to be renewed at that time. The credit agreement requires us to maintain certain financial covenants. We were in full compliance with all debt covenants as of December 31, 2003. Our Oakland County branch expansion plan will pose a challenge to liquidity as both the capital investment and loan growth will require incremental funding. We are confident that through a combination of wholesale funding and deposit generation of both the new Oakland County branches and the existing branch network, we will be able to fund all aspects of the expansion plan. We also have contingent letter of credit commitments that may impact liquidity. Since many of these commitments historically have expired without being drawn upon, the total amount of these commitments does not necessarily represent our future cash requirements in connection with them. Further information on these commitments is presented in Note 17 to the Consolidated Financial Statements in this report. As discussed in Note 21 to the Consolidated Financial Statements, the Federal Reserve Bank requires our banking subsidiaries to maintain certain noninterest-bearing deposits with the Federal Reserve Bank. These balance requirements averaged $36.4 million and $35.3 million during 2003 and 2002, respectively, and were satisfied with cash balances maintained by our subsidiaries. Our long-term debt to equity ratio was 147.5% as of December 31, 2003 compared to 92.1% in 2002. The increase in long-term debt reflects our issuance of additional funding to support the expansion of the investment portfolio and the decrease in time deposits. The increase also reflects the issuance of $125 million of subordinated debt in January 2003 and approximately $25 million of trust preferred securities in June 2003 to increase liquidity in our parent company and improve our capital ratios. Changes in long-term debt during 2003 are further discussed in the section titled "Borrowed Funds". We believe that we have sufficient liquidity and capital sources to meet presently known short and long term cash flow requirements arising from ongoing business transactions. 62 INTEREST RATE RISK Interest rate risk arises when there is a mismatch in the timing of the repricing of assets and liabilities, typically as a result of option risk, which can alter the expected timing of repricing of certain assets or liabilities, or basis risk. Many assets and liabilities contain embedded options which allow customers, and entities associated with our investments and wholesale funding, to prepay loans or securities prior to maturity, or to withdraw or reprice deposits or other funding instruments prior to maturity. Basis risk occurs when assets and liabilities reprice at the same time but based on different market rates, or when those market rates change by different amounts. We monitor asset, liability, and off-balance sheet portfolios to ensure comprehensive management of interest rate risk. The asset/liability management process includes monitoring contractual and expected repricing of assets and liabilities as well as forecasting earnings under different interest rate scenarios and balance sheet structures with the objective of insulating net interest income from large swings attributable to changes in market interest rates. Our static interest rate sensitivity (GAP) as of December 31, 2003 and 2002 is presented in the following table.
TABLE 13. INTEREST RATE SENSITIVITY TOTAL 0 - 3 4 - 6 7 - 12 WITHIN 1 - 5 Over (dollars in millions) Months Months Months 1 YEAR Years 5 Years Total - --------------------- ------ ------ ------ ------ ----- ------- ----- DECEMBER 31, 2003 RATE SENSITIVE ASSETS(1) Portfolio loans (2) $ 2,482.8 $ 258.2 $ 442.3 $ 3,183.3 $ 1,769.0 $ 293.4 $ 5,245.7 Mortgage loans held for sale 44.7 -- -- 44.7 -- -- 44.7 Investment securities 112.6 63.1 121.4 297.1 1,487.3 200.7 1,985.1 Short-term investments 2.2 -- -- 2.2 -- -- 2.2 --------- --------- --------- --------- --------- --------- --------- Total $ 2,642.3 $ 321.3 $ 563.7 $ 3,527.3 $ 3,256.3 $ 494.1 $ 7,277.7 ========= ========= ========= ========= ========= ========= ========= RATE SENSITIVE LIABILITIES Deposits (3) $ 1,058.2 $ 521.8 $ 943.8 $ 2,523.8 $ 1,768.8 $ 267.2 $ 4,559.8 Other interest bearing liabilities 678.9 28.0 50.7 757.6 378.8 432.1 1,568.5 --------- --------- --------- --------- --------- --------- --------- Total $ 1,737.1 $ 549.8 $ 994.5 $ 3,281.4 $ 2,147.6 $ 699.3 $ 6,128.3 ========= ========= ========= ========= ========= ========= ========= Period GAP (4) $ 905.2 $ (228.5) $ (430.8) $ 245.9 $ 1,108.7 $ (205.2) $ 1,149.4 Cumulative GAP 905.2 676.7 245.9 1,354.6 1,149.4 Cumulative GAP to total assets 11.74% 8.78% 3.19% 17.57% 14.91% 14.91% Multiple of rate sensitive assets to liabilities 1.52 0.58 0.57 1.07 1.52 0.71 1.19 DECEMBER 31, 2002 RATE SENSITIVE ASSETS(1) Portfolio loans (2) $ 2,670.5 $ 247.3 $ 474.6 $ 3,392.4 $ 1,723.1 $ 317.1 $ 5,432.6 Mortgage loans held for sale 160.7 -- -- 160.7 -- -- 160.7 Investment securities 132.4 53.6 180.7 366.7 645.0 445.6 1,457.3 Short-term investments 71.3 -- -- 71.3 -- -- 71.3 --------- --------- --------- --------- --------- --------- --------- Total $ 3,034.9 $ 300.9 $ 655.3 $ 3,991.1 $ 2,368.1 $ 762.7 $ 7,121.9 ========= ========= ========= ========= ========= ========= ========= RATE SENSITIVE LIABILITIES Deposits (3) $ 704.9 $ 570.5 $ 1,065.8 $ 2,341.2 $ 2,338.8 $ 356.2 $ 5,036.2 Other interest bearing liabilities 418.0 9.9 -- 427.9 165.6 308.2 901.7 --------- --------- --------- --------- --------- --------- --------- Total $ 1,122.9 $ 580.4 $ 1,065.8 $ 2,769.1 $ 2,504.4 $ 664.4 $ 5,937.9 ========= ========= ========= ========= ========= ========= ========= Period GAP (4) $ 1,912.0 $ (279.5) $ (410.5) $ 1,222.0 $ (136.3) $ 98.3 $ 1,184.0 Cumulative GAP 1,912.0 1,632.5 1,222.0 1,085.7 1,184.0 Cumulative GAP to total assets 25.42% 21.70% 16.25% 16.25% 14.43% 15.74% 15.74% Multiple of rate sensitive assets to liabilities 2.70 0.52 0.61 1.44 0.95 1.15 1.20
(1) Incorporates prepayment projections for certain assets which may shorten the time frame for repricing or maturity compared to contractual runoff. (2) Balances exclude mortgage loans held for sale. (3) Includes interest bearing savings and demand deposits without contractual maturities of $1.143 billion in the less than one year category and $1.436 billion in the over one year category as of December 31, 2003. The same amounts as of December 31, 2002 were $811 million and $1.855 billion, respectively. This runoff is based on historical trends, which reflects industry standards. (4) GAP is the excess of rate sensitive assets (liabilities). 63 As shown, as of December 31, 2003 rate sensitive assets repricing within one year exceeded rate sensitive liabilities repricing within one year by $245.9 million or 3.19% of total assets, compared to $1.222 billion or 16.25% of total assets as of December 31, 2002. These results suggest an interest rate risk position which is not significantly mismatched. GAP analysis is limited in its ability to measure interest rate sensitivity, as embedded options can change the repricing characteristics of assets, liabilities, and off-balance sheet hedges thereby changing the repricing position from that outlined above. Further, basis risk is not captured by repricing gap analysis. Because of these limitations, we utilize net interest income simulation modeling as our primary tool to evaluate the impact of changes in market interest rates and balance sheet strategies on net interest income. We may, from time-to-time, use derivative contracts to help manage or hedge our exposure to interest rate risk and to market value risk in conjunction with our mortgage banking operations. We currently use interest rate swaps, mortgage loan commitments and forward mortgage loan sales. Interest rate swaps are contracts with a third party (the "counter-party") to exchange interest payment streams based upon an assumed principal amount (the "notional amount"). The notional amount is not advanced from the counter-party. Swap contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. The fair values of the contracts change daily as market interest rates change. Further discussion of derivative instruments is included in Notes 1 and 18 to the Consolidated Financial Statements. Holding residential mortgage loans for sale and committing to fund residential mortgage loan applications at specific rates exposes Citizens to market value risk caused by changes in interest rates during the period from rate commitment issuance until sale. To minimize this risk, we enter into mandatory forward commitments to sell residential mortgage loans at the time a rate commitment is issued. These mandatory forward commitments are considered derivatives under SFAS 133. These forward commitments qualify and have been designated as fair value hedges of our portfolio of loans held for sale. Our practice to hedge our market value risk with mandatory forward commitments has been effective and has not generated any material gains or losses. As of December 31, 2003, we had forward commitments to sell mortgage loans of $29 million. Sensitivity of our net interest income to changes in market interest rates is quantified using income simulation modeling. Key assumptions in the model include prepayment speeds on various loan and investment assets; cash flows and maturities of financial instruments, changes in market conditions, loan and deposit volumes, pricing, client preferences and our financial capital plans. These assumptions are inherently uncertain, subject to fluctuation and revision in a dynamic environment and, as a result, the model cannot precisely estimate net interest income nor exactly predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of balance sheet component and interest rate changes, differences in client behavior, market conditions and management strategies, among other factors. We performed simulations as of December 31, 2003 to evaluate the impact of market rate changes on net interest income over the following 12 months assuming expected levels of balance sheet growth over that time period. Net interest income is expected to decline modestly over the period if rates remain at December 31, 2003 levels. See "Net Interest Income". If market interest rates were to increase immediately by 100 or 200 basis points (a parallel and immediate shift along the yield curve) net interest income would be expected to decline by 0.5% and 1.5% respectively from what it would be if rates were to remain at December 31, 2003 levels. An immediate 50 basis point parallel decline in market rates would be expected to reduce net interest income over the following 12 months by 0.9% from what it would be if rates remain constant over the entire time period at December 31, 2003 levels. The expansion of the investment portfolio in 2003 has modified our interest rate risk profile. At December 31, 2003, unlike at the prior year end, as the model results indicate, an increase in interest rates will have a negative impact on net interest income. Net interest income is not only affected by the level and direction of interest rates, but also by the shape of the yield curve, pricing spreads in relation to market rates, balance sheet growth, the mix of different types of assets or liabilities, and the timing of changes in these variables. A flattening of the yield curve would exacerbate the negative impact on net interest income. Scenarios different from those outlined above, whether different by only timing, level, or a combination of factors, could produce different results. 64 SELECTED QUARTERLY INFORMATION Table 14 below sets forth selected quarterly financial information for each calendar quarter during 2003 and 2002. TABLE 14. SELECTED QUARTERLY INFORMATION
2003 2002 (in thousands except, --------------------------------------------- ---------------------------------------------- per share data) FOURTH THIRD SECOND FIRST Fourth Third Second First --------- --------- --------- --------- --------- --------- --------- --------- Interest income $ 97,398 $ 99,687 $ 104,683 $ 104,209 $ 112,558 $ 115,558 $ 116,993 $ 118,275 Interest expense 26,720 28,533 31,763 32,703 36,326 40,376 41,584 43,316 Net interest income 70,678 71,154 72,920 71,506 76,232 75,182 75,409 74,959 Provision for loan losses 8,020 10,300 25,650 18,992 16,300 89,250 9,400 5,250 Noninterest income before securities gains (1) 21,629 25,012 24,836 23,239 26,689 19,689 28,238 24,724 Investment securities gains (2) 2 42 11 48 12 45 2,377 2 Noninterest expense (3) 60,446 59,600 56,361 56,581 57,126 79,545 61,521 61,191 Net income (loss) 18,074 19,605 13,214 15,058 21,525 (45,929) 25,339 24,103 PER SHARE OF COMMON STOCK Net income (loss): Basic 0.42 0.45 0.30 0.35 0.49 (1.03) 0.57 0.53 Diluted 0.41 0.45 0.30 0.34 0.48 (1.03) 0.56 0.53 Cash dividends declared 0.285 0.285 0.285 0.285 0.285 0.285 0.285 0.275 Market value:(4) High 34.26 28.01 28.17 26.05 26.46 29.43 33.88 33.20 Low 26.41 24.77 21.72 23.58 21.25 23.35 27.82 30.67 Close 32.72 26.41 27.01 23.62 24.78 24.17 28.98 32.47
(1) Noninterest income includes, in the third quarter of 2002, charges of $1.6 million, and in the second quarter of 2002, a gain of $5.4 million on the sale of our merchant services business. The charges in the third quarter of 2002 included market valuation write-downs to an equity investment and life insurance cash surrender values as well as the write-off of certain obsolete assets and uncollectible fees. (2) Investment securities gains include $2.4 million in the second quarter of 2002 from the securitization of mortgages and subsequent sale of the related mortgage-backed securities. (3) Noninterest expense includes special and other charges in each period as follows:
2003 2002 -------------------------------------- ---------------------------------- FOURTH THIRD SECOND FIRST Fourth Third Second First ------ ------- ------- ------- ------- ------- ----- ----- Special charge $ -- $ (370) $ (221) $ (100) $ (405) $13,807 $ -- $ -- Other charges -- -- -- -- -- 7,137 -- --
The special charge covered the cost of restructuring our consumer, commercial and wealth management lines of business. The other charges in the third quarter of 2002 included: a $3.3 million prepayment penalty on FHLB advances, a $2.0 million contribution to Citizens' charitable trust, $1.0 million valuation allowance on other real estate owned, $406,000 in additional equipment depreciation and $452,000 in losses and other items. (4) Citizens Banking Corporation common stock is traded on the National Market tier of the Nasdaq stock market (trading symbol: CBCF). At December 31, 2003, there were approximately 15,158 shareholders of the Corporation's common stock. 65 CONSOLIDATED BALANCE SHEETS CITIZENS BANKING CORPORATION AND SUBSIDIARIES
December 31, (in thousands, except share amounts) 2003 2002 ----------- ----------- ASSETS Cash and due from banks $ 182,545 $ 171,864 Money market investments: Federal funds sold -- 69,000 Interest-bearing deposits with banks 2,223 2,332 ----------- ----------- Total money market investments 2,223 71,332 Securities available for sale (amortized cost $1,930,606 in 2003; $1,391,089 in 2002) 1,965,201 1,457,281 Securities held to maturity (fair value of $19,913 in 2003) 19,857 -- Mortgage loans held for sale 44,677 160,743 Loans: Commercial 2,885,868 3,111,208 Real estate construction 192,759 262,363 Real estate mortgage 402,910 545,834 Consumer 1,764,165 1,513,156 ----------- ----------- Total loans 5,245,702 5,432,561 Less: Allowance for loan losses (123,545) (106,777) ----------- ----------- Net loans 5,122,157 5,325,784 Premises and equipment 112,784 117,704 Goodwill 54,785 54,785 Other intangible assets 16,932 19,862 Bank owned life insurance 80,461 78,434 Other assets 109,448 66,935 ----------- ----------- TOTAL ASSETS $ 7,711,070 $ 7,524,724 =========== =========== LIABILITIES Noninterest-bearing deposits $ 882,429 $ 900,674 Interest-bearing deposits 4,559,838 5,036,239 ----------- ----------- Total deposits 5,442,267 5,936,913 Federal funds purchased and securities sold under agreements to repurchase 588,593 223,289 Other short-term borrowings 43,077 79,062 Other liabilities 65,112 35,678 Long-term debt 936,859 599,313 ----------- ----------- Total liabilities 7,075,908 6,874,255 SHAREHOLDERS' EQUITY Preferred stock - no par value: Authorized - 5,000,000 shares; Issued - none Common stock - no par value: Authorized - 100,000,000 shares Issued and outstanding - 43,241,918 in 2003; 43,702,371 in 2002 100,314 112,253 Retained earnings 512,045 495,570 Accumulated other comprehensive income 22,803 42,646 ----------- ----------- Total shareholders' equity 635,162 650,469 ----------- ----------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 7,711,070 $ 7,524,724 =========== ===========
See notes to consolidated financial statements. 66 CONSOLIDATED STATEMENTS OF INCOME CITIZENS BANKING CORPORATION AND SUBSIDIARIES
(in thousands, except share amounts) 2003 2002 2001 ------------ ------------ ------------ INTEREST INCOME Interest and fees on loans $ 323,739 $ 385,812 $ 492,437 Interest and dividends on investment securities: Taxable 61,631 55,447 57,633 Tax-exempt 20,502 21,301 21,715 Money market investments 105 824 1,774 ------------ ------------ ------------ Total interest income 405,977 463,384 573,559 INTEREST EXPENSE Deposits 83,449 127,849 204,929 Short-term borrowings 4,960 4,033 27,458 Long-term debt 31,310 29,720 33,191 ------------ ------------ ------------ Total interest expense 119,719 161,602 265,578 ------------ ------------ ------------ NET INTEREST INCOME 286,258 301,782 307,981 Provision for loan losses 62,962 120,200 26,407 ------------ ------------ ------------ Net interest income after provision for loan losses 223,296 181,582 281,574 ------------ ------------ ------------ NONINTEREST INCOME Service charges on deposit accounts 29,916 26,456 27,773 Trust fees 17,527 18,956 21,028 Mortgage and other loan income 18,046 16,845 13,159 Bankcard fees 3,042 6,142 11,799 Brokerage and investment fees 7,720 9,502 8,157 Investment securities gains 103 2,436 6,195 Gain on sale of merchant business -- 5,400 -- Gain on sale of equity investment -- -- 11,017 Gain on sale of credit card assets -- -- 2,623 Gain on sale of bank -- -- 793 Other 18,465 16,039 14,937 ------------ ------------ ------------ Total noninterest income 94,819 101,776 117,481 ------------ ------------ ------------ NONINTEREST EXPENSE Salaries and employee benefits 122,322 126,847 126,278 Equipment 16,087 19,869 19,317 Occupancy 18,449 17,855 17,713 Data processing fees 12,744 12,641 13,101 Professional services 17,815 14,790 12,277 Postage and delivery 6,896 7,120 7,746 Telephone 4,793 5,279 5,556 Advertising and public relations 5,786 5,112 5,219 Stationery and supplies 3,935 4,032 4,426 Intangible asset amortization 2,899 2,899 10,115 Bankcard fees 378 3,879 9,308 Special charge (691) 13,402 -- Other 21,575 25,658 20,127 ------------ ------------ ------------ Total noninterest expense 232,988 259,383 251,183 ------------ ------------ ------------ INCOME BEFORE INCOME TAXES 85,127 23,975 147,872 Income tax provision (benefit) 19,176 (1,063) 43,215 ------------ ------------ ------------ NET INCOME $ 65,951 $ 25,038 $ 104,657 ============ ============ ============ NET INCOME PER SHARE: Basic $ 1.52 $ 0.56 $ 2.27 Diluted 1.51 0.56 2.25 AVERAGE SHARES OUTSTANDING: Basic 43,303,573 44,657,153 46,085,405 Diluted 43,609,148 45,076,684 46,589,962
See notes to consolidated financial statements. 67 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY CITIZENS BANKING CORPORATION AND SUBSIDIARIES
Accumulated Other Common Retained Comprehensive (in thousands, except per share amounts) Stock Earnings Income (loss) Total - ---------------------------------------- ----- -------- ------------- ----- BALANCE - JANUARY 1, 2001 $201,549 $466,692 $11,738 $679,979 Comprehensive income: Net income 104,657 104,657 Other comprehensive income: Net unrealized gain on securities available-for-sale, net of tax effect of $7,858 14,569 Less: Reclassification adjustment for net gains included in net income, net of tax effect of $2,168 (4,027) Minimum pension liability, net of tax effect of $929 (1,727) ------- Other comprehensive income total 8,815 ----- Total comprehensive income 113,472 Tax benefit on non-qualified stock options 2,000 2,000 Exercise of stock options, net of shares purchased 10,662 10,662 Cash dividends - $1.085 per share (50,158) (50,158) Shares acquired for retirement (58,491) (58,491) -------- ------- ------- -------- BALANCE - DECEMBER 31, 2001 155,720 521,191 20,553 697,464 Comprehensive income: Net income 25,038 25,038 Other comprehensive income: Net unrealized gain on securities available-for-sale, net of tax effect of $12,023 22,328 Less: Reclassification adjustment for net gains included in net income, net of tax effect of $853 (1,583) Minimum pension liability, net of tax effect of $724 1,348 ----- Other comprehensive income total 22,093 ------ Total comprehensive income 47,131 Exercise of stock options, net of shares purchased 6,562 6,562 Net change in deferred compensation, net of tax effect 267 267 Cash dividends - $1.13 per share (50,659) (50,659) Shares acquired for retirement (50,296) (50,296) -------- ------- ------- -------- BALANCE - DECEMBER 31, 2002 112,253 495,570 42,646 650,469 Comprehensive income: Net income 65,951 65,951 Other comprehensive income: Net unrealized loss on securities available-for-sale, net of tax effect of ($11,023) (20,472) Less: Reclassification adjustment for net gains included in net income, net of tax effect of $36 (67) Net change in unrealized gain on qualifying cash flow hedges, net of tax effect of $280 520 Minimum pension liability, net of tax effect of $95 176 --- Other comprehensive income total (19,843) -------- Total comprehensive income 46,108 Tax benefit on non-qualified stock options 2,500 2,500 Exercise of stock options, net of shares purchased 6,334 6,334 Net change in deferred compensation, net of tax effect 350 350 Stock issued for compensation 200 200 Cash dividends - $1.14 per share (49,476) (49,476) Shares acquired for retirement (21,323) (21,323) -------- ------- ------- -------- BALANCE - DECEMBER 31, 2003 $100,314 $512,045 $22,803 $ 635,162 ======== ======== ======= =========
See notes to consolidated financial statements. 68
CONSOLIDATED STATEMENTS OF CASH FLOWS CITIZENS BANKING CORPORATION AND SUBSIDIARIES YEAR ENDED DECEMBER 31, (in thousands) 2003 2002 2001 ----------- ----------- ----------- OPERATING ACTIVITIES: Net income $ 65,951 $ 25,038 $ 104,657 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 62,962 120,200 26,407 Depreciation and amortization 13,864 17,045 16,241 Amortization of goodwill and other intangibles 2,899 2,899 11,063 Deferred income tax (credit) 1,526 (5,110) (279) Net amortization (accretion) on investment securities 9,969 1,926 (563) Investment securities gains (103) (2,436) (6,195) Loans originated for sale (1,207,072) (1,024,257) (782,009) Proceeds from sales of mortgage loans held for sale 1,334,182 1,023,821 638,407 Gains from loan sales (11,044) (9,864) (6,841) Gains on sale of equity securities, credit card assets and bank -- -- (14,433) Accrued merger related and other special charges -- (8,614) (3,337) Amortization of stock-based compensation expense 350 267 -- Stock-based compensation 200 -- -- Other (3,843) 723 (2,720) ----------- ----------- ----------- Net cash provided by operating activities 269,841 141,638 (19,602) INVESTING ACTIVITIES: Net (increase) decrease in money market investments 69,109 (66,986) (15,003) Securities available-for-sale: Proceeds from sales 1,440 69,677 297,492 Proceeds from maturities 749,774 307,546 352,369 Purchases (1,300,600) (504,382) (502,261) Securities held-to-maturity: Purchases (19,854) -- -- Net decrease in loans and leases 140,665 248,370 595,211 Net increase in properties and equipment (8,944) (5,944) (7,952) Purchase of bank owned life insurance -- (78,000) -- Sale of credit card assets -- -- 29,454 Net cash provided by acquisitions and sales -- -- 14,433 ----------- ----------- ----------- Net cash used by investing activities (368,410) (29,719) 763,743 FINANCING ACTIVITIES: Net increase (decrease) in demand and savings deposits (83,877) 255,720 143,669 Net decrease in time deposits (410,769) (283,933) (422,684) Net increase (decrease) in short-term borrowings 329,319 (12,079) (618,820) Proceeds from issuance of long-term debt 370,332 121,000 183,182 Principal reductions in long-term debt (31,290) (150,786) (25,200) Cash dividends paid (49,476) (50,659) (50,158) Proceeds from stock options exercised 6,334 6,562 10,662 Shares acquired for retirement (21,323) (50,296) (58,491) ----------- ----------- ----------- Net cash provided by financing activities 109,250 (164,471) (837,840) ----------- ----------- ----------- Net increase (decrease) in cash and due from banks 10,681 (52,552) (93,699) Cash and due from banks at beginning of period 171,864 224,416 318,115 ----------- ----------- ----------- Cash and due from banks at end of period $ 182,545 $ 171,864 $ 224,416 =========== =========== =========== Supplemental Cash Flow Information: Interest paid $ 119,834 $ 168,588 $ 278,979 Income taxes paid 114 22,888 40,481
See notes to consolidated financial statements. 69 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of Citizens Banking Corporation (Citizens) and its subsidiaries conform to generally accepted accounting principles in the United States. Management makes estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates. The following describes Citizens' policies: CONSOLIDATION: The Consolidated Financial Statements include the accounts of Citizens and its subsidiaries after elimination of all material intercompany transactions and accounts. BUSINESS COMBINATIONS: Since the issuance of SFAS 141, Business Combinations, by the Financial Accounting Standards Board (FASB), business combinations initiated after June 30, 2001, are required to be accounted for by the purchase method. Under the purchase method, net assets of the business acquired are recorded at their estimated fair values as of the date of acquisition with any excess of the cost of the acquisition over the fair value of the net tangible and intangible assets acquired recorded as goodwill. Results of operations of the acquired business are included in the income statement from the date of acquisition. Prior to SFAS 141, certain business combinations not accounted for as purchase acquisitions were accounted for under the pooling-of-interests method, which required the retroactive combining of the assets, liabilities, stockholders' equity, and results of operations of the merged entity with Citizens' respective accounts at historical amounts. Prior period financial statements were then restated to give effect to business combinations accounted for under this method. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE: Securities purchased under agreements to resell and securities sold under agreements to repurchase are generally accounted for as collateralized financing transactions and are recorded at the amounts at which the securities were acquired or sold plus accrued interest. Securities, generally U.S. government and Federal agency securities, pledged as collateral under these financing arrangements cannot be sold or repledged by the secured party. The fair value of collateral either received from or provided to a third party is continually monitored and additional collateral obtained or requested to be returned to Citizens as deemed appropriate. INVESTMENT SECURITIES: Citizens classifies substantially all debt and equity securities as available for sale. Debt and marketable equity securities are reported at fair value with unrealized gains and losses included in shareholders' equity. Non-marketable equity securities such as Federal Reserve Bank and Federal Home Loan Bank stock are reported at cost. In the event that an investment security is sold, the adjusted cost of the specific security sold is used to compute the applicable gain or loss. In the third quarter of 2003, Citizens began classifying purchases of certain municipal securities as held to maturity. These securities are recorded at amortized cost. When it is determined that securities or other investments are impaired and the impairment is other than temporary, an impairment loss is recorded in earnings and a new basis is established. Citizens intends to hold securities with unrealized losses for a period of time necessary to recover the amortized cost. LOANS: Loans are generally reported at the principal amount outstanding, net of unearned income. Interest income is recognized on an accrual basis. Loan origination fees, certain direct costs, and unearned discounts are deferred and amortized into interest income as an adjustment to the yield over the term of the loan. Loan commitment fees are generally deferred and amortized into fee income on a straight-line basis over the commitment period. Other credit-related fees, including letter and line of credit fees, are recognized as fee income when earned. Gains and losses on the sales of loans are determined using the specific-identification method. Mortgage loans held for sale are valued on an aggregate basis at the lower of carrying amount or fair value. The majority of mortgage loans held for sale are sold within 60 days after closing. Citizens uses mandatory forward commitments, generally entered into at time of application, to protect the value of the mortgage loans from changes in interest rates during the period held. The cost basis of mortgage loans held for sale is adjusted, if material, by any gains or losses generated from mandatory forward commitments to sell the loans to investors in the secondary market. Citizens' policy to hedge its market rate risk with mandatory forward commitments has been highly effective and has not generated any material gains or losses. Loans are placed on nonaccrual status when the collection of principal or interest is considered doubtful, or payment of principal or interest is past due 90 days or more and the loan is not well secured and in the process of collection. When these loans (including a loan impaired) are placed on nonaccrual status, all interest previously accrued but unpaid is reversed 70 against current year interest income. Interest payments received on nonaccrual loans are credited to income if future collection of principal is probable. Loans are normally restored to accrual status when interest and principal payments are current and it is believed that the financial condition of the borrower has improved to the extent that future principal and interest payments will be met on a timely basis. Commercial loans and commercial loans secured by real estate are generally charged off to the extent principal and interest due exceed the net realizable value of the collateral, with the charge-off occurring when the loss is reasonably quantifiable but not later than when the loan becomes 180 days past due. Loans secured by residential real estate are generally charged off after foreclosure to the extent principal and interest due exceed 75% of the current appraised value. Consumer loans (open and closed end) are generally charged off before the loan becomes 120 days past due. Based on their internal credit rating, commercial and commercial real estate loans exceeding certain fixed dollar amounts are evaluated for impairment in accordance with the provisions of SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires an allowance to be established as a component of the allowance for loan losses when it is probable all amounts due will not be collected pursuant to the contractual terms of the loan and the recorded investment in the loan exceeds its fair value. In most instances the fair value is measured based on the fair value of the collateral. Fair value may also be measured using either the present value of expected future cash flows discounted at the loan's effective interest rate or the observable market price of the loan. ALLOWANCE FOR LOAN LOSSES: The allowance for loan losses is maintained at a level believed adequate by management to absorb probable losses inherent in the loan portfolio and is based on the size and current risk characteristics of the loan portfolio, an assessment of individual problem loans and actual loss experience, current economic events in specific industries and geographical areas, including unemployment levels, and other pertinent factors, including regulatory guidance and general economic conditions. Determination of the allowance is inherently subjective as it requires significant estimates, including the amounts and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends, all of which may be susceptible to significant change. The allowance is increased by the provision charged to income and reduced by the amount charged-off, net of recoveries. Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management's periodic evaluation of the factors previously mentioned, as well as other pertinent factors. Evaluations are conducted at least quarterly and more often if deemed necessary. The allowance for loan losses consists of an allocated component and an unallocated component. The components of the allowance for loan losses represent an estimation done pursuant to either SFAS 5, Accounting for Contingencies, or SFAS 114. The allocated component of the allowance for loan losses reflects expected losses resulting from analysis developed through specific credit allocations for individual loans (the specific allocation allowance) and on historical loss experience for each loan category (the risk allocation allowance). Specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate it is probable that a loss has been or will be incurred. The specific credit allocations are based on a regular quarterly analysis of all commercial and commercial mortgage loans over a fixed dollar amount where the internal credit rating is at or below a predetermined classification. The allowance attributed to these credits is determined in accordance with the methods prescribed by SFAS 114, "Accounting by Creditors for Impairment of a Loan" by analyzing the borrower's debt service capacity (a discounted estimate of future cash flows); overall financial condition, resources and payment record; the prospects for support from any financially responsible guarantors; and the liquidation value of any collateral. The risk allocated allowance is calculated by applying projected loss rates to outstanding loans (excluding specifically identified credits) stratified by risk rating for commercial credits and by accrual and past due status for homogenous residential mortgage and consumer pools of loans. The projected loss rates are based on historical loss experience (generally an eighteen month rolling average of net charge-offs) adjusted for trends in past due and nonaccrual amounts, the condition of the economy, and changes in portfolio concentrations, mix and volume. The allocated component of the allowance for loan losses also includes consideration of Citizens' current business strategy and credit process, including credit limit setting and compliance, credit approvals, loan underwriting, and loan workout procedures. The unallocated portion of the allowance reflects management's estimate of probable inherent but undetected losses within the portfolio due to uncertainties in economic conditions, delays in obtaining information, including unfavorable information about a borrower's financial condition, the difficulty in identifying triggering events that correlate perfectly to subsequent loss rates, and risk factors that have not yet manifested themselves in loss allocation factors. In addition, the unallocated 71 allowance includes a component that explicitly accounts for the inherent imprecision in loan loss projection models. Citizens has grown through acquisition, expanded the geographic footprint in which it operates, and changed its portfolio mix in recent years. As a result, historical loss experience data used to establish allocation estimates may not precisely correspond to the current portfolio. The uncertainty surrounding the strength and timing of economic cycles, including management's concerns over the effects of the prolonged economic downturn in the current cycle, also affects the allocation model's estimates of loss. The historical losses used may not be representative of actual losses inherent in the portfolio that have not yet been realized. DEPRECIABLE ASSETS: Premises and equipment, including leasehold improvements, are carried at cost less accumulated depreciation and amortization. Depreciation and amortization are computed principally on a straight-line basis and are charged to expense over the lesser of the estimated useful life of the assets or lease term. Maintenance and repairs are charged to expense as incurred. Gains and losses on dispositions are charged to income as incurred. Long-lived depreciable assets are evaluated periodically for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. Impairment exists when the expected undiscounted future cash flows of a long-lived asset are less than its carrying value. In that event, Citizens recognizes a loss for the difference between the carrying amount and the estimated fair value of the asset based on a quoted market price, if applicable, or a discounted cash flow analysis. OTHER REAL ESTATE: Other real estate is comprised of commercial and residential real estate properties acquired in partial or total satisfaction of a debt. These properties are carried at the lower of cost or fair value, net of estimated costs to sell, based upon current appraised value. Losses arising from the initial acquisition of such properties are charged against the allowance for loan losses at time of transfer. Subsequent valuation adjustments and gains or losses on disposal of these properties are charged to other expenses as incurred. BANK OWNED LIFE INSURANCE: Bank Owned Life Insurance is recorded as an asset at the amount that could be realized under the insurance contracts as of the date of the consolidated balance sheets. The change in cash surrender value during the period is an adjustment of premiums paid in determining the expense or income to be recognized under the contracts for the period. This change is recorded in noninterest income as cash surrender value of life insurance revenue. GOODWILL AND OTHER INTANGIBLE ASSETS: Goodwill represents the excess of the cost of an acquisition over the fair value of net identifiable tangible and intangible assets acquired. Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset, or liability. On January 1, 2002, Citizens adopted SFAS 142, Goodwill and Other Intangible Assets. Under the provisions of SFAS 142, goodwill is no longer ratably amortized into the income statement over an estimated life, but rather is tested at least annually for impairment. Impairment of goodwill is evaluated by line of business and geographic region and is based on a comparison of the recorded balance of goodwill to the applicable market value or discounted cash flows. To the extent that impairment may exist, the current carrying amount is reduced by the estimated shortfall. Intangible assets which have finite lives continue to be amortized over their estimated useful lives and also continue to be subject to impairment testing. All of Citizens' other intangible assets have finite lives and are amortized on a straight-line basis over varying periods not exceeding 10 years. Prior to the adoption of SFAS 142, Citizens' goodwill was amortized on a straight-line basis over varying periods not exceeding 20 years. Note 7 includes a summary of Citizens' goodwill and other intangible assets as well as further detail about the impact of the adoption of SFAS 142. MORTGAGE SERVICING RIGHTS: Citizens recognizes as a separate asset rights to service mortgage loans it does not own but services for others for a fee. This asset is included in other assets on the balance sheet and is carried at the lower of the initial carrying value, adjusted for amortization, or estimated fair value. Amortization is determined in proportion to and over the period of estimated net servicing income. Impairment of servicing assets is assessed based on the fair value of those rights. For purposes of measuring impairment, the rights are stratified by product type and interest rate. The fair value of mortgage servicing assets is estimated by calculating the present value of estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other economic factors. The expected and actual rate of mortgage loan prepayments are the most significant factors driving the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced. 72 SECURITIZATIONS AND SALES OF MORTGAGE LOANS: Citizens sells substantially all of the fixed-rate single-family mortgage loans it originates, including adjustable-rate loans that convert to fixed-rate loans. These sales are accomplished through cash sales to Federal Home Loan Mortgage Corporation ("FHLMC"), Federal National Mortgage Association ("FNMA") and other third-party investors, as well as through securitizations with FHLMC and FNMA. In general, mortgage-backed securities ("MBSs") received from FHMLC or FNMA in exchange for fixed-rate mortgage loans are sold immediately in the securities market. From time to time, Citizens also exchanges fixed and variable rate mortgage loans held in portfolio for FHLMC or FNMA MBSs backed by the same loans. The resulting MBSs are sold to third party investors or classified as held for sale in Citizens' investment security portfolio. If MBSs are retained in the investment portfolio, any gain or loss at time of sale is recorded as a security gain or loss. All other gains or losses associated with sales of single-family mortgage loans are recorded as a component of mortgage banking revenue. Typically, Citizens does not service the loans after they are sold or exchanged, but sells the mortgage servicing rights, in a separate transaction, before or at the time of the securitization. Sales or securitizations of mortgage loans through FHLMC and FNMA are done under terms that do not provide for any material recourse to Citizens by the investor. Citizens does not retain any interest in these securitized mortgage loans. DERIVATIVE INSTRUMENTS: Citizens enters into derivative transactions principally to protect against the risk of adverse price or interest rate movements on the value of certain assets and liabilities and on future cash flows. Citizens is also required to recognize certain contracts and commitments as derivatives when the characteristics of those contracts and commitments meet the definition of a derivative. Citizens utilizes mandatory forward commitments for the aforementioned fair value hedge of its mortgage loans held for sale. This hedging policy has been highly effective and therefore the impact on income has been immaterial. Citizens has also utilized derivatives to hedge the fair value of $125 million of subordinated debt issued in January 2003 and certain brokered time deposits issued in the second half of 2003. In addition, Citizens has utilized derivatives to hedge the cash flows on a pool of prime-based variable rate commercial loans. Under the guidelines of SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as amended, all derivative instruments are required to be carried at fair value on the balance sheet. SFAS 133 also provides special hedge accounting provisions. Derivative instruments designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges under SFAS 133. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Fair value hedges are accounted for by recording the fair value of the derivative instrument and the fair value related to the risk being hedged of the hedged asset or liability on the balance sheet with corresponding offsets recorded in the income statement. The adjustment to the hedged asset or liability is included in the basis of the hedged item, while the fair value of the derivative is recorded as a freestanding asset or liability. Actual cash receipts or payments and related amounts accrued during the period on derivatives included in a fair value hedge relationship are recorded as adjustments to the interest income or expense recorded on the hedged asset or liability. Cash flow hedges are accounted for by recording the fair value of the derivative instrument on the balance sheet as either a freestanding asset or liability, with a corresponding offset recorded in other comprehensive income within shareholders' equity, net of tax. Amounts are reclassified from other comprehensive income to the income statement in the period or periods the hedged forecasted transaction affects earnings. Under both the fair value and cash flow hedge methods, derivative gains and losses not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized immediately in the income statement. STOCK-BASED COMPENSATION: Citizens' stock-based compensation plans are accounted for based on the intrinsic value method set forth in Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. Compensation expense for employee stock options is generally not recognized if the exercise price of the option equals or exceeds the fair value of the stock on the date of grant. Compensation expense for restricted share awards is ratably recognized over the period of service, usually the restricted period, based on the fair value of the stock on the date of grant. 73 The following table illustrates the effect on net income and earnings per share if Citizens had applied the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, to its stock option awards.
Year Ended December 31, (in thousands, except per share amounts) 2003 2002 2001 ----------- ----------- ----------- Net income, as reported $ 65,951 $ 25,038 $ 104,657 Less pro forma expense related to options granted 2,261 2,401 1,849 ----------- ----------- ----------- Pro forma net income $ 63,690 $ 22,637 $ 102,808 =========== =========== =========== Pro forma net income per share: Basic - as reported $ 1.52 $ 0.56 $ 2.27 Basic - pro forma 1.47 0.51 2.23 Diluted - as reported 1.51 0.56 2.25 Diluted - pro forma 1.46 0.50 2.21
The fair values of stock options granted were estimated at the date of grant using a Black-Scholes option pricing model. The weighted-average assumptions used to determine the fair value of options granted are provided in Note 16 to the Consolidated Financial Statements. INCOME TAXES: Citizens and its subsidiaries file a consolidated federal income tax return. Income tax expense is based on income as reported in the Consolidated Statements of Income. When income and expenses are recognized in different periods for tax purposes, applicable deferred taxes are provided in the Consolidated Financial Statements. NET INCOME PER SHARE: Basic net income per share is based on net income divided by the weighted average number of shares outstanding in each period. Diluted net income per share shows the dilutive effect of additional common shares issuable upon the assumed exercise of stock options granted under Citizens' stock option plans, using the treasury stock method. CASH FLOWS: For purposes of reporting cash flows, cash and cash equivalents include cash on hand and amounts due from banks. RECLASSIFICATIONS: Certain amounts have been reclassified to conform to the current year presentation. NOTE 2. RECENT ACCOUNTING PRONOUNCEMENTS EMPLOYERS' DISCLOSURES ABOUT PENSIONS AND OTHER POSTRETIREMENT BENEFITS: In December 2003, the FASB issued a revised SFAS 132, Employers' Disclosures about Pensions and Other Postretirement Benefits - an amendment SFAS 87,88, and 106 which revises employers' disclosures about pension plans and other postretirement benefit plans. SFAS 132 does not change the measurement or recognition of those plans required by SFAS 87, Employers' Accounting for Pensions, SFAS 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and SFAS 106, Employers' Accounting for Postretirement Benefits Other Than Pensions. SFAS 132, as revised, retains the disclosure requirements contained in the original SFAS 132, which it replaces. Additional disclosures, however, have been added to those in the original SFAS 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The required information should be provided separately for pension plans and for other postretirement benefit plans. In addition, SFAS 132 requires interim period disclosure of the components of net period benefit cost and contributions if significantly different from previously reported amounts. The new disclosures required by SFAS 132 become effective for Citizens as of year end 2003 (see Note 13) and do not impact our results of operations, financial position, or liquidity. ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH LIABILITIES AND EQUITY: In May 2003, the FASB issued SFAS 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of 74 both liabilities and equity. SFAS 150 also addresses questions about the classification of certain financial instruments that embody obligations to issue equity shares. SFAS 150 requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS 150 was effective for Citizens as of July 1, 2003. As Citizens has not issued any instruments within the scope of this Statement, adoption did not have any impact on our results of operations, financial position, or liquidity. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES: In April 2003, the FASB issued SFAS 149 Amendment of Statement 133 on Derivative Instruments and Hedging Activities which amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS 133, Accounting for Derivative Instruments and Hedging Activities. In particular, this SFAS 149 (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, (2) clarifies when a derivative contains a financing component, (3) amends the definition of an underlying to conform it to language used in FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, and (4) amends certain other existing pronouncements. Those changes result in more consistent reporting of contracts as either derivatives or hybrid instruments. SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. Citizens does not expect the requirements of SFAS 149 to have a material impact on results of operations, financial position, or liquidity. CONSOLIDATION OF VARIABLE INTEREST ENTITIES: In December 2003, the FASB revised FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, first issued in January 2003. The objective of this interpretation is to provide guidance on how to identify a variable interest entity (VIE) and determine when the assets, liabilities, noncontrolling interests, and results of operations of a VIE need to be included in a company's Consolidated Financial Statements. A company that holds variable interests in an entity will need to consolidate the entity if the company's interest in the VIE is such that the company will absorb a majority of the VIE's expected losses and/or receive a majority of the entity's expected residual returns, if they occur. FIN 46 also requires additional disclosures by primary beneficiaries and other significant variable interest holders. The provisions of this interpretation became effective upon issuance. Citizens does not hold any variable interests that require consolidation. Therefore, the adoption of this interpretation did not have any effect on Citizens' financial position, results of operations or cash flows. GUARANTEES: In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. This interpretation expands the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees and requires the guarantor to recognize a liability for the fair value of an obligation assumed under a guarantee. FIN 45 clarifies the requirements of SFAS 5, Accounting for Contingencies, relating to guarantees. In general, FIN 45 applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying that is related to an asset, liability, or equity security of the guaranteed party. Certain guarantee contracts are excluded from both the disclosure and recognition requirements of this interpretation, including, among others, guarantees relating to employee compensation, residual value guarantees under capital lease arrangements, commercial letters of credit, loan commitments, subordinated interests in an SPE, and guarantees of a company's own future performance. Other guarantees are subject to the disclosure requirements of FIN 45 but not to the recognition provisions and include, among others, a guarantee accounted for as a derivative instrument under SFAS 133, a parent's guarantee of debt owed to a third party by its subsidiary or vice versa, and a guarantee which is based on performance not price. The disclosure requirements of FIN 45 were effective for Citizens as of December 31, 2002, and require disclosure of the nature of the guarantee, the maximum potential amount of future payments that the guarantor could be required to make under the guarantee, and the current amount of the liability, if any, for the guarantor's obligations under the guarantee. The recognition requirements of FIN 45 have been applied prospectively to guarantees issued or modified after December 31, 2002. Significant guarantees that have been entered into by Citizens are disclosed in Note 17. The adoption of FIN 45 did not have a material impact on results of operations, financial position, or liquidity. ACCOUNTING FOR STOCK-BASED COMPENSATION: In December 2002, the FASB issued SFAS 148, Accounting for Stock-Based Compensation - Transition and Disclosure, which provides guidance on how to transition from the intrinsic value method of accounting for stock-based employee compensation under APB 25 to SFAS 123's fair value method of accounting, if a company so elects. Citizens has elected to continue its current practice of accounting for stock based employee compensation in accordance with APB Opinion 25 and SFAS 123. Therefore, the adoption of this interpretation did not have an impact on Citizens' financial position, results of operations or cash flows. 75 ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS: In October 2002, the FASB issued SFAS 147, Acquisitions of Certain Financial Institutions, which provides guidance on the accounting for the acquisition of a financial institution and supersedes the specialized accounting guidance provided in SFAS 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions. SFAS 147 became effective upon issuance and requires companies to cease amortization of unidentified intangible assets associated with certain branch acquisitions and reclassify these assets to goodwill. SFAS 147 also modifies SFAS 144 to include in its scope long-term customer-relationship intangible assets and thus subject those intangible assets to the same undiscounted cash flow recoverability test and impairment loss recognition and measurement provisions required for other long-lived assets. While SFAS 147 may affect how future business combinations, if undertaken, are accounted for and disclosed in the financial statements, the issuance of the new guidance had no effect on results of operations, financial position, or liquidity because Citizens does not have any assets subject to the specialized accounting guidance provided in SFAS 72 or SFAS 147. ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES: SFAS 146, Accounting for Costs Associated with Exit or Disposal Activities, was issued in July 2002 and became effective for Citizens beginning January 1, 2003. This statement requires a cost associated with an exit or disposal activity, such as the sale or termination of a line of business, the closure of business activities in a particular location, or a change in management structure, to be recorded as a liability at fair value when it becomes probable the cost will be incurred and no future economic benefit will be gained by the company for such cost. Applicable costs include employee termination benefits, contract termination costs, and costs to consolidate facilities or relocate employees. SFAS 146 supersedes EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity, which in some cases required certain costs to be recognized before a liability was actually incurred. The adoption of this standard did not have a material impact on results of operations, financial position, or liquidity. GOODWILL AND OTHER INTANGIBLE ASSETS: On January 1, 2002, Citizens adopted SFAS 142, Goodwill and Other Intangible Assets, which addresses the accounting and reporting for acquired goodwill and other intangible assets and supersedes APB Opinion 17, Intangible Assets. Notes 1 and 7 provide further detail on the accounting for goodwill and intangible assets under the standard and the impact of the adoption on the financial statements. The standard's adoption had no impact on liquidity but reduced goodwill amortization by $7.2 million ($5.5 million after tax) in both 2003 and 2002 from the 2001 amount. NOTE 3. DIVESTITURE In November 2001, Citizens sold F&M Bank-Minnesota with assets of $27 million, resulting in a pretax gain of $793,000. The bank was Citizens' sole location in Minnesota. NOTE 4. BUSINESS RESTRUCTURING, MERGER AND OTHER CHARGES In the third quarter of 2002, Citizens recorded a charge of $13.8 million ($9.0 million after-tax) for restructuring, impairment and other costs associated with reorganization of Citizens' consumer, commercial and wealth management lines of business. In December 2002, the charge was reduced to $13.4 million as Citizens reversed $404,600 of employee benefits and severance, professional fees and lease termination fees included in the original charge that were no longer expected to be paid. An additional $690,800 of employee benefits and severance, professional fees and other fees no longer expected to be paid were reversed in 2003. The charge was recorded as a separate component of noninterest expense and identified as the "special charge." The reorganization was the result of a detailed review of Citizens' consumer banking, commercial banking and wealth management areas by banking industry consultants and key members of management during the second and third quarters of 2002. This review revealed opportunities for process change, staff reassignment, reporting structure changes, branch closures, expense reduction and business growth. As a result of the reorganization, we displaced 134 employees (157 original employees less employees subsequently rehired for other available positions). Displaced employees are offered severance packages and outplacement assistance. Twelve banking offices were closed in the fourth quarter of 2002 and six additional offices were closed during the second quarter of 2003. The following table provides details on the special charge recorded and presents the activity in the related liability during 2003 and 2002. 76
Beginning Reserve Reserve Reserve/ Balance Balance Special Changes in 2002 December 31, Changes in 2003 December 31, (in thousands) Charge Cash Noncash(1) 2002 Cash Noncash(1) 2003 ------- ----- --------- ------------ ---- ---------- ----------- Employee benefits and severance $ 8,072 $(3,433) $ (358) $ 4,281 $(3,578) $ (378) $ 325 Professional fees 2,369 (1,899) (62) 408 (83) (316) 9 Facilities and lease impairment 2,358 (77) (1,959) 322 (46) -- 276 Contract termination fees and write-off of obsolete equipment, software and supplies 1,008 (725) (101) 182 (51) (131) -- ------- ------- ------- ------- ------- ------- ------- Total $13,807 $(6,134) $(2,480) $ 5,193 $(3,758) $ (825) $ 610 ======= ======= ======= ======= ======= ======= =======
(1) Includes credits (accrual reversals) of $690,800 in 2003 and $404,600 in 2002 primarily for employee benefits and severance, and professional fees. NOTE 5. INVESTMENT SECURITIES The amortized cost, estimated fair value and gross unrealized gains and losses of investment securities follow:
DECEMBER 31, 2003 December 31, 2002 ------------------------------------------------- ------------------------------------------------- ESTIMATED GROSS UNREALIZED Estimated Gross Unrealized AMORTIZED FAIR --------------------- Amortized Fair ----------------------- (in thousands) COST VALUE GAINS LOSSES Cost Value Gains Losses ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- AVAILABLE FOR SALE: U.S. Treasury $ -- $ -- $ -- $ -- $ 5,978 $ 6,135 $ 157 $ -- Federal agencies: Mortgage-backed 1,186,539 1,180,493 6,413 12,459 762,733 787,821 25,281 193 Other 261,051 272,089 11,066 28 135,436 148,687 13,251 -- State and municipal 407,625 437,003 30,384 1,006 417,549 444,951 27,670 268 Mortgage and asset-backed 3,994 4,135 141 -- 6,228 6,452 236 12 Other 71,397 71,481 84 -- 63,165 63,235 70 -- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total available for sale $1,930,606 $1,965,201 $ 48,088 $ 13,493 $1,391,089 $1,457,281 $ 66,665 $ 473 ========== ========== ========== ========== ========== ========== ========== ========== HELD TO MATURITY: State and municipal 19,857 19,913 153 97 -- -- -- -- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total held to maturity $ 19,857 $ 19,913 $ 153 $ 97 $ -- $ -- $ -- $ -- ========== ========== ========== ========== ========== ========== ========== ==========
Management does not believe any individual unrealized loss as of December 31, 2003 represents other-than-temporary impairment. The unrealized losses reported for mortgage-backed securities primarily relate to securities issued by FNMA, FHLMC and GNMA. These unrealized losses are attributable to changes in interest rates and were for periods of less than twelve months. The unrealized losses reported for state and municipal securities also are attributable to changes in interest rates and were predominately for periods of less than twelve months. Citizens has both the intent and ability to hold the securities with unrealized losses for a period of time necessary to recover the amortized cost. 77 The amortized cost, estimated fair value and weighted average yields of debt securities by maturity at December 31, 2003 are shown below. Maturities of mortgage-backed securities are based upon current industry prepayment schedules.
- ------------------------------------------------------------------------------------------------------------------------------- Weighted Within 1 to 5 5 to 10 After 10 Average (in thousands) 1 Year Years Years Years Total Yield - ------------------------------------------------------------------------------------------------------------------------------- AVAILABLE FOR SALE: U S Treasury and Federal Agency $ 90,599 $ 150,947 $ 19,506 $ -- $ 261,052 5.30% Mortgage-backed securities 154,137 767,179 247,412 17,810 1,186,538 3.76 Asset-backed and corporate debt 3,214 5,565 61 168 9,008 4.31 State and Municipal 14,276 92,342 184,991 116,016 407,625 7.32 Other 592 -- -- 65,792 66,384 5.32 ---------- ---------- ---------- ---------- ---------- Amortized Cost $ 262,818 $1,016,033 $ 451,970 $ 199,786 $1,930,607 ---------- ---------- ---------- ---------- ---------- Fair Value $ 267,718 $1,021,279 $ 467,638 $ 208,566 $1,965,201 ---------- ---------- ---------- ---------- ---------- Weighted Average Yield 5.37% 4.03% 5.45% 6.28% 4.78% HELD TO MATURITY: State and Municipal $ -- $ 3,669 $ 12,879 $ 3,309 $ 19,857 6.35 ---------- ---------- ---------- ---------- ---------- Amortized Cost $ -- $ 3,669 $ 12,879 $ 3,309 $ 19,857 ---------- ---------- ---------- ---------- ---------- Fair Value $ -- $ 3,635 $ 12,949 $ 3,329 $ 19,913 ---------- ---------- ---------- ---------- ---------- Weighted Average Yield -- 5.73% 6.46% 6.59% 6.35% - -------------------------------------------------------------------------------------------------------------------------------
Sales of investment securities resulted in realized gains and losses as follows:
- --------------------------------------------------------- Year Ended December 31, (in thousands) 2003 2002 2001 - --------------------------------------------------------- Securities gains $ 182 $ 2,527 $ 6,202 Securities losses (79) (91) (7) ------- ------- ------- Net gain $ 103 $ 2,436 $ 6,195 ======= ======= ======= - ---------------------------------------------------------
Securities with amortized cost of $1.178 billion at December 31, 2003, and $775.2 million at December 31, 2002, were pledged to secure public deposits, repurchase agreements, and other liabilities. Except for obligations of the U.S. Government and its agencies, no holdings of securities of any single issuer exceeded 10% of consolidated shareholders' equity at December 31, 2003 or 2002. NOTE 6. LOANS AND NONPERFORMING ASSETS Citizens extends credit primarily within the Midwestern states of Michigan, Wisconsin, Illinois and Iowa. In Michigan the primary market includes most parts of the Lower Peninsula. In Wisconsin the primary market area is the Fox Valley region extending from Green Bay to Appleton to Oshkosh as well as northeastern and southwestern Wisconsin. Other primary market areas are central Iowa and the western suburban market of Chicago, Illinois. Citizens seeks to limit its credit risk by establishing guidelines to review its aggregate outstanding commitments and loans to particular borrowers, industries and geographic areas. Collateral is secured based on the nature of the credit and management's credit assessment of the customer. Citizens' loan portfolio is widely diversified by borrowers with no concentration within a single industry that exceeds 10% of total loans. Citizens does not have any loans to foreign debtors and generally does not purchase nationally syndicated loans or participate in highly leveraged transactions. Approximately two-thirds of Citizens' commercial real estate loans consist of mortgages on owner-occupied properties. Those borrowers are involved in business activities other than real estate, and the sources of repayment are not dependent on the performance of the real estate market. 78 A summary of nonperforming assets follows:
December 31, (in thousands) 2003 2002 ------- ------- Nonperforming loans: Nonaccrual $68,744 $86,717 Loans 90 days past due (still accruing) 345 860 Restructured -- -- ------- ------- Total nonperforming loans 69,089 87,577 Other real estate 6,634 6,599 Other assets acquired by repossession 1,309 1,495 ------- ------- Total nonperforming assets $77,032 $95,671 ======= =======
The effect of nonperforming loans on interest income follows:
Year Ended December 31, (in thousands) 2003 2002 2001 ------ ------ ------ Interest income: At original contract rates $6,261 $7,721 $6,392 As actually recognized 4,011 4,685 3,344 ------ ------ ------ Interest foregone $2,250 $3,036 $3,048 ====== ====== ======
There are no significant commitments outstanding to lend additional funds to clients whose loans were classified as nonaccrual or restructured at December 31, 2003. A summary of impaired loans and their effect on interest income follows:
Valuation Reserve ----------------- (in thousands) 2003 2002 2003 2002 ------- ------- ------- ------- Balances - December 31 Impaired loans with valuation reserve $36,603 $41,240 $12,449 $13,338 Impaired loans with no valuation reserve 35,155 35,272 -- -- ------- ------- ------- ------- Total impaired loans $71,758 $76,512 $12,449 $13,338 ======= ======= ======= ======= Impaired loans on nonaccrual basis $55,159 $70,345 $ 3,913 $ 8,690 Impaired loans on accrual basis 16,599 6,167 8,536 4,648 ------- ------- ------- ------- Total impaired loans $71,758 $76,512 $12,449 $13,338 ======= ======= ======= ======= Average balance for the year $84,077 $80,487 Interest income recognized for the year 854 1,376 Cash collected applied to outstanding principal 3,758 4,415
Certain directors and executive officers of Citizens and its significant subsidiaries, including their families and entities in which they have 10% or more ownership, were clients of the banking subsidiaries. Total loans to these clients aggregated $16.3 million and $3.4 million at December 31, 2003 and 2002, respectively. During 2003, new loans of $13.5 million were made and repayments totaled $0.6 million. Substantially all such loans were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those for comparable transactions with unrelated parties and did not involve more than normal risk of collectibility. 79 The Consolidated Financial Statements do not include loans serviced for others, which totaled $58.8 million and $159.8 million at December 31, 2003 and 2002, respectively. The carrying value of mortgage servicing rights approximates fair value at December 31, 2003 and 2002. Changes in originated mortgage servicing rights for the years ended December 31 were as follows:
(in thousands) 2003 2002 2001 ------- ------- ------- UNAMORTIZED COST OF MORTGAGE SERVICING RIGHTS Balance - January 1 $ 942 $ 1,993 $ 2,940 Additions of mortgage servicing rights -- -- -- Amortization (432) (1,051) (947) ------- ------- ------- Balance - December 31 $ 510 $ 942 $ 1,993 ------- ------- ------- IMPAIRMENT VALUATION ALLOWANCE Balance - January 1 $ (510) $ (260) $ (260) Impairment valuation allowance charged to expense -- (250) -- ------- ------- ------- Balance - December 31 $ (510) $ (510) $ (260) ------- ------- ------- NET CARRYING VALUE OF MORTGAGE SERVICING RIGHTS $ -- $ 432 $ 1,733 ======= ======= =======
The valuation reserve for impairment of mortgage servicing rights was $510,000 at December 31, 2003 and 2002. NOTE 7. GOODWILL AND OTHER INTANGIBLE ASSETS On January 1, 2002 Citizens adopted SFAS 142 which changed the accounting for intangible assets. Upon adoption, Citizens ceased amortizing its goodwill, which decreased noninterest expense and increased net income in 2003 and 2002 as compared to 2001. The following table shows the pro forma effects of applying SFAS 142 to the year 2001 period.
2003 2002 2001 ---- ---- ---- (in thousands, except Net Earnings Net Earnings Net Earnings per share amounts) Income Per Share Income Per Share Income Per Share -------- -------- -------- -------- -------- -------- Diluted earnings per common share computation: Net income/diluted EPS as reported $ 65,951 $ 1.51 $ 25,038 $ 0.56 $104,657 $ 2.25 Add back: Goodwill amortization, net of tax effect -- -- -- -- 5,545 0.12 -------- -------- -------- -------- -------- -------- Adjusted net income/diluted EPS $ 65,951 $ 1.51 $ 25,038 $ 0.56 $110,202 $ 2.37 ======== ======== ======== ======== ======== ========
SFAS 142 requires that goodwill be tested for impairment at adoption and at least annually thereafter. Citizens completed it's transitional impairment testing in June 2002 and no impairment under SFAS 142 was identified. Citizens performed its annual impairment testing as of October 1, 2003 and no impairment was identified. A summary of goodwill allocated to Citizens' lines of business as of December 31, 2003 follows.
December 31, (in thousands) 2003 2002 ---- ---- Commercial Banking $23,982 $23,982 Consumer Banking 29,002 29,002 Wealth Management 1,801 1,801 Other -- -- ------- ------- Total Goodwill $54,785 $54,785 ======= =======
80 No changes in the carrying amount of goodwill were recorded during 2003. Citizens' other intangible assets are shown in the table below.
December 31, (in thousands) 2003 2002 ---- ---- Core deposit intangibles $28,989 $28,989 Accumulated amortization 12,058 9,160 ------- ------- Net core deposit intangibles 16,931 19,829 Minimum pension liability 1 33 ------- ------- Total other intangibles $16,932 $19,862 ======= =======
The estimated annual amortization expense for core deposit intangibles for each of the next five years is $2.9 million. As part of adopting SFAS 142, Citizens has had no material reclassifications or adjustments to the useful lives of finite-lived (core deposit) intangible assets. NOTE 8. ALLOWANCE FOR LOAN LOSSES A summary of changes in the allowance for loan losses follows: (in thousands) 2003 2002 2001 ---- ---- ---- Allowance for loan losses - January 1 $ 106,777 $ 76,275 $ 75,413 Allowance of sold banks and branches -- -- (240) Transfer to reserve for commitments -- 1,334 633 Provision for loan losses 62,962 120,200 26,407 Charge-offs (66,063) (101,704) (32,732) Recoveries 19,869 10,672 6,794 --------- --------- -------- Net charge-offs (46,194) (91,032) (25,938) --------- --------- -------- Allowance for loan losses - December 31 $ 123,545 $ 106,777 $ 76,275 ========= ========= ======== Allowance for losses on lending-related commitments - December 31 $ 2,690 $ 2,690 $ 4,024 ========= ========= ========
During the fourth quarter of 2003 Citizens reclassified $2.7 million of the allowance for loan losses related to unfunded loan commitments to other liabilities. Prior period amounts were restated to conform to the new presentation. NOTE 9. PREMISES AND EQUIPMENT A summary of premises and equipment follows:
December 31, (in thousands) 2003 2002 ---- ---- Land $ 20,722 $ 21,115 Buildings 147,840 145,511 Leasehold improvements 5,509 5,544 Furniture and equipment 117,946 124,450 --------- --------- 292,017 296,620 Accumulated depreciation and amortization (179,233) (178,916) --------- --------- Total $ 112,784 $ 117,704 ========= =========
81 Certain branch facilities and equipment are leased under various operating leases. Total rental expense, including expenses related to these operating leases, was $4.6 million in 2003, $4.5 million in 2002 and $4.8 million in 2001. Future minimum rental commitments under non-cancelable operating leases are as follows at December 31, 2003: $3.1 million in 2004, $2.7 million in 2005, $2.1 million in 2006, $1.6 million in 2007, $1.1 million in 2008, and $3.8 million after 2008. NOTE 10. DEPOSITS A summary of deposits follows:
December 31, (in thousands) 2003 2002 ---- ---- Noninterest-bearing demand $ 882,429 $ 900,674 Interest-bearing demand 1,360,756 1,307,524 Savings 1,239,178 1,358,042 Time deposits over $100,000 618,957 677,628 Other time deposits 1,340,947 1,693,045 ---------- ---------- Total $5,442,267 $5,936,913 ========== ==========
Excluded from total deposits are demand deposit account overdrafts, which have been reclassified as loans. At December 31, 2003 and 2002, these overdrafts totaled $5.3 million and $5.4 million, respectively. Time deposits with remaining maturities of one year or more are $578.7 million at December 31, 2003. The maturities of these time deposits are as follows: $354.5 million in 2005, $120.1 million in 2006, $21.0 million in 2007, $20.2 million in 2008 and $62.9 million after 2008. NOTE 11. SHORT-TERM BORROWINGS Short-term borrowings consist of federal funds purchased and securities sold under agreements to repurchase, Federal Home Loan Bank (FHLB) borrowings, other bank borrowings, and demand notes to the U.S. Treasury. Federal funds purchased are overnight borrowings from other financial institutions. Securities sold under agreements to repurchase are secured transactions done principally with investment banks which generally mature within ninety days. Information relating to federal funds purchased and securities sold under agreements to repurchase follows:
(in thousands) 2003 2002 2001 ---- ---- ---- At December 31: Balance $588,593 $223,289 $233,077 Weighted average interest rate paid 1.01% 1.29% 1.81% During the year: Maximum outstanding at any month-end $664,065 $281,676 $354,612 Daily average 445,383 195,983 242,945 Weighted average interest rate paid 1.08% 1.51% 4.32%
82 Citizens did not have any significant short-term borrowings with the FHLB in 2003 or 2002. In 2001 a significant amount of short-term borrowings consisted of FHLB advances and lines of credit to Citizens' subsidiary banks. Information relating to short-term FHLB borrowings in 2001 follows:
(in thousands) 2001 ---- At December 31: Balance $ -- Weighted average interest rate paid -- During the year: Maximum outstanding at any month-end $ 425,200 Daily average 222,310 Weighted average interest rate paid 6.25%
Citizens' parent company maintains a short-term line of credit with two unaffiliated banks totaling $50 million. As of December 31, 2003, there was no outstanding balance. The credit facility will mature in August 2004 and is expected to renew at that time. The credit agreement requires Citizens to maintain certain financial covenants. Citizens is in full compliance with all debt covenants as of December 31, 2003. NOTE 12. LONG-TERM DEBT A summary of long-term debt follows:
December 31, (in thousands) 2003 2002 ---- ---- Citizens (Parent only): Subordinated debt: Notes maturing February 2013 $123,061 -- Deferrable interest debenture maturing June 2033 25,774 -- Subsidiaries: Federal Home Loan Bank advances 787,930 599,139 Other borrowed funds 94 174 -------- -------- Total long-term debt $936,859 $599,313 ======== ========
On January 27, 2003, Citizens issued $125 million of 5.75% subordinated notes maturing February 1, 2013. Citizens also entered into an interest rate swap to hedge the interest rate risk on the subordinated debt. The carrying value of the subordinated notes has been adjusted to reflect the gain or loss attributable to the risk hedged. Issuance costs of $1.3 million were capitalized and are included in other assets on the balance sheet. The issuance costs are being amortized over 10 years as a component of interest expense. The subordinated debt qualifies under the risk-based capital guidelines as Tier 2 supplementary capital for regulatory purposes. On June 26, 2003, Citizens issued approximately $25 million of floating rate, 30 year trust preferred securities through an unconsolidated special purpose trust to unrelated institutional investors. The gross proceeds from issuance were used to purchase a floating rate junior subordinated deferrable interest debenture (the "Debenture") issued by Citizens, which is the sole asset of the trust. The Debenture matures in thirty years and bears interest at an annual rate equal to the three-month LIBOR plus 3.10%, payable quarterly beginning in September, 2003. Interest is adjusted on a quarterly basis provided that prior to May 2008, the interest rate shall not exceed 11.75%. The Debenture is an unsecured obligation of Citizens and is junior in the right of payment to all future senior indebtedness of Citizens. Citizens has guaranteed that interest payments on the Debenture made to the trust will be distributed by the trust to the holders of the trust preferred securities. Issuance costs of $490,000 were incurred related to the issuance. These costs have been capitalized and are included in other assets on the balance sheet. The issuance costs are being amortized over five years as a component of interest expense. The trust preferred securities of the special purpose trust are callable after five years at par and must be redeemed in 30 years after issuance. For regulatory purposes, these trust preferred securities qualify under the risk-based capital guidelines as Tier 1 capital. 83 Long-term advances from the FHLB are at fixed and variable rates ranging from 1.16% to 7.10% and mature in 2004 through 2021. The majority of the fixed rate FHLB advances are convertible to a floating rate at the option of the Federal Home Loan Bank. Interest is paid monthly. At December 31, 2003, qualifying mortgage loans of $484 million, investment securities of $455 million and FHLB stock collaterized long-term advances from the FHLB. At December 31, 2002, $699 million of mortgage loans, $286 million of investment securities and FHLB stock collateralized long-term advances from the FHLB. Maturities of long-term debt during the next five years follow:
(in thousands) Parent Subsidiaries Consolidated - -------------- ------ ------------ ------------ 2004 $ -- $ 85,256 $ 85,256 2005 -- 225,038 225,038 2006 -- 95,200 95,200 2007 -- 25,000 25,000 2008 -- 70,204 70,204 Over 5 Years 148,835 287,326 436,161 -------- -------- -------- Total $148,835 $788,024 $936,859 ======== ======== ========
NOTES 13. EMPLOYEE BENEFIT PLANS PENSION AND POSTRETIREMENT BENEFITS: Citizens maintains cash balance defined benefit pension plans covering the majority of its employees, and postretirement benefit plans for retirees that include health care benefits and life insurance coverage. Pension retirement benefits are based on the employee's length of service and salary levels. Actuarially determined pension costs are charged to current operations. It is Citizens' policy to fund pension costs in an amount sufficient to meet or exceed the minimum funding requirements of applicable laws and regulations, plus such additional amounts as Citizens deems appropriate up to that allowable by federal tax regulations. Citizens also maintains nonqualified supplemental benefit plans for certain key employees. These plans are provided for by charges to earnings sufficient to meet the projected benefit obligation. The defined pension benefits provided under these plans are unfunded and any payments to plan participants are made by Citizens. As part of the third quarter 2002 restructuring initiatives, Citizens recognized a curtailment related to the termination of certain officers' employment earlier than expected. The curtailment caused a charge of $891,870 for accelerated recognition of their prior service cost bases. Effective January 1, 2002 the defined benefit plan for Citizens' Michigan and Illinois employees (CBC Plan) was amended to provide for a new cash balance pension benefit. This amendment increased the projected benefit obligation of the CBC Plan at December 31, 2001 by $1.1 million. Full-time employees that retire within the next five years with at least 10 years of service under the CBC Plan may elect to receive a benefit under the old formula, which is, in part, based on the employees' final five-year average base pay. The defined benefit plan established for Citizens' F&M employees in 2000 also provides for a cash balance pension benefit. Citizens' postretirement benefit plan, as amended, is available to full-time employees who retire at normal retirement age, were age 50 prior to January 1, 1993 and have at least 15 years of credited service under Citizens' defined benefit pension plan. The medical portion of the plan is contributory to the participants. The life insurance coverage is noncontributory and provided on a reducing basis for 5 years. Those retired prior to January 1, 1993 receive benefits provided by the plan prior to its amendment. That plan included dental care, had some retiree contribution requirements, and had less restrictive eligibility requirements. 84 An actuarial measurement date of December 31 was utilized to determine the projected benefit obligations and fair value of plan assets as follows:
Pension Postretirement Benefits Benefits -------- -------- (in thousands) 2003 2002 2003 2002 ---- ---- ---- ---- CHANGE IN BENEFIT OBLIGATION Projected benefit obligation, beginning of year $ 81,428 73,530 $ 18,502 $ 15,714 Service cost 4,124 3,893 11 8 Interest cost 5,095 5,095 1,161 1,249 Participant contribution -- -- 409 779 Actuarial (gains) losses 1,517 4,698 535 2,702 Plan amendments 116 -- -- -- Special termination benefits 31 -- -- -- Benefits paid (7,364) (5,788) (1,864) (1,950) -------- -------- -------- -------- Projected benefit obligation, end of year $ 84,947 $ 81,428 $ 18,754 $ 18,502 ======== ======== ======== ======== Accumulated benefit obligation, end of year $ 83,216 $ 80,257 $ 18,754 $ 18,502 ======== ======== ======== ======== CHANGE IN PLAN ASSETS Fair value of plan assets, beginning of year $ 74,927 $ 63,127 $ -- $ -- Actual return on plan assets 17,234 (6,951) -- -- Employer contribution 243 24,780 1,455 1,171 Participant contribution -- -- 409 779 Expenses paid -- (241) -- -- Benefits paid (7,364) (5,788) (1,864) (1,950) -------- -------- -------- -------- Fair value of plan assets, end of year $ 85,040 $ 74,927 $ -- $ -- ======== ======== ======== ======== RECONCILIATION OF FUNDED STATUS (Under)/Over funded $ 93 $ (6,501) $(18,754) $(18,502) Unrecognized: Net transition asset - 16 yr amortization (14) (24) -- -- Prior service cost (benefit) 1,678 1,785 (28) (33) Net actuarial (gain) loss 14,849 22,724 3,899 3,510 Adjustment to recognize minimum liability (314) --- --- --- -------- -------- -------- -------- Net amount recognized in the consolidated balance sheets $ 16,292 $ 17,984 $(14,883) $(15,025) ======== ======== ======== ========
85 The components of net periodic benefit cost charged to operations each year for all plans follow:
Year Ended December 31, ----------------------- (in thousands) 2003 2002 2001 ---- ---- ---- DEFINED BENEFIT PENSION PLANS Service cost $ 4,124 $ 3,893 $ 2,988 Interest cost 5,095 5,095 4,878 Expected return on plan assets (7,901) (6,837) (6,873) Curtailment loss -- 892 -- Amortization of unrecognized: Net transition asset (10) (18) (123) Prior service cost 222 728 626 Net actuarial gain (loss) 61 6 (586) ------- ------- ------- Net pension cost (income) 1,591 3,759 910 ------- ------- ------- POSTRETIREMENT BENEFIT PLANS Service cost 11 8 12 Interest cost 1,161 1,249 1,148 Amortization of unrecognized: Prior service cost (4) (4) (5) Net actuarial loss 146 120 -- ------- ------- ------- Net postretirement benefit cost 1,314 1,373 1,155 ------- ------- ------- DEFINED CONTRIBUTION RETIREMENT AND 401(K) PLANS Employer contributions 3,033 3,271 2,850 ------- ------- ------- Total periodic benefit cost $ 5,938 $ 8,403 $ 4,915 ======= ======= =======
The assumptions used in determining the actuarial present value of the benefit obligations and the net periodic pension expense follow:
Pension Postretirement Benefits Benefits -------- -------- December 31, 2003 2002 2003 2002 ---- ---- ---- ---- ASSUMPTIONS USED TO COMPUTE PROJECTED BENEFIT OBLIGATION Discount rate 6.25% 6.50% 6.25% 6.50% Rate of compensation increase: -- -- Cash balance defined benefit plans (1) (1) Nonqualified supplemental benefit plans 6.00% 5.00% ASSUMPTIONS USED TO COMPUTE NET BENEFIT COSTS Discount rate 6.50% 7.25% 6.50% 7.25% Expected return on plan assets 9.25 9.75 -- -- Rate of compensation increase: Cash balance defined benefit plans (1) (1) Nonqualified supplemental benefit plans 5.00% 5.00%
(1) Scaled by age of plan participant - 9.0% at age 24 or under declining to 4.0% at age 50 or older. At December 31, 2003, plan assets exceeded the accumulated plan benefits for all plans except the supplemental benefit plans. The projected benefit obligation and accumulated benefit obligation for these supplemental benefit plans were approximately $7.1 million and $6.6 million, respectively, as of December 31, 2003. Except for the F&M cash balance plan, accumulated plan benefits exceeded plan assets for all plans in 2002. The projected benefit obligation, accumulated benefit obligation, and plan assets for the F&M plan at December 31, 2002 was $9.1 million, $9.0 million and $9.3 million, respectively. 86 INVESTMENT POLICY AND STRATEGY: Citizens' investment policy and strategy for managing the defined benefit plan assets is described as "growth with income" which includes an asset allocation of 70% equities and 30% fixed income and cash. The strategy includes optimization modeling to determine the investment style weights to maximize the performance potential for the accepted level of risk. The equity component at December 31, 2003 is weighted 70% domestic and 30% international, with large cap stocks comprising two thirds of the domestic equities. Intermediate term bonds comprise the majority of the fixed income component. Implementation of this strategy also includes regular rebalancing of the portfolio to the target asset allocation. Pension plan assets included $517,000 of Citizens' common stock at December 31, 2002. Pension plan assets did not include any common stock of Citizens at December 31, 2003. The plans' target asset allocation and the actual asset allocation at December 31, 2003 and 2002 is presented below.
Percentage of Target Plan Assets December 31, Allocation 2003 2002 ---------- ---- ---- ASSET CATEGORY: Equity securities 70% 72% 48% Debt securities 29 27 20 Cash and Cash Equivalents 1 1 32 --- --- --- 100% 100% 100%
The expected return on plan assets was determined using the long-term historical returns of the various investment categories, weighted by target asset allocations. The 2004 pension plan assumptions used to determine net periodic benefit cost will be a discount rate of 6.25% and an expected long-term return on plan assets of 8.75%. Estimated employer contributions for 2004 are approximately $0.5 million. Employer contributions for 2004 could increase as a result of changing market conditions and other factors that may affect actual return on plan assets. At December 31, 2002 the plans' asset allocation differed significantly from the target asset allocation due to a large employer contribution of $24.1 million, or approximately 32% of the plan assets at that date, received in late December 2002. Due to the large amount of the contribution, the funds were held in money market funds and invested in various stock and bond funds over a period of several months to achieve the targeted asset allocation. Prior service pension costs are amortized on a straight-line basis over the average remaining service period of employees expected to receive benefits under the plans. For postretirement health care benefit plans, Citizens assumed a 7.5% annual health care cost trend rate in 2003, declining to 5.0% by 2008 and remaining constant for all future years. This assumption can have a significant effect on the amounts reported. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
One Percentage One Percentage (in thousands) Point Increase Point Decrease -------------- -------------- Effect on total of service and interest cost components $ 103 $ (91) Effect on the postretirement benefit obligation 1,722 (1,511)
In December 2003, President Bush signed into law a bill that expands Medicare benefits, primarily adding a prescription drug benefit for Medicare-eligible retirees beginning in 2006. The law also provides a federal subsidy to companies which sponsor postretirement benefit plans that provide prescription drug coverage. FASB Staff Position 106-1, Accounting and Disclosure Requirements Related to the Medicare Prescription, Drug, Improvement and Modernization Act of 2003 permits deferring the recognition of the new Medicare provisions' impact due to lack of specific authoritative guidance on accounting for the federal subsidy. The Corporation has elected to defer accounting for the effects of this new legislation until the specific authoritative guidance is issued. Accordingly, the postretirement benefit obligations and net periodic costs reported in the accompanying financial statements and notes do not reflect the impact of this legislation. The accounting guidance, when issued, could require changes to previously reported financial information. The corporation anticipates its benefit costs by 2006, or as early as guidance is issued, will be somewhat lower as a result of the new Medicare provision, however, the adoption of this standard is not expected to have a material impact on results of operations, financial position, or liquidity. 87 DEFINED CONTRIBUTION SAVINGS AND RETIREMENT PLANS: Substantially all employees are eligible to contribute a portion of their pre-tax salary to a defined contribution 401(k) savings plan. Under the plan, employee contributions are partially matched by Citizens. The employer matching contribution is 75 percent of the first 6% (100 percent of the first 3% plus 50 percent of the next 3%) of each eligible employee's qualifying salary contributed to the plan. In addition, one third of these matching contributions are used to fund a postretirement medical savings account established within the plan for each contributing employee. NOTE 14. INCOME TAXES Significant components of income taxes are as follows:
- -------------------------------------------------------------------------- Year Ended December 31, (in thousands) 2003 2002 2001 - -------------------------------------------------------------------------- Current tax expense: Federal $ 17,309 $ 3,676 $ 42,926 State 341 371 568 -------- ------- -------- Total current tax expense 17,650 4,047 43,494 Deferred tax expense (credit) 1,526 (5,110) (279) -------- ------- -------- Total income tax expense $ 19,176 $ (1,063) $ 43,215 ======== ======== ======== - --------------------------------------------------------------------------
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of Citizens' deferred tax assets and liabilities as of December 31, 2003 and 2002 follow:
- ------------------------------------------------------------------------------- (in thousands) 2003 2002 ------- ------- Deferred tax assets: Allowance for loan losses $45,901 $40,629 Accrued postemployment benefits other than pensions 5,257 5,359 Alternative minimum tax -- 3,257 Accrued special charges -- 1,898 Other deferred tax assets 9,055 6,908 ------- ------- Deferred tax assets 60,213 58,051 ------- ------- Deferred tax liabilities: Pension 8,159 8,414 Acquisition premium on loans 7,136 5,156 Tax over book depreciation 3,513 3,353 Net unrealized gains on securities 12,279 22,963 Other deferred tax liabilities 6,006 4,203 ------- ------- Deferred tax liabilities 37,093 44,089 ------- ------- Net deferred tax assets $23,120 $13,962 ======= ======= - -------------------------------------------------------------------------------
A reconciliation of income tax expense to the amount computed by applying the federal statutory rate of 35% to income before income taxes follows:
- ------------------------------------------------------------------------------------------------------------- Year Ended December 31, (in thousands) 2003 2002 2001 -------- -------- -------- Tax at federal statutory rate applied to income before income taxes $ 29,794 $ 8,391 $ 51,755 Increase (decrease) in taxes resulting from: Tax-exempt income (9,291) (8,623) (8,793) Other (1,327) (831) 253 -------- -------- -------- Total income tax expense $ 19,176 $ (1,063) $ 43,215 ======== ======== ======== - -------------------------------------------------------------------------------------------------------------
88 NOTE 15. EARNINGS PER SHARE A reconciliation of the numerators and denominators of the basic and diluted earnings per share computations follows:
- ---------------------------------------------------------------------------------------------------- Year Ended December 31, (in thousands) 2003 2002 2001 -------- -------- -------- NUMERATOR: Numerator for basic and dilutive earnings per share -- net income available to common shareholders $ 65,951 $ 25,038 $104,657 ======== ======== ======== DENOMINATOR: Denominator for basic earnings per share -- weighted average shares 43,304 44,657 46,085 Effect of dilutive securities -- potential conversion of employee stock options 305 420 505 -------- -------- -------- Denominator for diluted earnings per share -- adjusted weighted-average shares and assumed conversions 43,609 45,077 46,590 ======== ======== ======== BASIC EARNINGS PER SHARE $ 1.52 $ 0.56 $ 2.27 ======== ======== ======== DILUTED EARNINGS PER SHARE $ 1.51 $ 0.56 $ 2.25 ======== ======== ======== - ----------------------------------------------------------------------------------------------------
Basic net income per share is calculated by dividing net income by the weighted-average number of shares outstanding for the period. Diluted net income per share takes into consideration the pro forma dilution assuming all in-the-money outstanding stock options were exercised. The average price of Citizens' stock for the period is used to determine the dilutive effect of outstanding stock options. See Note 16 for additional disclosures regarding employee stock options. NOTE 16. SHAREHOLDERS' EQUITY RIGHTS AGREEMENT: Citizens is a party to a Rights Agreement, dated May 23, 2000, designed to protect shareholders from unfair takeover offers by encouraging a potential buyer to negotiate with Citizens' board prior to attempting a takeover. Owners of Citizens' common shares have been granted rights under the Rights Agreement to purchase one one-thousandth of a share of Series B Preferred Stock at an exercise price of $65, subject to adjustment. The rights are not exercisable or separately tradable until after a public announcement that a person or group, without board approval, has acquired 15% or more of Citizens' common shares or has commenced a tender offer to do so. If a person or group acquires 15% or more of the common shares, the rights (other than those held by the acquiror, which become void) become exercisable to purchase common shares having a fair value of $130 for $65, or the board may exchange one common share for each outstanding right (other than those held by the acquiror). If the acquiror merges Citizens into another entity, the rights become exercisable for common shares of the surviving entity having a fair value of $130 for $65. The rights are redeemable by the board at any time prior to May 23, 2010 for $.001 per right. The Rights Agreement may be amended by the board without shareholder or right holder approval at any time prior to the acquisition by a person or group of 15% or more of the common shares. The rights will cause substantial dilution to a person or group attempting to acquire Citizens without action by Citizens' board to deactivate the rights. STOCK REPURCHASE PLANS: Citizens purchased shares under a stock repurchase program initiated in October 2001. This program authorizes Citizens to purchase up to 3,000,000 shares for treasury. During the year, 810,800 shares were purchased under this plan at an average price of $26.30. As of December 31, 2003, there were 254,600 shares available for purchase under the program. An additional 3,000,000 shares are authorized for repurchase under a new plan, approved in October 2003. The repurchased shares have been accorded the accounting treatment as if retired. STOCK OPTION PLAN: Citizens' Stock Compensation plan, effective January 18, 2002 and approved by shareholders on April 16, 2002, authorizes the granting of incentive and nonqualified stock options, restricted stock, restricted stock units and performance awards to employees and non-employee directors at any time prior to January 18, 2012. Aggregate grants under the plan may not exceed 7,000,000 shares, and grants other than stock options are further limited to 2,000,000 shares. The 89 plan replaces the option plan for key employees that expired January 16, 2002 and the Stock Option Plan for Directors, which was terminated. Options granted to employees expire ten years from the date of grant. Options granted before the fourth quarter of 2002 are vested five years from the grant date, but may vest sooner based on Citizens' achievement of certain earnings per share targets. For options granted after the third quarter of 2002, the vesting is 20% on each of the first five grant date anniversaries. At December 31, 2003, options outstanding under the plan to employees (including those issued under the expired plan) totaled 3,897,283 shares of which 1,037,266 shares are currently vested and exercisable. Canceled or expired options become available for future grants. A total of 27,500 shares of options were granted to non-employee directors in 2003. The options vest 20% on each of the first five grant date anniversaries and expire ten years from the date of grant. As of December 31, 2003, there were 55,500 shares of options that were issued to directors before 2003. These options have a term of 5 years and are fully vested. OTHER STOCK OPTIONS: On May 18, 2000, Citizens granted stock options to all employees who did not receive grants under the key employee stock option plan. Each full-time employee received 200 shares and each part-time employee received 100 shares. The $16.66 exercise price of the grant was the market price of Citizens' stock on the grant date. The options became exercisable on May 18, 2003 and expire ten years from the date of grant. A total of 550,700 shares were granted of which 164,050 shares were outstanding as of December 31, 2003. In addition, there were also 28,895 shares of stock options from a previous acquisition of a subsidiary outstanding at December 31, 2003. Citizens has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock issued to Employees" (APB 25) and related Interpretations in accounting for its employee stock options as permitted by Financial Accounting Standards Board Statement No. 123, "Accounting for Stock-Based Compensation." Under APB 25, no compensation expense is recognized by Citizens because the exercise price of the stock options equals the market price of the underlying stock on the date of grant. Statement 123 requires certain pro forma disclosures regarding net income and earnings per share as if Citizens had accounted for its stock options under the fair value method of that statement. The following table provides these disclosures along with significant assumptions used to estimate the fair value of these options:
- -------------------------------------------------------------------------------- 2003 2002 2001 ---------- ---------- ----------- Pro forma amounts: Net income (in thousands) $ 63,690 $ 22,637 $ 102,808 Net income per share: Basic 1.47 0.51 2.23 Diluted 1.46 0.50 2.21 Weighted-average assumptions: Dividend yield 3.5% 3.5% 3.5% Expected volatility 28.0% 28.0% 28.0% Risk-free interest rate 2.64% 4.18% 5.02% Expected lives 5 yrs. 5 yrs. 5 yrs. - --------------------------------------------------------------------------------
The weighted average fair values of stock options granted during 2003, 2002 and 2001 were $5.02, $6.75 and $5.77, respectively. 90 A summary of stock option transactions under the plans for 2003, 2002 and 2001 follows:
- ------------------------------------------------------------------------------------------------- Options Option Price --------------------------- --------------------------- Available Per Share for Grant Outstanding Range Average --------- ----------- ----- ------- January 1, 2001 252,580 3,191,004 $ 8.50-36.31 $ 21.36 Authorized 566,858 -- -- -- Granted (651,200) 651,200 25.42-25.72 25.43 Exercised -- (591,602) 8.50-28.21 18.07 Canceled 117,277 (207,729) 16.66-36.31 20.45 ---------- --------- ------------- --------- December 31, 2001 285,515 3,042,873 11.75-36.31 22.94 Old Plans Expired or Terminated (285,515) -- -- -- New Plan Authorized 7,000,000 -- -- -- Granted (901,200) 901,200 25.11-33.41 30.85 Restricted Stock Granted (25,000) -- -- -- Exercised -- (327,629) 11.77-30.50 20.13 Canceled 24,500 (182,277) 16.66-36.31 23.08 ---------- --------- ------------- --------- December 31, 2002 6,098,300 3,434,167 11.75-36.31 25.28 Granted (1,255,200) 1,255,200 23.10-33.66 26.27 Restricted Stock Granted (8,862) -- -- -- Exercised -- (341,485) 11.75-30.50 18.55 Canceled 49,200 (174,654) 16.66-36.31 25.90 ---------- --------- ------------- --------- December 31, 2003 4,883,438 4,173,228 $ 15.10-35.63 $ 26.10 ========== ========= ============= ========= - -------------------------------------------------------------------------------------------------
The following table summarizes information on stock options outstanding as of December 31, 2003:
- ---------------------------------------------------------------------------------------------------- Options Outstanding Options Exercisable ---------------------------------------------- -------------------------- Weighted- Weighted- Average Weighted- Average Remaining Average Exercise Range Amount Life Exercise Price Amount Price - ---------------------------------------------------------------------------------------------------- $ 15.10 - 21.99 970,014 5.0 years $ 17.92 611,057 $ 18.67 22.00 - 28.99 1,929,055 8.7 25.82 164,155 25.51 29.00 - 35.63 1,274,159 6.5 32.74 510,499 33.74 --------- --------- $ 15.10 - 35.63 4,173,228 7.2 26.10 1,285,711 25.52 ========= ========= - ----------------------------------------------------------------------------------------------------
NOTE 17. COMMITMENTS, CONTINGENT LIABILITIES AND GUARANTEES The Consolidated Financial Statements do not reflect various loan commitments (unfunded loans and unused lines of credit) and letters of credit originated in the normal course of business. Loan commitments are made to accommodate the financial needs of clients. Generally, new loan commitments do not extend beyond 90 days and unused lines of credit are reviewed at least annually. Letters of credit guarantee future payment of client financial obligations to third parties. They are issued primarily for services provided or to facilitate the shipment of goods, and generally expire within one year. Both arrangements have essentially the same level of credit risk as that associated with extending loans to clients and are subject to Citizens' normal credit policies. Inasmuch as these arrangements generally have fixed expiration dates or other termination clauses, most expire unfunded and do not necessarily represent future liquidity requirements. Collateral is obtained based on management's assessment of the client and may include receivables, inventories, real property and equipment. 91 Amounts available to clients under loan commitments and letters of credit follow:
- ---------------------------------------------------------------------- December 31, (in thousands) 2003 2002 ---------- ---------- LOAN COMMITMENTS AND LETTERS OF CREDIT: Commitments to extend credit $1,593,426 $1,739,091 Standby letters of credit 48,868 36,396 Commercial letters of credit 183,665 138,679 ---------- ---------- $1,825,959 $1,914,166 ========== ========== - ----------------------------------------------------------------------
Loan commitments outstanding include $45.8 million of credit card commitments and $379.8 million of home equity credit lines in 2003. The same amounts for 2002 were $71.1 million and $298.3 million, respectively. Citizens and its subsidiaries are parties to litigation arising in the ordinary course of business. Management believes that the aggregate liability, if any, resulting from these proceedings would not have a material effect on Citizens' consolidated financial position or results of operations. CONTINGENT GUARANTEES: Citizens has performance obligations upon the occurrence of certain events under financial guarantees provided in certain contractual arrangements. At December 31, 2003, Citizens had issued approximately $42.1 million of financial standby letters of credit and $6.8 million of performance standby letters of credit. The same amounts at December 31, 2002 were $28.8 million and $7.6 million, respectively. NOTE 18. DERIVATIVES AND HEDGING ACTIVITIES SFAS 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS 138 and SFAS 149, "Accounting for Certain Derivative Instruments and Certain Hedging Activities," (collectively referred to as "SFAS 133") establish accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. Citizens designates its derivatives based upon criteria established by SFAS 133. For a derivative designated as a fair value hedge, the derivative is recorded at fair value on the consolidated balance sheet. Any difference between the fair value change of the hedge versus the fair value change of the hedged item is considered to be the "ineffective" portion of the hedge. The ineffectiveness of the hedge is recorded in current earnings. For a derivative designated as a cash flow hedge, the effective portion of the derivative's gain or loss is initially reported as a component of accumulated other comprehensive income (loss) and subsequently reclassified into earnings when the hedged exposure affects earnings. Citizens may use derivative instruments to hedge the variability in interest payments or protect the value of certain assets and liabilities recorded in its balance sheet from changes in interest rates. Citizens uses interest rate contracts such as interest rate swaps to manage its interest rate risk. These contracts are designated as hedges of specific assets or liabilities. The net interest receivable or payable on swaps is accrued and recognized as an adjustment to the interest income or expense of the hedged asset or liability. The following table summarizes the derivative financial instruments held or issued by Citizens. 92
- ---------------------------------------------------------------------------------------------------------------- DERIVATIVE FINANCIAL INSTRUMENTS: DECEMBER 31, DECEMBER 31, 2003 2002 --------------------------------------------------- Notional Fair Notional Fair (dollars in thousands) Amount Value Amount Value - ---------------------------------------------------------------------------------------------------------------- Received fixed swaps $190,000 $ 499 $ -- $ -- Interest rate lock commitments 14,683 109 66,787 1,176 Forward mortgage loan contracts 29,000 (161) 175,537 (2,700) -------- ----- -------- ------- TOTAL $233,683 $ 447 $242,324 $(1,524) ======== ===== ======== ======= - ----------------------------------------------------------------------------------------------------------------
- ---------------------------------------------------------------------------------------------------------------- DERIVATIVE CLASSIFICATIONS AND HEDGING RELATIONSHIPS: DECEMBER 31, DECEMBER 31, 2003 2002 -------------------------------------------------- Notional Fair Notional Fair (dollars in thousands) Amount Value Amount Value - ---------------------------------------------------------------------------------------------------------------- Derivatives Designated as Cash Flow Hedges: Hedging commercial loans $ 25,000 $ 339 $ -- $ -- Derivatives Designated as Fair Value Hedges: Hedging time deposits 40,000 31 -- -- Hedging long-term debt 125,000 129 -- -- -------- ----- --- --- Total $190,000 $ 499 $ -- $ -- ======== ===== === === - ----------------------------------------------------------------------------------------------------------------
At December 31, 2003, Citizens had outstanding $190 million of interest rate swap agreements with an average receive rate of 4.78% and pay rate of 1.62%. There were no interest rate swaps in 2002. Interest rate lock commitments on mortgages held for sale were approximately $14.7 million at December 31, 2003 and $66.8 million at December 31, 2002. Citizens also had outstanding mandatory forward commitments to sell $29 million of residential mortgage loans at December 31, 2003, which hedged the year end balance of mortgage loans held for sale. These outstanding forward commitments to sell mortgage loans are expected to settle in the first quarter of 2004 with no material gain or loss. At December 31, 2002, outstanding forward commitments to sell mortgage loans were approximately $175.5 million. Citizens' policy to hedge its market rate risk with mandatory forward commitments has been highly effective and has not generated any material gains or losses. 93 NOTE 19. FAIR VALUES OF FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS 107, "Disclosure About Fair Value of Financial Instruments". Where quoted market prices are not available, as is the case for a significant portion of Citizens' financial instruments, the fair values are based on estimates using present value or other valuation techniques. These techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the derived fair value estimates presented herein cannot be substantiated by comparison to independent markets and are not necessarily indicative of the amounts Citizens could realize in a current market exchange. In addition, the fair value estimates are based on existing on- and off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, Citizens has a substantial trust department that contributes net fee income annually. The trust department is not considered a financial instrument and its value has not been incorporated into the fair value estimates. Other significant assets and liabilities that are not considered financial assets or liabilities include Citizens' brokerage network, net deferred tax asset, premises and equipment, goodwill and deposit based intangibles. In addition, tax ramifications related to the recognition of unrealized gains and losses such as those within the investment securities portfolio can also have a significant effect on estimated fair values and have not been considered in the estimates. Accordingly, the aggregate fair value amounts do not represent the underlying value of Citizens. The estimated fair values of Citizens' financial instruments follow:
- ------------------------------------------------------------------------------------------------------------------ DECEMBER 31, 2003 DECEMBER 31, 2002 ------------------------- ----------------------- CARRYING ESTIMATED CARRYING ESTIMATED (in millions) AMOUNT FAIR VALUE AMOUNT FAIR VALUE - ------------------------------------------------------------------------------------------------------------------ Financial assets: Cash and money market investments $ 184.8 $ 184.8 $ 243.2 $243.2 Securities available-for-sale 1,965.2 1,965.2 1,457.3 1,457.3 Securities held-to-maturity 19.9 19.9 --- --- Mortgage loans held for sale 44.7 44.6 160.7 160.9 Net loans 5,122.2 5,266.0 5,325.8 5,510.6 Financial liabilities: Deposits 5,442.3 5,457.7 5,936.9 5,983.9 Short-term borrowings 631.7 632.0 302.4 302.5 Long-term debt 936.9 947.5 599.3 618.8 Off-balance sheet financial instrument liabilities: Loan commitments to extend credit --- 2.6 --- 3.9 Standby and commercial letters of credit --- 1.2 --- 0.9 Interest rate swap agreements --- 0.5 --- --- Interest rate lock commitments --- 0.1 --- 1.2 Forward commitments to sell mortgage loans --- (0.2) --- (2.7) - -----------------------------------------------------------------------------------------------------------------
The various methods and assumptions used by Citizens in estimating fair value for its financial instruments are set forth below: CASH AND MONEY MARKET INVESTMENTS: The carrying amounts reported in the balance sheet for cash and money market investments approximate those assets' fair values because they mature within six months and do not present unanticipated credit concerns. INVESTMENT SECURITIES AVAILABLE FOR SALE AND HELD TO MATURITY: The carrying amounts reported in the balance sheet for investment securities classified as available-for-sale approximate those assets' fair values. SFAS 115 requires securities carried in the available for sale category to be carried at fair value - see Note 5. The carrying amounts for investment securities classified as held-to-maturity are amortized costs. The fair values of both available-for-sale and held-to-maturity 94 securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments. MORTGAGE LOANS HELD FOR SALE: Fair values are determined by the current market values of similar loans - see Net Loans Receivable below. NET LOANS RECEIVABLE: Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, commercial real estate, residential mortgage, and home equity and other consumer. Each loan category is further segmented into fixed and variable-rate interest types and for certain categories by performing and nonperforming. For performing variable-rate loans that reprice frequently (within twelve months) and with no significant change in credit risk, fair values are based on carrying values. Similarly, for credit card loans with no significant credit concerns and average interest rates approximating current market origination rates, the carrying amount is a reasonable estimate of fair value. Fair values of other loans (e.g., fixed-rate commercial, commercial real estate, residential mortgage and consumer loans) are estimated by discounting the future cash flows using interest rates currently being offered by Citizens for loans with similar terms and remaining maturities (new loan rates). Management believes the risk factor embedded in the new loan rates adequately represents the credit risk within the portfolios. Fair values for nonperforming loans are estimated after giving consideration to credit risk and estimated cash flows and discount rates based on available market and specific borrower information. The carrying amount of accrued interest for all loan types approximates its fair value. DEPOSIT LIABILITIES: Under SFAS 107, the fair value of demand deposits (e.g., interest and noninterest checking, passbook savings and certain types of money market accounts) are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). Fair values for certificates of deposit are based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for certificates of similar remaining maturities. SHORT-TERM BORROWINGS: The carrying amounts of federal funds purchased, securities sold under agreement to repurchase and other short-term borrowings approximate their fair values. LONG-TERM DEBT: The carrying value of Citizens' variable-rate long-term debt approximates its fair value. The fair value of fixed-rate long-term debt is estimated using discounted cash flow analyses, based on Citizens' current incremental borrowing rates for similar types of borrowing arrangements. LOAN COMMITMENTS AND LETTERS OF CREDIT: The fair value of loan commitments and letter of credit guarantees is based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties' credit standing. INTEREST RATE SWAP AGREEMENTS: Fair values are based on the estimated amount Citizens would receive or pay to terminate the swap agreements, taking into account the current interest rates and creditworthiness of the swap counterparties. INTEREST RATE LOCK COMMITMENTS AND FORWARD COMMITMENTS TO SELL MORTGAGES: The estimated fair values are based on quoted market prices. 95 NOTE 20. LINES OF BUSINESS The financial performance of Citizens is monitored by an internal profitability measurement system, which provides line of business results and key performance measures. The profitability measurement system is based on internal management methodologies designed to produce consistent results and reflect the underlying economics of the businesses. The development and application of these methodologies is a dynamic process. Accordingly, these measurement tools and assumptions may be revised periodically to reflect methodological, product, and/or management organizational changes. Further, these policies measure financial results that support the strategic objectives and internal organizational structure of Citizens. Consequently, the information presented is not necessarily comparable with similar information for other institutions. Beginning in 2002, all activities formerly housed in our F&M business line were integrated into our other lines of business: Commercial Banking, Retail Banking, Financial Services and Other and the three major business lines were renamed Business Banking, Consumer Banking and Wealth Management, respectively. In the fourth quarter of 2003 we renamed Business Banking again as Commercial Banking, to better reflect the broad range of services Citizens provides to both middle market commercial and small business clients. The activities of the renamed business lines remained the same. A description of each business line, selected financial performance and the methodologies used to measure financial performance are presented below. Financial information for the year 2001 has been restated to reflect the new organizational structure. COMMERCIAL BANKING: Commercial Banking provides a full range of credit and related financial services to middle market commercial, small business, government and leasing clients. Products and services offered include commercial loans, commercial mortgages, small business loans, letters of credit, deposit accounts, treasury management and international trade services. CONSUMER BANKING: Consumer Banking includes consumer lending and deposit gathering, electronic banking and residential mortgage loan origination and servicing. This line of business offers a variety of retail financial products and services including deposit accounts, direct and indirect installment loans, debit and credit cards, home equity lines of credit, residential mortgage loans, fixed and variable annuities and ATM network services. WEALTH MANAGEMENT: Wealth Management provides commercial and retail clients with private banking, trust and investment, retirement plan, and brokerage and insurance services. Private banking focuses on high net-worth customers and offers a broad array of asset management, estate settlement and administration, deposit and credit products. Trust and investment includes personal trust and planning services, investment management services, estate settlement, administration and advises the Golden Oak family of mutual funds. Retirement plan services focus on investment management and fiduciary activities with special emphasis on 401(k) plans. The brokerage and insurance businesses deliver Citizens' retail mutual funds, other securities, variable and fixed annuities, personal disability and life insurance products and discounted brokerage services. OTHER: All other includes activities that are not directly attributable to one of the major lines of business. Included in this category is the parent company; Citizens' Treasury unit, including the securities portfolio, wholesale funding and asset liability management activities; inter-company eliminations; and the economic impact of certain assets, capital and support functions not specifically identifiable with the three primary lines of business. The accounting policies of the individual business units are the same as those of Citizens described in Note 1 to the Consolidated Financial Statements. Funds transfer pricing is used in the determination of net interest income by assigning a cost for funds used or credit for funds provided to assets and liabilities within each business unit. Assets and liabilities are match-funded based on their maturity, prepayment and/or repricing characteristics. As a result, the Commercial, Consumer and Wealth Management units are largely insulated from changes in interest rates. Changes in net interest income due to changes in interest rates are reported in Citizens' Treasury unit. Noninterest income and expenses directly attributable to a line of business are assigned to that business. Expenses for centrally provided services are allocated to the business lines as follows: product processing and technology expenditures are allocated based on standard unit costs applied to actual volume measurements; corporate overhead is allocated based on the ratio of a line of business' noninterest expenses to total noninterest expenses incurred by all business lines. The provision for loan losses was allocated in an amount based primarily upon the actual net charge-offs of each respective line of business, adjusted for loan growth and changes in risk profile. 96 Selected segment information is included in the following table.
- -------------------------------------------------------------------------------------------------------------------------- LINE OF BUSINESS INFORMATION COMMERCIAL CONSUMER WEALTH (IN THOUSANDS) BANKING BANKING MGMT OTHER TOTAL - -------------------------------------------------------------------------------------------------------------------------- EARNINGS SUMMARY - 2003 Net interest income (taxable equivalent) $ 124,339 $ 154,190 $ 312 $ 20,925 $ 299,766 Provision for loan losses 47,347 15,615 -- -- 62,962 --------- --------- --------- --------- --------- Net interest income after provision 76,992 138,575 312 20,925 236,804 Noninterest income 14,882 53,319 22,086 4,532 94,819 Noninterest expense 63,048 132,611 21,374 15,955 232,988 --------- --------- --------- --------- --------- Income before income taxes 28,826 59,283 1,024 9,502 98,635 Income tax expense (taxable equivalent) 10,265 20,734 398 1,287 32,684 --------- --------- --------- --------- --------- Net income $ 18,561 $ 38,549 $ 626 $ 8,215 $ 65,951 ========= ========= ========= ========= ========= AVERAGE ASSETS (IN MILLIONS) $ 3,044 $ 2,415 $ 8 $ 2,227 $ 7,694 ========= ========= ========= ========= ========= - -------------------------------------------------------------------------------------------------------------------------- EARNINGS SUMMARY - 2002 Net interest income (taxable equivalent) $ 140,926 $ 152,398 $ 273 $ 22,655 $ 316,252 Provision for loan losses 108,002 13,590 -- (1,392) 120,200 --------- --------- --------- --------- --------- Net interest income after provision 32,924 138,808 273 24,047 196,052 Noninterest income 17,179 58,524 23,881 2,192 101,776 Noninterest expense 69,555 140,098 17,563 32,167 259,383 --------- --------- --------- --------- --------- Income (loss) before income taxes (19,452) 57,234 6,591 (5,928) 38,445 Income tax expense (benefit) (taxable equivalent) (6,804) 20,034 2,307 (2,130) 13,407 --------- --------- --------- --------- --------- Net income (loss) $ (12,648) $ 37,200 $ 4,284 $ (3,798) $ 25,038 ========= ========= ========= ========= ========= AVERAGE ASSETS (IN MILLIONS) $ 3,388 $ 2,721 $ 7 $ 1,453 $ 7,569 ========= ========= ========= ========= ========= - -------------------------------------------------------------------------------------------------------------------------- EARNINGS SUMMARY - 2001 Net interest income (taxable equivalent) $ 139,766 $ 166,312 $ 1,232 $ 15,506 $ 322,816 Provision for loan losses 17,380 8,881 -- 146 26,407 --------- --------- --------- --------- --------- Net interest income after provision 122,386 157,431 1,232 15,360 296,409 Noninterest income 16,429 62,305 25,050 13,697 117,481 Noninterest expense 67,267 146,578 16,823 20,515 251,183 --------- --------- --------- --------- --------- Income before income taxes 71,548 73,158 9,459 8,542 162,707 Income tax expense (taxable equivalent) 25,047 25,605 3,311 4,087 58,050 --------- --------- --------- --------- --------- Net income $ 46,501 $ 47,553 $ 6,148 $ 4,455 $ 104,657 ========= ========= ========= ========= ========= AVERAGE ASSETS (IN MILLIONS) $ 3,461 $ 3,075 $ 11 $ 1,389 $ 7,936 ========= ========= ========= ========= ========= - --------------------------------------------------------------------------------------------------------------------------
97 NOTE 21. REGULATORY MATTERS The Federal Reserve Bank requires Citizens' banking subsidiaries to maintain certain noninterest-bearing deposits. These reserve balances vary depending upon the level of client deposits in the subsidiary banks. During 2003 and 2002, the average reserve balances were $36.4 million and $35.3 million, respectively. The banking subsidiaries are also subject to limitations under banking laws on extensions of credit to members of the affiliate group and on dividends that can be paid to Citizens. Generally extensions of credit are limited to 10% to any one affiliate and 20% in aggregate to all affiliates of a subsidiary bank's capital and surplus (net assets) as defined. Unless prior regulatory approval is obtained, dividends declared in any calendar year may not exceed the retained net profit, as defined, of that year plus the retained net profit of the preceding two years. As of January 1, 2004, Citizens' banking subsidiaries are able to distribute dividends of $36.2 million without further regulatory approval. During 2004, net income of Citizens' banking subsidiaries will also become available for such dividends. Citizens and its banking subsidiaries are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, specific capital guidelines must be met that involve quantitative measures of the assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require Citizens and its banking subsidiaries to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital to risk-weighted assets (as defined in the regulations), and of Tier 1 capital to average assets (as defined). Management believes, as of December 31, 2003, that Citizens and its banking subsidiaries meet all capital adequacy requirements to which it is subject. As of December 31, 2003, the most recent notification from the Federal Reserve Board categorized Citizens and its banking subsidiaries as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized Citizens and its banking subsidiaries must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes would result in a change. 98
- -------------------------------------------------------------------------------------------------------------------------------- RISK BASED CAPITAL REQUIREMENTS To Be Well Capitalized For Capital Under Prompt Corrective Actual Adequacy Purposes Action Provisions ------------------- ---------------------- -------------------------- (in thousands) Amount Ratio Amount Ratio Amount Ratio - -------------------------------------------------------------------------------------------------------------------------------- CITIZENS BANKING CORPORATION AS OF DECEMBER 31, 2003: Total Capital to risk weighted assets (1) $763,779 13.2% $466,052 >/= 8.0% $ 582,565 >/= 10.0% Tier 1 Capital to risk weighted assets (1) 565,958 9.8 233,026 >/= 4.0 349,539 >/= 6.0 Tier 1 Leverage (2) 565,958 7.5 303,771 >/= 4.0 379,714 >/= 5.0 As of December 31, 2002: Total Capital to risk weighted assets (1) $606,133 10.4% $464,714 >/= 8.0% $ 580,892 >/= 10.0% Tier 1 Capital to risk weighted assets (1) 533,066 9.2 232,357 >/= 4.0 348,535 >/= 6.0 Tier 1 Leverage (2) 533,066 7.2 296,413 >/= 4.0 370,517 >/= 5.0 CITIZENS BANK AS OF DECEMBER 31, 2003: Total Capital to risk weighted assets (1) $470,505 11.3% $335,669 >/= 8.0% $ 419,586 >/= 10.0% Tier 1 Capital to risk weighted assets (1) 418,057 10.0 167,834 >/= 4.0 251,752 >/= 6.0 Tier 1 Leverage (2) 418,057 7.7 215,918 >/= 4.0 269,897 >/= 5.0 As of December 31, 2002: Total Capital to risk weighted assets (1) $427,868 10.6% $323,496 >/= 8.0% $ 404,370 >/= 10.0% Tier 1 Capital to risk weighted assets (1) 377,195 9.3 161,748 >/= 4.0 242,622 >/= 6.0 Tier 1 Leverage (2) 377,195 7.6 199,460 >/= 4.0 249,325 >/= 5.0 - --------------------------------------------------------------------------------------------------------------------------------
(1)Total Capital is comprised of Tier 1 Capital, a portion of the allowance for loan losses and qualifying subordinated debt. Tier 1 Capital consists of total equity and trust preferred securities less unrealized gains and losses accumulated in other comprehensive income, certain intangible assets and adjustments related to the valuation of mortgage servicing assets. (2) Tier 1 Capital to quarterly average assets 99 NOTE 22. CITIZENS BANKING CORPORATION (PARENT ONLY) STATEMENTS - -------------------------------------------------------------------------------- BALANCE SHEETS CITIZENS BANKING CORPORATION (PARENT ONLY)
December 31, (in thousands) 2003 2002 - -------------------------------------------------------------------------------- ASSETS Cash $ 5 $ 5 Money market investments 48,664 3,166 Investment securities 101 83 Investment in subsidiaries - principally banks 733,365 682,010 Goodwill - net 258 265 Other assets 6,966 3,850 -------- -------- Total assets $789,359 $689,379 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Short-term revolving credit $ -- $ 30,000 Long-term debt 148,835 -- Other liabilities 5,362 8,910 -------- -------- Total liabilities 154,197 38,910 Shareholders' equity 635,162 650,469 -------- -------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $789,359 $689,379 ======== ======== - --------------------------------------------------------------------------------
- -------------------------------------------------------------------------------- STATEMENTS OF INCOME CITIZENS BANKING CORPORATION (PARENT ONLY)
Year Ended December 31, (in thousands) 2003 2002 2001 - -------------------------------------------------------------------------------------------------------------------- INCOME Dividends from subsidiaries - principally banks $ 24,000 $ 90,500 $ 107,400 Interest from bank subsidiary 540 -- 32 Service fees from bank subsidiaries 10,520 10,887 9,435 Equity security gain -- -- 11,017 Other 771 703 890 --------- --------- --------- Total 35,831 102,090 128,774 --------- --------- --------- EXPENSES Interest 4,054 710 1,904 Amortization of goodwill -- -- 796 Salaries and employee benefits 12,104 14,352 9,955 Service fees paid to bank subsidiaries 2,883 1,168 1,265 Special charge -- 1,434 -- Other noninterest expense 1,717 3,042 3,888 --------- --------- --------- Total 20,758 20,706 17,808 --------- --------- --------- Income before income taxes and equity in undistributed earnings of subsidiaries 15,073 81,384 110,966 Income tax benefit (provision) 4,508 3,465 (1,197) Equity in undistributed (dividends in excess of) earnings of subsidiaries 46,370 (59,811) (5,112) --------- --------- --------- NET INCOME $ 65,951 $ 25,038 $ 104,657 ========= ========= ========= - --------------------------------------------------------------------------------------------------------------------
100
- ------------------------------------------------------------------------------------------------------------------------- STATEMENTS OF CASH FLOWS CITIZENS BANKING CORPORATION (PARENT ONLY) Year Ended December 31, (in thousands) 2003 2002 2001 --------- --------- --------- OPERATING ACTIVITIES Net income $ 65,951 $ 25,038 $ 104,657 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of goodwill -- -- 796 Equity security gain -- -- (11,017) Amortization of stock-based compensation expense 350 267 -- Stock-based compensation 200 -- -- Dividends in excess of (equity in undistributed) earnings of subsidiaries (46,370) 59,811 5,112 Other (5,538) 9,474 475 --------- --------- --------- Net cash provided by operating activities 14,593 94,590 100,023 --------- --------- --------- INVESTING ACTIVITIES Net (increase) decrease in money market investments (45,498) (197) 4,947 Proceeds from sales and maturities of investment securities 5 -- -- Investments in and advances to subsidiaries (25,000) -- -- Proceeds from sale of NYCE stock -- -- 11,017 --------- --------- --------- Net cash provided (used) by investing activities (70,493) (197) 15,964 --------- --------- --------- FINANCING ACTIVITIES Proceeds from short-term borrowings -- -- 6,000 Principal reductions in short-term borrowings (30,000) -- (24,000) Proceeds from long-term borrowings 150,365 -- -- Cash dividends paid (49,476) (50,659) (50,158) Proceeds from stock options exercised 6,334 6,562 10,662 Shares acquired for retirement (21,323) (50,296) (58,491) --------- --------- --------- Net cash used by financing activities 55,900 (94,393) (115,987) --------- --------- --------- Net increase in cash -- -- -- Cash at beginning of year 5 5 5 --------- --------- --------- Cash at end of year $ 5 $ 5 $ 5 ========= ========= ========= - --------------------------------------------------------------------------------------------------------------------------
101 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS BOARD OF DIRECTORS CITIZENS BANKING CORPORATION We have audited the accompanying consolidated balance sheets of Citizens Banking Corporation and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform our audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Citizens Banking Corporation and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. As discussed in Note 7 to the Consolidated Financial Statements, in 2002 Citizens Banking Corporation and subsidiaries changed their method of accounting for goodwill and intangible assets. /s/ Ernst & Young LLP Detroit, Michigan January 29, 2004 102 REPORT OF MANAGEMENT Management is responsible for the preparation, integrity and fair presentation of the Consolidated Financial Statements and all other financial information appearing in this Annual Report. The Consolidated Financial Statements have been prepared in accordance with generally accepted accounting principles in the United States, and accordingly include some amounts that are based on management's best estimates and judgements. We, as management of Citizens Banking Corporation are responsible for establishing and maintaining effective internal controls over financial reporting that are designed to produce reliable financial statements in conformity with accounting principles generally accepted in the United States. The system of internal control over financial reporting is tested and evaluated through a program of internal audits. Actions are taken to correct potential deficiencies as they are identified. Management recognizes that the cost of a system of internal controls should not exceed the benefits derived and that there are inherent limitations to be considered in the potential effectiveness of any system. Management believes Citizens' system provides the appropriate balance between costs of controls and the related benefits. The Audit Committee of the Board of Directors, comprised entirely of outside directors, recommends the independent auditors who are engaged upon approval by the Board of Directors. The committee meets regularly with management, internal auditors and independent auditors to review timing and scope of audits and audit results. Ernst & Young, LLP, independent auditors, and the internal auditors have direct and confidential access to the Audit Committee to discuss the results of their examinations. Management assessed the Corporation's system of internal control over financial reporting as of December 31, 2003, in relation to criteria for effective internal control over financial reporting as described in "Internal Control - Integrated Framework," issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that, as of December 31, 2003, its system of internal control over financial reporting met those criteria. /s/ Charles D. Christy /s/ William R. Hartman - --------------------------- --------------------------- Charles D. Christy William R. Hartman Executive Vice President Chairman, President and Chief Financial Officer and Chief Executive Officer 103 EX-21 6 k82546exv21.txt SUBSIDIARIES Exhibit 21 (Form 10-K) SUBSIDIARIES OF CITIZENS BANKING CORPORATION
Jurisdiction or Ownership Incorporation of Subsidiaries Percentage Organization - --------------------------------------------- ----------- -------------------- Citizens Bank Michigan Citizens Commercial Leasing Corporation 100% Michigan CB Financial Services, Inc. 100% Michigan Citizens Title Services, Inc. 100% Michigan Citizens Bank Mortgage Company, LLC 99% Michigan Citizens Service Company, Inc. 100% Michigan Citizens Bank Consumer Finance, LLC 1% Michigan Citizens Bank Mortgage Company, LLC 1% Michigan Citizens Bank Consumer Finance, LLC 99% Michigan CB Capital Management, Inc. 100% Michigan Citizens Bank - Illinois, N.A. 100% National Association Citizens Bank Wealth Management, N.A. 100% National Association F&M Bancorporation, Inc. 100% Wisconsin F&M Bank - Wisconsin 100% Wisconsin Pulaski Capital Corporation 100% Nevada F&M Bank - Iowa 100% Iowa Security Bancservices, Inc. 100% Iowa
EX-23 7 k82546exv23.txt CONSENT OF INDEPENDENT AUDITORS Exhibit 23 (Form 10-K) CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in (1) the Registration Statement (Form S-8 No. 33-47686 dated May 5, 1992) pertaining to the Citizens Banking Corporation Second Amended Stock Option Plan; (2) the Registration Statement (Form S-8 No. 333-09455 dated August 2, 1996) pertaining to the Citizens Banking Corporation Amended and Restated Section 401(k) Plan; (3) the Registration Statement (Post Effective Amendment No. 1 to Form S-4 on Form S-8 No. 333-86569 dated December 22, 1999) pertaining to the F&M Bancorporation, Inc. stock option plans; (4) the Registration Statement (Form S-8 No. 333-40100 dated June 26, 2000) pertaining to the Citizens Banking Corporation All Employee Stock Option Plan; (5) the Registration Statement (Form S-8 No. 333-86326 dated April 16, 2002) pertaining to Citizens Banking Corporation Stock Compensation Plan, and (6) the Registration Statement (Post Effective Amendment No. 1 to Form S-8 No. 33-61197 dated February 24, 2003) pertaining to the Citizens Banking Corporation Stock Option Plan for Directors; of our report dated January 29, 2004, with respect to the Consolidated Financial Statements of Citizens Banking Corporation incorporated by reference in the Annual Report (Form 10-K) for the year ended December 31, 2003. /s/ Ernst & Young LLP - ----------------------- Ernst & Young LLP Detroit, Michigan March 15, 2004 EX-31.1 8 k82546exv31w1.txt SEC. 302 CERTIFICATION OF CHIEF EXECUTIVE OFFICER Exhibit 31.1 (Form 10-K) CERTIFICATIONS I, William R. Hartman, Chief Executive Officer, President and Chairman of Citizens Banking Corporation, certify that: 1. I have reviewed this annual report on Form 10-K of Citizens Banking Corporation; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have; a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: March 15, 2004 /s/ William R. Hartman ----------------------------------------------- William R. Hartman Chairman, President and Chief Executive Officer EX-31.2 9 k82546exv31w2.txt SEC. 302 CERTIFICATION OF CHIEF FINANCIAL OFFICER Exhibit 31.2 (Form 10-K) CERTIFICATIONS I, Charles D. Christy, Executive Vice President and Chief Financial Officer of Citizens Banking Corporation, certify that: 1. I have reviewed this annual report on Form 10-K of Citizens Banking Corporation; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have; a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) All significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: March 15, 2004 /s/ Charles D. Christy ------------------------------- Charles D. Christy Executive Vice President and Chief Financial Officer EX-32.1 10 k82546exv32w1.txt SEC. 906 CERTIFICATION OF CHIEF EXECUTIVE OFFICER Exhibit 32.1 (Form 10-K) CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AND RULE 13A-14(B) UNDER THE SECURITIES EXCHANGE ACT OF 1934 In connection with the Annual Report of Citizens Banking Corporation ("Citizens") on Form 10-K for the period ending December 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, William R. Hartman, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) under the Securities Exchange Act of 1934, that: (1) The Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934; and (2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of Citizens. Dated: March 15, 2004 /s/ William R. Hartman -------------------------------------------- William R. Hartman Chairman, President and Chief Executive Officer EX-32.2 11 k82546exv32w2.txt SEC. 906 CERTIFICATION OF CHIEF FINANCIAL OFFICER Exhibit 32.2 (Form 10-K) CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AND RULE 13A-14(B) UNDER THE SECURITIES EXCHANGE ACT OF 1934 In connection with the Annual Report of Citizens Banking Corporation ("Citizens") on Form 10-K for the period ending December 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Charles D. Christy, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) under the Securities Exchange Act of 1934, that: (1) The Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934; and (2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of Citizens. Dated: March 15, 2004 /s/ Charles D. Christy --------------------------------- Charles D. Christy Executive Vice President and Chief Financial Officer -----END PRIVACY-ENHANCED MESSAGE-----