10-Q 1 form10-q09302004.txt FORM 10-Q 3Q04 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q (Mark One) X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) ----- OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2004 ------------------------------------------ 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 0-5519 -------------------------------------------------------- Associated Banc-Corp ------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Wisconsin 39-1098068 ------------------------------------------------------------------------------- (State or other jurisdiction of (IRS employer identification no.) of incorporation or organization) 1200 Hansen Road, Green Bay, Wisconsin 54304 ------------------------------------------------------------------------------- (Address of principal executive offices) (Zip code) (920) 491-7000 ------------------------------------------------------------------------------- (Registrant's telephone number, including area code) ------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No ------- -------- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No ------- -------- APPLICABLE ONLY TO CORPORATE ISSUERS: The number of shares outstanding of registrant's common stock, par value $0.01 per share, at October 28, 2004, was 110,418,966 shares. 1 ASSOCIATED BANC-CORP TABLE OF CONTENTS Page No. -------- PART I. Financial Information Item 1. Financial Statements (Unaudited): Consolidated Balance Sheets - September 30, 2004, September 30, 2003 and December 31, 2003 3 Consolidated Statements of Income - Three and Nine Months Ended September 30, 2004 and 2003 4 Consolidated Statement of Changes in Stockholders' Equity - Nine Months Ended September 30, 2004 5 Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2004 and 2003 6 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 20 Item 3. Quantitative and Qualitative Disclosures About Market Risk 42 Item 4. Controls and Procedures 42 PART II. Other Information Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 43 Item 6. Exhibits 43 Signatures 44 2 PART I - FINANCIAL INFORMATION ITEM 1. Financial Statements: ASSOCIATED BANC-CORP Consolidated Balance Sheets (Unaudited)
September 30, September 30, December 31, 2004 2003 2003 --------------------------------------------- (In Thousands, except share data) ASSETS Cash and due from banks $ 286,799 $ 340,042 $ 389,140 Interest-bearing deposits in other financial institutions 10,381 6,180 7,434 Federal funds sold and securities purchased under agreements to resell 63,105 19,950 3,290 Investment securities available for sale, at fair value 4,166,760 3,415,574 3,773,784 Loans held for sale 72,266 390,332 104,336 Loans 10,830,627 10,289,242 10,291,810 Allowance for loan losses (175,007) (176,223) (177,622) -------------------------------------------- Loans, net 10,655,620 10,113,019 10,114,188 Premises and equipment 131,288 131,873 131,315 Goodwill 232,564 224,388 224,388 Other intangible assets 69,863 58,565 63,509 Other assets 447,115 414,246 436,510 -------------------------------------------- Total assets $ 16,135,761 $ 15,114,169 $ 15,247,894 ============================================ LIABILITIES AND STOCKHOLDERS' EQUITY Noninterest-bearing demand deposits $ 1,867,905 $ 1,804,596 $ 1,814,446 Interest-bearing deposits, excluding brokered certificates of deposit 7,623,042 7,673,766 7,813,267 Brokered certificates of deposit 186,326 156,994 165,130 -------------------------------------------- Total deposits 9,677,273 9,635,356 9,792,843 Short-term borrowings 2,956,626 2,049,833 1,928,876 Long-term funding 1,911,797 1,993,104 2,034,160 Accrued expenses and other liabilities 136,600 134,928 143,588 -------------------------------------------- Total liabilities 14,682,296 13,813,221 13,899,467 Stockholders' equity Preferred stock -- -- -- Common stock (par value $0.01 per share, authorized 250,000,000 shares, issued 110,458,038, 110,375,547 and 110,163,832 shares, respectively) 1,105 736 734 Surplus 585,274 580,823 575,975 Retained earnings 824,909 695,076 724,356 Accumulated other comprehensive income 49,265 36,310 52,089 Deferred compensation (1,981) (1,744) (1,981) Treasury stock, at cost (177,312, 460,206 and 122,863 shares, respectively) (5,107) (10,253) (2,746) -------------------------------------------- Total stockholders' equity 1,453,465 1,300,948 1,348,427 -------------------------------------------- Total liabilities and stockholders' equity $ 16,135,761 $ 15,114,169 $ 15,247,894 ============================================ See accompanying notes to consolidated financial statements.
3 ITEM 1. Financial Statements Continued: ASSOCIATED BANC-CORP Consolidated Statements of Income (Unaudited)
Three Months Ended Nine Months Ended September 30, September 30, 2004 2003 2004 2003 ----------------------------------------------- (In Thousands, except per share data) INTEREST INCOME Interest and fees on loans $ 142,389 $ 145,246 $ 415,090 $ 441,527 Interest and dividends on investment securities and deposits with other financial institutions: Taxable 31,590 26,710 93,389 79,430 Tax exempt 10,255 9,825 30,757 29,822 Interest on federal funds sold and securities purchased under agreements to resell 241 38 336 127 ---------------------------------------------- Total interest income 184,475 181,819 539,572 550,906 INTEREST EXPENSE Interest on deposits 27,191 30,327 81,401 93,875 Interest on short-term borrowings 10,262 6,757 24,042 23,766 Interest on long-term funding 13,806 15,759 39,959 49,640 ---------------------------------------------- Total interest expense 51,259 52,843 145,402 167,281 ---------------------------------------------- NET INTEREST INCOME 133,216 128,976 394,170 383,625 Provision for loan losses -- 12,118 11,065 37,210 ---------------------------------------------- Net interest income after provision for loan losses 133,216 116,858 383,105 346,415 NONINTEREST INCOME Trust service fees 7,773 7,001 23,684 21,427 Service charges on deposit accounts 13,672 13,338 39,210 37,611 Mortgage banking 6,593 21,671 24,664 73,284 Credit card and other nondeposit fees 6,253 5,435 17,998 18,023 Retail commission income 11,925 6,830 34,444 17,540 Bank owned life insurance income 3,580 3,532 10,576 10,373 Asset sale gains, net 309 871 749 203 Investment securities gains (losses), net (6) 1 1,356 702 Other 3,034 3,245 8,908 14,795 ---------------------------------------------- Total noninterest income 53,133 61,924 161,589 193,958 NONINTEREST EXPENSE Personnel expense 53,467 53,080 159,355 153,649 Occupancy 6,939 7,101 21,275 21,367 Equipment 3,022 3,178 8,899 9,612 Data processing 5,865 6,322 17,666 17,542 Business development and advertising 3,990 4,113 10,704 11,029 Stationery and supplies 1,214 1,651 3,869 4,964 Mortgage servicing rights expense 5,975 4,199 10,379 28,818 Intangible amortization expense 935 871 2,651 2,091 Loan expense 1,152 1,806 4,208 6,104 Other 12,447 13,486 39,275 39,372 ---------------------------------------------- Total noninterest expense 95,006 95,807 278,281 294,548 ---------------------------------------------- Income before income taxes 91,343 82,975 266,413 245,825 Income tax expense 27,977 24,589 78,982 72,777 ---------------------------------------------- NET INCOME $ 63,366 $ 58,386 $ 187,431 $ 173,048 ============================================== Earnings per share: Basic $ 0.58 $ 0.53 $ 1.70 $ 1.56 Diluted $ 0.57 $ 0.52 $ 1.68 $ 1.55 Average shares outstanding: Basic 110,137 110,209 110,182 110,837 Diluted 111,699 111,485 111,614 111,894
See accompanying notes to consolidated financial statements. 4 ITEM 1. Financial Statements Continued: ASSOCIATED BANC-CORP Consolidated Statement of Changes in Stockholders' Equity (Unaudited)
Accumulated Other Common Retained Comprehensive Deferred Treasury Stock Surplus Earnings Income Compensation Stock Total ---------------------------------------------------------------------------------------- (In Thousands, except per share data) Balance, December 31, 2003 $ 734 $ 575,975 $ 724,356 $ 52,089 $ (1,981) $ (2,746) $ 1,348,427 Comprehensive income: Net income -- -- 187,431 -- -- -- 187,431 Net unrealized losses on derivative instruments arising during the period, net of taxes of $1.3 million -- -- -- (1,467) -- -- (1,467) Add: reclassification adjustment to interest expense for interest differential, net of taxes of $2.3 million -- -- -- 2,891 -- -- 2,891 Net unrealized losses on available for sale securities arising during the period, net of taxes of $2.4 million -- -- -- (3,380) -- -- (3,380) Less: reclassification adjustment for net gains on available for sale securities realized in net income, net of taxes of $0.5 million -- -- -- (868) -- -- (868) ------- Comprehensive income 184,607 ------- Cash dividends, $0.7267 per share -- -- (80,066) -- -- -- (80,066) Common stock issued: Incentive stock options 2 5,474 (6,812) -- -- 18,473 17,137 3-for-2 stock split effected in the form of a stock dividend 369 (369) -- -- -- -- -- Purchase of treasury stock -- -- -- -- -- (20,834) (20,834) Tax benefit of stock options -- 4,194 -- -- -- -- 4,194 ---------------------------------------------------------------------------------------- Balance, September 30, 2004 $1,105 $585,274 $824,909 $49,265 $(1,981) $(5,107) $1,453,465 ========================================================================================
See accompanying notes to consolidated financial statements. 5 ITEM 1. Financial Statements Continued: ASSOCIATED BANC-CORP Consolidated Statements Of Cash Flows (Unaudited)
For the Nine Months Ended September 30, 2004 2003 --------------------------- ($ in Thousands) CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 187,431 $ 173,048 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 11,065 37,210 Depreciation and amortization 11,697 12,397 Provision for (recovery of) valuation allowance on mortgage servicing rights, net (2,204) 15,832 Amortization (accretion) of: Mortgage servicing rights 12,583 12,986 Intangible assets 2,651 2,091 Investment premiums and discounts 17,916 15,546 Deferred loan fees and costs (13) (659) Gain on sales of securities, net (1,356) (702) Gain on sales of assets, net (749) (203) Gain on sales of loans held for sale, net (9,698) (52,843) Mortgage loans originated and acquired for sale (1,192,729) (3,749,288) Proceeds from sales of mortgage loans held for sale 1,234,497 3,717,635 Increase in interest receivable and other assets (5,152) (15,590) Increase (decrease) in interest payable and other liabilities 3,893 (20,996) -------------------------- Net cash provided by operating activities 269,832 146,464 -------------------------- CASH FLOWS FROM INVESTING ACTIVITIES Net increase in loans (564,471) (19,168) Capitalization of mortgage servicing rights (13,457) (33,158) Purchases of: Securities available for sale (973,226) (1,180,342) Premises and equipment, net of disposals (8,330) (10,256) Proceeds from: Sales of securities available for sale 31,021 1,264 Maturities and paydowns of securities available for sale 530,979 1,073,622 Sales of other real estate owned and other assets 8,424 14,491 Net cash paid in business combinations (17,457) (18,025) -------------------------- Net cash used in investing activities (1,006,517) (171,572) -------------------------- CASH FLOWS FROM FINANCING ACTIVITIES Net increase (decrease) in deposits (108,694) 510,503 Net cash paid in sale of branch deposits (6,575) -- Net increase (decrease) in short-term borrowings 1,027,750 (339,773) Repayment of long-term funding (881,692) (507,876) Proceeds from issuance of long-term funding 750,080 407,364 Cash dividends (80,066) (73,232) Proceeds from exercise of incentive stock options 17,137 18,580 Purchase and retirement of treasury stock -- (68,567) Purchase of treasury stock (20,834) (732) -------------------------- Net cash provided by (used in) financing activities 697,106 (53,733) -------------------------- Net decrease in cash and cash equivalents (39,579) (78,841) Cash and cash equivalents at beginning of period 399,864 445,013 -------------------------- Cash and cash equivalents at end of period $ 360,285 $ 366,172 ========================== Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 145,463 $ 173,100 Income taxes 61,237 83,553 Supplemental schedule of noncash investing activities: Loans transferred to other real estate 7,744 10,100
See accompanying notes to consolidated financial statements. 6 ITEM 1. Financial Statements Continued: ASSOCIATED BANC-CORP Notes to Consolidated Financial Statements These interim consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission and, therefore, certain information and footnote disclosures normally presented in accordance with U.S. generally accepted accounting principles have been omitted or abbreviated. The information contained in the consolidated financial statements and footnotes in Associated Banc-Corp's 2003 annual report on Form 10-K, should be referred to in connection with the reading of these unaudited interim financial statements. NOTE 1: Basis of Presentation In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly the financial position, results of operations, changes in stockholders' equity, and cash flows of Associated Banc-Corp (individually referred to herein as the "Parent Company," and together with all of its subsidiaries and affiliates, collectively referred to herein as the "Corporation") for the periods presented, and all such adjustments are of a normal recurring nature. The consolidated financial statements include the accounts of all subsidiaries. All material intercompany transactions and balances have been eliminated. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full year. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses, mortgage servicing rights, derivative financial instruments and hedging activities, and income taxes. On April 28, 2004, the Board of Directors declared a 3-for-2 stock split, effected in the form of a stock dividend, payable on May 12, 2004, to shareholders of record at the close of business on May 7, 2004. Any fractional shares resulting from the stock split were paid in cash. All share and per share information has been restated to reflect the effect of this stock split (see Note 4). NOTE 2: Reclassifications Certain items in the prior period consolidated financial statements have been reclassified to conform with the September 30, 2004 presentation. NOTE 3: New Accounting Pronouncements In December 2003, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 132 (revised December 2003), "Employers' Disclosures about Pensions and Other Postretirement Benefits, an amendment of FASB Statements No. 87, 88, and 106," ("SFAS 132"). SFAS 132 revises employers' disclosures about pension plans and other postretirement benefit plans. This Statement does not change the measurement or recognition of pension plans and other postretirement benefit plans required by FASB Statements No. 87, "Employers' Accounting for Pensions," No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits," and No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The revised SFAS 132 retains the disclosure requirements contained in the original SFAS 132 and requires additional disclosures about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. In general, the annual provisions of SFAS 132 are effective for fiscal years ending after December 15, 2003, and the interim-period disclosures are effective for interim periods 7 beginning after December 15, 2003. See Note 11 for further discussion of the Corporation's retirement plans. The adoption had no material impact on the Corporation's results of operations, financial position, or liquidity. In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"). This interpretation provides guidance on how to identify a variable interest entity and determine when the assets, liabilities, noncontrolling interests, and results of operations of a variable interest entity are to be included in an entity's consolidated financial statements. A variable interest entity exists when either the total equity investment at risk is not sufficient to permit the entity to finance its activities by itself, or the equity investors lack one of three characteristics associated with owning a controlling financial interest. Those characteristics include the direct or indirect ability to make decisions about an entity's activities through voting rights or similar rights, the obligation to absorb the expected losses of an entity if they occur, or the right to receive the expected residual returns of the entity if they occur. The adoption had no material impact on the Corporation's results of operations, financial position, or liquidity. In December 2003, the FASB reissued FIN 46 ("FIN 46R") with certain modifications and clarifications. Application of FIN 46R was effective for interests in certain variable interest entities as of December 31, 2003, and for all other types of variable interest entities for periods ending after March 15, 2004, unless FIN 46 was previously applied. Under the application of FIN 46R a previously consolidated subsidiary relating to the issuance of trust preferred securities was deconsolidated in the first quarter of 2004. See Note 7 for further discussion of this trust and the Corporation's related obligations. The adoption had no material impact on the Corporation's results of operations, financial position, or liquidity. In March 2004, the SEC issued Staff Accounting Bulletin ("SAB") No. 105, "Application of Accounting Principles to Loan Commitments," ("SAB 105"). SAB 105 provides guidance regarding loan commitments accounted for as derivative instruments. Specifically, SAB 105 requires servicing assets to be recognized only once the servicing asset has been contractually separated from the underlying loan by sale or securitization of the loan with servicing retained. As such, consideration for the expected future cash flows related to the associated servicing of the loan may not be recognized in valuing the loan commitment. This will result in a lower fair value mark of loan commitments, and recognition of the value of the servicing asset later upon sale or securitization of the underlying loan. The provisions of SAB 105 were effective for loan commitments accounted for as derivatives entered into after March 31, 2004. The adoption of SAB 105 had no material impact on the Corporation's results of operations, financial position, or liquidity. See Note 8 for further discussion of the Corporation's loan commitments accounted for as derivative instruments. In March 2004, the FASB ratified the consensus reached by the Emerging Issues Task Force in Issue 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," ("EITF 03-1"). EITF 03-1 provides guidance for determining when an investment is considered impaired, whether impairment is other-than-temporary, and measurement of an impairment loss. An investment is considered impaired if the fair value of the investment is less than its cost. Generally, an impairment is considered other-than-temporary unless the investor has the ability and intent to hold an investment for a reasonable period of time sufficient for a forecasted recovery of fair value up to (or beyond) the cost of the investment, and evidence indicating that the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary. If impairment is determined to be other-than-temporary, then an impairment loss should be recognized through earnings equal to the difference between the investment's cost and its fair value. In September 2004, the FASB delayed the accounting requirements of EITF 03-1 until additional implementation guidance is issued and goes into effect. The Corporation does not expect the requirements of EITF 03-1 will have a material impact on the Corporation's results of operations, financial position, or liquidity. In December 2003, the AICPA's Accounting Standards Executive Committee issued Statement of Position ("SOP") 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer," ("SOP 03-3"). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part, to credit quality. The provisions of this SOP are effective for 8 loans acquired in fiscal years beginning after December 15, 2004. The Corporation does not expect the requirements of SOP 03-3 to have a material impact on the results of operations, financial position, or liquidity. NOTE 4: Earnings Per Share Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per share is calculated by dividing net income by the weighted average number of shares adjusted for the dilutive effect of outstanding stock options. Presented below are the calculations for basic and diluted earnings per share.
Three Months Ended Nine Months Ended September 30, September 30, 2004 2003 2004 2003 ------------------------------------------------ (In Thousands, except per share data) Net income $ 63,366 $ 58,386 $ 187,431 $ 173,048 ================================================ Weighted average shares outstanding 110,137 110,209 110,182 110,837 Effect of dilutive stock options outstanding 1,562 1,276 1,432 1,057 ------------------------------------------------ Diluted weighted average shares outstanding 111,699 111,485 111,614 111,894 ================================================ Basic earnings per share $ 0.58 $ 0.53 $ 1.70 $ 1.56 ================================================ Diluted earnings per share $ 0.57 $ 0.52 $ 1.68 $ 1.55 ================================================
NOTE 5: Business Combinations Completed Business Combinations: ------------------------------- On April 1, 2004, the Corporation (through its subsidiary Associated Financial Group, LLC) consummated its cash acquisition of 100% of the outstanding shares of Jabas Group, Inc. ("Jabas"). Jabas is an insurance agency specializing in employee benefit products headquartered in Kimberly, Wisconsin, and was acquired to enhance the Corporation's existing insurance business. Jabas operates as part of Associated Financial Group, LLC. The acquisition was accounted for under the purchase method of accounting. Goodwill of approximately $8 million and other intangibles of approximately $6 million recognized in the transaction at acquisition were assigned to the wealth management segment. In addition, goodwill may increase in the future as contingent payments may be made to the former Jabas shareholders through December 31, 2007, if Jabas exceeds certain performance targets. On April 1, 2003, the Corporation consummated its cash acquisition of 100% of the outstanding shares of CFG Insurance Services, Inc. ("CFG"), a closely-held insurance agency headquartered in Minnetonka, Minnesota. Effective in June 2003, CFG operated as Associated Financial Group, LLC. CFG, an independent, full-line insurance agency, was acquired to enhance the growth of the Corporation's existing insurance business. The acquisition was accounted for under the purchase method of accounting; thus, the results of operations of CFG prior to the consummation date were not included in the accompanying consolidated financial statements. The acquisition was individually immaterial to the consolidated financial results. Goodwill of approximately $12 million and other intangibles of approximately $15 million recognized in the transaction at acquisition were assigned to the wealth management segment. Business Combination Completed Subsequent to September 30, 2004: --------------------------------------------------------------- On October 29, 2004, the Corporation consummated its acquisition of 100% of the outstanding shares of First Federal Capital Corp ("First Federal"), based in La Crosse, Wisconsin. The acquisition will be accounted for under the purchase method and was, therefore, appropriately not included in the consolidated financial statements herewith, but will be included in the Corporation's financial results effective upon the date of acquisition and thereafter. The Corporation is in the process of recording the transaction and assigning fair values of the assets acquired and liabilities assumed. The excess cost of the acquisition over the fair value of the net assets acquired will be allocated to the identifiable intangible assets with the remainder then 9 allocated to goodwill. Thus, at the time of this filing it is not practicable to provide detailed updated financial information on the transaction. Any specific transaction results disclosed in the paragraphs below should be considered to be best estimates available at the time of this filing and subject to change upon the completion of the recording of the transaction. As of September 30, 2004, First Federal operated a $3.7 billion savings bank with over 90 banking locations serving more than 40 communities in Wisconsin, northern Illinois, and southern Minnesota, building upon and complimenting the Corporation's footprint. As a result of the acquisition, the Corporation will enhance its current branch distribution (including supermarket locations which are new to the Corporation's distribution model), improve its operational and managerial efficiencies, increase revenue streams, and strengthen its community banking model. Per the definitive agreement signed on April 28, 2004 (the "Merger Agreement"), First Federal shareholders receive 0.9525 shares (restated for the Corporation's 3-for-2 stock split in May 2004) of the Corporation's common stock for each share of First Federal common stock held, an equivalent amount of cash, or a combination thereof. The Merger Agreement provides that the aggregate consideration paid by the Corporation for the First Federal outstanding common stock must be equal to 90% stock and 10% cash (including cash paid for fractional shares), with the cash consideration based upon the Corporation's closing stock price on the effective date of the merger. The Corporation's closing stock price on October 29, 2004 was $34.69 per share. The value of the common stock consideration is based upon the Corporation's average market price surrounding the date of signing and announcing the definitive agreement. Based upon the aforementioned values for the 90% stock/10% cash, the consummation of the transaction included the issuance of approximately 19.4 million shares of common stock (valued at approximately $535 million) and $75 million in cash. The preliminary amount of goodwill is estimated to range from $450 million to $470 million. NOTE 6: Goodwill and Other Intangible Assets Goodwill: -------- Goodwill is not amortized, but is subject to impairment tests on at least an annual basis. No impairment loss was incurred in 2003 or through September 30, 2004. At September 30, 2004, goodwill of $212 million is assigned to the banking segment and goodwill of $21 million is assigned to the wealth management segment. The change in the carrying amount of goodwill was as follows.
As of and for the As of and for the nine months ended year ended September 30, 2004 September 30, 2003 December 31, 2003 --------------------------------------------------------------------- Goodwill: ($ in Thousands) --------- Balance at beginning of period $ 224,388 $ 212,112 $ 212,112 Goodwill acquired 8,176 12,276 12,276 --------------------------------------------------------------------- Balance at end of period $ 232,564 $ 224,388 $ 224,388 =====================================================================
Other Intangible Assets: ----------------------- The Corporation has other intangible assets that are amortized, consisting of core deposit intangibles, other intangibles (primarily related to customer relationships acquired in connection with the CFG and Jabas acquisitions), and mortgage servicing rights. The core deposit intangibles and mortgage servicing rights are assigned to the banking segment, while the other intangibles are assigned to the wealth management segment. 10 For core deposit intangibles and other intangibles, changes in the gross carrying amount, accumulated amortization, and net book value were as follows:
As of and for the As of and for the nine months ended year ended September 30, 2004 September 30, 2003 December 31, 2003 ---------------------------------------------------------------------- ($ in Thousands) Core deposit intangibles: (1) ------------------------ Gross carrying amount $ 16,783 $ 28,165 $ 28,165 Accumulated amortization (10,497) (20,212) (20,682) ---------------------------------------------------------------------- Net book value $ 6,286 $ 7,953 $ 7,483 ====================================================================== Amortization during the period $ (1,197) $ (1,289) $ (1,759) Other intangibles: Gross carrying amount $ 20,678 $ 14,751 $ 14,751 Accumulated amortization (2,656) (802) (1,202) ---------------------------------------------------------------------- Net book value $ 18,022 $ 13,949 $ 13,549 ====================================================================== Additions during the period $ 5,927 $ 14,751 $ 14,751 Amortization during the period (1,454) (802) (1,202) (1) Core deposit intangibles of $11.4 million were fully amortized during 2003 and were removed from both the gross carrying amount and the accumulated amortization effective January 1, 2004.
Mortgage servicing rights are amortized in proportion to and over the period of estimated servicing income. Mortgage servicing rights are carried on the balance sheet at the lower of cost or estimated market value. A valuation allowance is established to the extent the carrying value of the mortgage servicing rights exceeds the estimated fair value by stratification. The Corporation periodically evaluates its mortgage servicing rights asset for impairment and resulting additions to or reversals from the valuation allowance are recognized. An other-than-temporary impairment is recognized as a write-down of the mortgage servicing rights asset and the related valuation allowance (to the extent valuation allowance is available) and then against earnings. Given changes in interest rates, especially the extended period of historically low interest rates experienced during 2003, and the impact on mortgage banking volumes, refinances, prepayment speeds, and secondary markets, the Corporation evaluated its mortgage servicing rights asset for possible other-than-temporary impairment. As a result, $5.5 million and $15.6 million was determined to be other-than-temporarily impaired for the nine months ended September 30, 2004 and 2003, respectively, and $18.1 million for the year ended December 31, 2003. A summary of changes in the balance of the mortgage servicing rights asset and the mortgage servicing rights valuation allowance was as follows.
As of and for the As of and for the nine months ended year ended September 30, 2004 September 30, 2003 December 31, 2003 ---------------------------------------------------------------------- Mortgage servicing rights: ($ in Thousands) -------------------------- Mortgage servicing rights at beginning of period $ 65,062 $ 60,685 $ 60,685 Additions 13,457 33,158 39,707 Amortization (12,583) (12,986) (17,212) Other-than-temporary impairment (5,518) (15,583) (18,118) ----------------------------------------------------------------------- Mortgage servicing rights at end of period 60,418 65,274 65,062 ----------------------------------------------------------------------- Valuation allowance at beginning of period (22,585) (28,362) (28,362) Additions (4,450) (15,832) (15,832) Reversals 6,654 -- 3,491 Other-than-temporary impairment 5,518 15,583 18,118 ----------------------------------------------------------------------- Valuation allowance at end of period (14,863) (28,611) (22,585) ----------------------------------------------------------------------- Mortgage servicing rights, net $ 45,555 $ 36,663 $ 42,477 =======================================================================
11 At September 30, 2004, the Corporation was servicing one- to four- family residential mortgage loans owned by other investors with balances totaling $6.01 billion, compared to $5.59 billion and $5.93 billion at September 30 and December 31, 2003, respectively. The fair value of servicing was approximately $45.6 million (representing 76 basis points ("bp") of loans serviced) at September 30, 2004, compared to $36.7 million (or 66 bp of loans serviced) at September 30, 2003 and $42.5 million (or 72 bp of loans serviced) at December 31, 2003. Mortgage servicing rights expense, which includes the amortization of mortgage servicing rights and increases or decreases to the valuation allowance associated with the mortgage servicing rights, was $10.4 million and $28.8 million for the nine months ended September 30, 2004 and 2003, respectively, and $29.6 million for the year ended December 31, 2003. The following table shows the estimated future amortization expense for amortizing intangible assets. The projections of amortization expense for the next five years are based on existing asset balances, the current interest rate environment, and prepayment speeds as of September 30, 2004. The actual amortization expense the Corporation recognizes in any given period may be significantly different depending upon changes in interest rates, market conditions, regulatory requirements, and events or circumstances that indicate the carrying amount of an asset may not be recoverable. Estimated amortization expense:
Core Deposit Mortgage Intangibles Other Intangibles Servicing Rights ----------------------------------------------------- ($ in Thousands) Three months ending December 31, 2004 $ 300 $ 500 $ 4,000 Year ending December 31, 2005 1,000 1,800 14,200 Year ending December 31, 2006 1,000 1,400 11,700 Year ending December 31, 2007 1,000 1,300 9,500 Year ending December 31, 2008 1,000 1,200 7,500 =====================================================
NOTE 7: Long-term Funding Long-term funding was as follows:
September 30, September 30, December 31, 2004 2003 2003 ------------------------------------------ ($ in Thousands) Federal Home Loan Bank advances $ 712,048 $ 912,386 $ 912,138 Bank notes 300,000 350,000 300,000 Repurchase agreements 500,000 329,175 429,175 Subordinated debt, net 205,664 208,171 204,351 Junior subordinated debentures, net 187,493 -- -- Other borrowed funds 6,592 6,584 6,555 ----------------------------------------- Total long-term debt $ 1,911,797 $ 1,806,316 $ 1,852,219 Company-obligated mandatorily redeemable preferred securities, net -- 186,788 181,941 ----------------------------------------- Total long-term funding $ 1,911,797 $ 1,993,104 $ 2,034,160 ==========================================
Federal Home Loan Bank advances: ------------------------------- Long-term advances from the Federal Home Loan Bank had maturities through 2017 and had weighted-average interest rates of 2.78% at September 30, 2004, and 2.96% at both September 30 and December 31, 2003. These advances had a combination of fixed and variable rates, of which 65% was fixed rate at September 30, 2004 and 95% was fixed rate at both September 30 and December 31, 2003. 12 Bank notes: ---------- The long-term bank notes had maturities through 2007 and had weighted-average interest rates of 2.43% at September 30, 2004, 2.07% at September 30, 2003, and 2.20% at December 31, 2003. These notes had a combination of fixed and variable rates. Repurchase agreements: --------------------- The long-term repurchase agreements had maturities through 2007 and had weighted-average interest rates of 1.76% and 1.97% at September 30, 2004 and 2003, respectively, and 1.67% at December 31, 2003. These repurchase agreements had a combination of fixed and variable rates, predominantly fixed. Subordinated debt: ----------------- In August 2001, the Corporation issued $200 million of 10-year subordinated debt. This debt was issued at a discount and has a fixed coupon interest rate of 6.75%. The Corporation also entered into a fair value hedge to hedge the interest rate risk on the subordinated debt. As of September 30, 2004, September 30, 2003, and December 31, 2003, the fair value of the derivative was a $6.7 million gain, a $9.3 million gain, and a $5.5 million gain, respectively. Given the fair value hedge, subordinated debt is carried on the consolidated balance sheet at fair value. The subordinated debt qualifies under the risk-based capital guidelines as Tier 2 supplementary capital for regulatory purposes. Junior subordinated debentures and Company-obligated Mandatorily Redeemable Preferred Securities: --------------------- On May 30, 2002, ASBC Capital I (the "ASBC Trust"), a Delaware business trust whose common stock was wholly owned by the Corporation, completed the sale of $175 million of 7.625% preferred securities (the "Preferred Securities"). The Preferred Securities are traded on the New York Stock Exchange under the symbol "ABW PRA." The ASBC Trust used the proceeds from the offering to purchase a like amount of 7.625% Junior Subordinated Debentures (the "Debentures") of the Corporation. The Debentures are the sole assets of the ASBC Trust and were eliminated, along with the related income statement effects, in the consolidated financial statements for 2003 and prior years. Effective in the first quarter of 2004, in accordance with guidance provided on the application of FIN 46R, the Corporation was required to deconsolidate the ASBC Trust from its consolidated financial statements. Accordingly, the Debentures issued by the Corporation to ASBC Trust (as opposed to the trust preferred securities issued by the ASBC Trust) are reflected in the Corporation's consolidated balance sheet as long-term funding. The deconsolidation of the net assets and results of operations of this trust did not have a material impact on the Corporation's financial statements since the Corporation continues to be obligated to repay the Debentures held by the ASBC Trust and guarantees repayment of the Preferred Securities issued by the ASBC Trust. The consolidated long-term funding obligation related to the ASBC Trust increased from $175 million to $180 million upon deconsolidation, with the difference representing the Corporation's common ownership interest in the ASBC Trust recorded in investment securities available for sale. The Preferred Securities accrue and pay dividends quarterly at an annual rate of 7.625% of the stated liquidation amount of $25 per Preferred Security. The Corporation has fully and unconditionally guaranteed all of the obligations of the ASBC Trust. The guarantee covers the quarterly distributions and payments on liquidation or redemption of the Preferred Securities, but only to the extent of funds held by the ASBC Trust. The Preferred Securities are mandatorily redeemable upon the maturity of the Debentures on June 15, 2032, or upon earlier redemption as provided in the Indenture. The Corporation has the right to redeem the Debentures on or after May 30, 2007. The Preferred Securities qualify under the risk-based capital guidelines as Tier 1 capital for regulatory purposes within certain limitations. The Federal Reserve Board could re-evaluate the qualification of the preferred securities as Tier 1 capital at anytime. If it is determined that the preferred securities no longer qualify as Tier 1 capital, the effect of such a change is not expected to affect the Corporation's well-capitalized status. During 2002, the Corporation entered into a fair value hedge to hedge the interest rate risk on the Debentures. The fair value of the derivative was a $7.1 million gain at September 30, 2004, a $11.8 million gain at 13 September 30, 2003, and a $6.9 million gain at December 31, 2003. Given the fair value hedge, the Debentures are carried on the consolidated balance sheet at fair value. NOTE 8: Derivatives and Hedging Activities The Corporation uses derivative instruments primarily to hedge the variability in interest payments or protect the value of certain assets and liabilities recorded in its consolidated balance sheet from changes in interest rates. The predominant derivative and hedging activities include interest rate swaps, interest rate caps, and certain mortgage banking activities. Interest rate swaps are entered into primarily as an asset/liability management strategy to modify interest rate risk, while interest rate caps are entered into as interest rate protection instruments. The Corporation measures the effectiveness of its hedges on a periodic basis. Any difference between the fair value change of the hedge versus the fair value change of the hedged item is considered to be the "ineffective" portion of a fair value hedge. The ineffective portion of a fair value hedge is recorded as an increase or decrease in the related income statement classification of the item being hedged. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings. For the mortgage derivatives, which are not accounted for as hedges, changes in the fair value are recorded as adjustments to mortgage banking income.
Estimated Fair Notional Market Value Weighted Average Amount Gain/(Loss) Receive Rate Pay Rate Maturity ---------------------------------------------------------------------- September 30, 2004 ($ in Thousands) ------------------ Interest Rate Risk Management hedges: Swaps-receive variable / pay fixed (1), (3) $ 200,000 $ (17,742) 1.59% 5.03% 80 months Swaps-receive fixed / pay variable (2), (4) 375,000 13,771 7.21% 3.51% 202 months Swaps-receive variable / pay fixed (2), (5) 297,436 (5,633) 3.90% 6.34% 47 months Caps-written (1), (3) 200,000 210 Strike 4.72% -- 23 months ====================================================================== September 30, 2003 Interest Rate Risk Management hedges: Swaps-receive variable / pay fixed (1), (3) $ 200,000 $ (25,890) 1.11% 5.03% 92 months Swaps-receive fixed / pay variable (2), (4) 375,000 21,136 7.21% 2.77% 214 months Swaps-receive variable / pay fixed (2), (5) 365,063 (14,624) 3.29% 6.29% 53 months Caps-written (1), (3) 200,000 1,298 Strike 4.72% -- 35 months ====================================================================== (1) Cash flow hedges (2) Fair value hedges (3) Hedges variable rate long-term debt (4) Hedges fixed rate long-term debt (5) Hedges specific longer-term fixed rate commercial loans
Not included in the above table were customer swaps and caps with a notional amount of $110.1 million and $31.1 million as of September 30, 2004 and 2003, respectively, for which the Corporation has mirror swaps and caps. The change in fair value of the customer swaps and caps, and the mirror swaps and caps is recorded in earnings. The net impact of these swaps and caps for 2004 and 2003 was immaterial. Commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans represent the Corporation's mortgage derivatives, the fair value of which are included in other liabilities on the consolidated balance sheets. The net fair value of the mortgage derivatives at September 30, 2004, was a $1.0 million loss, compared to a $1.3 million loss at September 30, 2003. The net fair value change is recorded in mortgage banking income in the consolidated statements of income. The $1.0 million net fair value loss on mortgage derivatives at September 30, 2004, is composed of the net loss on commitments to fund approximately $146 million of loans to individual borrowers and the net loss on commitments to sell approximately $152 million of loans to various investors. The $1.3 million net fair value loss on mortgage derivatives at September 30, 2003, is comprised of the net gain on commitments to fund approximately $226 million of loans to individual borrowers and the net loss on commitments to sell 14 approximately $432 million of loans to various investors. As previously discussed in Note 3, the Corporation adopted SAB 105 effective April 1, 2004. NOTE 9: Contractual Obligations, Commitments, Off-Balance Sheet Risk, and Contingent Liabilities Commitments and Off-Balance Sheet Risk -------------------------------------- The Corporation utilizes a variety of financial instruments in the normal course of business to meet the financial needs of its customers and to manage its own exposure to fluctuations in interest rate. These financial instruments include lending-related commitments. Lending-related Commitments --------------------------- Through the normal course of operations, the Corporation has entered into certain contractual obligations and other commitments. As a financial services provider the Corporation routinely enters into commitments to extend credit. While contractual obligations represent future cash requirements of the Corporation, a significant portion of commitments to extend credit may expire without being drawn upon. Such commitments are subject to the same credit policies and approval process accorded to loans made by the Corporation. Lending-related commitments include commitments to extend credit, commitments to originate residential mortgage loans held for sale, commercial letters of credit, and standby letters of credit. Commitments to extend credit are agreements to lend to customers at predetermined interest rates as long as there is no violation of any condition established in the contracts. Commercial and standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. Commercial letters of credit are issued specifically to facilitate commerce and typically result in the commitment being drawn on when the underlying transaction is consummated between the customer and the third party, while standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of the underlying contract with the third party. Under SFAS 133, commitments to originate residential mortgage loans held for sale and forward commitments to sell residential mortgage loans are defined as derivatives and are therefore required to be recorded on the consolidated balance sheet at fair value. The Corporation's derivative and hedging activities are further summarized in Note 8. The following is a summary of lending-related commitments. September 30, ---------------------------- 2004 2003 ---------------------------- ($ in Thousands) Commitments to extend credit, excluding commitments to originate mortgage loans (1) $ 3,934,750 $ 3,597,438 Commercial letters of credit (1) 16,632 44,241 Standby letters of credit (2) 396,907 306,610 (1) These off-balance sheet financial instruments are exercisable at the market rate prevailing at the date the underlying transaction will be completed and thus are deemed to have no current fair value, or the fair value is based on fees currently charged to enter into similar agreements and is not material at September 30, 2004 or 2003. (2) As required by FASB Interpretation No. 45, an interpretation of FASB Statements No. 5, 57, and 107, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others," the Corporation has established a liability in other liabilities on the consolidated balance sheet of $3.7 million and $1.7 million at September 30, 2004 and 2003, respectively, as an estimate of the fair value of these financial instruments. The Corporation's exposure to credit loss in the event of nonperformance by the other party to these financial instruments is represented by the contractual amount of those instruments. The commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for extending loans to customers. The Corporation evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Corporation upon extension of credit, is based on management's credit evaluation of the customer. Since many of the commitments are expected to expire 15 without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Contingent Liabilities ---------------------- In the ordinary course of business, the Corporation may be named as defendant in or be a party to various pending and threatened legal proceedings. In view of the intrinsic difficulty in ascertaining the outcome of such matters, the Corporation cannot state what the eventual outcome of any such proceeding will be. Management believes, based upon discussions with legal counsel and current knowledge, that liabilities arising out of any such proceedings (if any) will not have a material adverse effect on the consolidated financial position, results of operations, or liquidity of the Corporation. A contingent liability is required to be established if it is probable that the Corporation will incur a loss on the performance of a letter of credit. During the second quarter of 2003, given the deterioration of the financial condition of a borrower, the Corporation established a $2.5 million liability for standby letters of credit, of which $0.9 million remained at September 30, 2004. NOTE 10: Stock-Based Compensation As allowed under SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), the Corporation accounts for stock-based compensation cost under the intrinsic value method of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), and related Interpretations, under which no compensation cost has been recognized for any periods presented, except with respect to restricted stock awards. 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, as such options would have no intrinsic value at the date of grant. The Corporation may issue common stock with restrictions to certain key employees. The shares are restricted as to transfer, but are not restricted as to dividend payment or voting rights. Transfer restrictions lapse over three or five years, depending upon whether the award is fixed or performance-based, are contingent upon continued employment, and for performance awards are based on earnings per share performance goals. The Corporation amortizes the expense over the vesting period. During the second quarter of 2003, 75,000 restricted stock shares were awarded. Expense on the restricted stock of approximately $564,000 and $259,000 was recorded for the nine months ended September 30, 2004 and 2003, respectively, and expense of approximately $211,000 and $158,000 was recorded for the three months ended September 30, 2004 and 2003, respectively. For purposes of providing the pro forma disclosures required under SFAS 123, the fair value of stock options granted in the comparable three and nine month periods ended September 30, 2004 and 2003 was estimated at the date of grant using a Black-Scholes option pricing model which was originally developed for use in estimating the fair value of traded options which have different characteristics from the Corporation's employee stock options. The model is also sensitive to changes in the subjective assumptions that can materially affect the fair value estimate. As a result, management believes the Black-Scholes model may not necessarily provide a reliable single measure of the fair value of employee stock options. The following table illustrates the effect on net income and earnings per share if the Corporation had applied the fair value recognition provisions of SFAS 123. 16
For the Three Months For the Nine Months Ended September 30, Ended September 30, ------------------------------------------------ 2004 2003 2004 2003 ------------------------------------------------ ($ in Thousands, except per share amounts) Net income, as reported $ 63,366 $ 58,386 $ 187,431 $ 173,048 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 127 95 338 155 Less: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects ( 1,026) (710) (3,006) (2,137) ---------------------------------------------- Net income, as adjusted $ 62,467 $ 57,771 $ 184,763 $ 171,066 ============================================== Basic earnings per share, as reported $ 0.58 $ 0.53 $ 1.70 $ 1.56 Less: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects (0.01) (0.01) (0.03) (0.02) ---------------------------------------------- Basic earnings per share, as adjusted $ 0.57 $ 0.52 $ 1.67 $ 1.54 ============================================== Diluted earnings per share, as reported $ 0.57 $ 0.52 $ 1.68 $ 1.55 Less: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects (0.01) (0.01) (0.03) (0.02) ---------------------------------------------- Diluted earnings per share, as adjusted $ 0.56 $ 0.51 $ 1.65 $ 1.53 ===============================================
The following assumptions were used in estimating the fair value for options granted in 2004 and 2003: 2004 2003 ------------------------------ Dividend yield 3.12% 3.59% Risk-free interest rate 3.59% 3.27% Weighted average expected life 7 yrs 7 yrs Expected volatility 27.98% 28.30% The weighted average per share fair values of options granted in the comparable nine-month periods of 2004 and 2003 were $6.97 and $5.06, respectively. The annual expense allocation methodology prescribed by SFAS 123 attributes a higher percentage of the reported expense to earlier years than to later years, resulting in accelerated expense recognition for proforma disclosure purposes. NOTE 11: Retirement Plans
Three Months Ended Nine Months Ended September 30, September 30, ---------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------- Components of Net Periodic Benefit Cost ($ in Thousands) ---------------------------------------- Service cost $ 1,673 $ 1,464 $ 5,020 $ 4,393 Interest cost 964 901 2,891 2,702 Expected return on plan assets (1,572) (1,325) (4,715) (3,976) Amortization of: Transition asset (81) (81) (243) (243) Prior service cost 19 19 56 56 Actuarial loss 93 18 278 55 --------------------------------------------- Total net periodic benefit cost $ 1,096 $ 996 $ 3,287 $ 2,987
As previously disclosed in its notes to consolidated financial statements for the year ended December 31, 2003, the Corporation does not expect to make a contribution to its pension plan in 2004. The Corporation regularly reviews the funding of its pension plans. Therefore, it is possible that after that review, the Corporation may decide to make a contribution to the pension plan at that time. 17 NOTE 12: Segment Reporting SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," requires selected financial and descriptive information about reportable operating segments. The statement uses a "management approach" concept as the basis for identifying reportable segments. The management approach is based on the way that management organizes the segments within the enterprise for making operating decisions, allocating resources, and assessing performance. Consequently, the segments are evident from the structure of the enterprise's internal organization, focusing on financial information that an enterprise's chief operating decision-makers use to make decisions about the enterprise's operating matters. The Corporation's primary segment is banking, conducted through its bank and lending subsidiaries. For purposes of segment disclosure under this statement, these have been combined as one segment, as these segments have similar economic characteristics and the nature of their products, services, processes, customers, delivery channels, and regulatory environment are similar. Banking includes: lending and deposit gathering to businesses (including commercial and specialized lending, lease financing, and other banking services to larger businesses and metro or niche markets, as well as business-related services such as cash management and international banking services) and to consumers (including mortgages, home equity lending, and card products) and the support to deliver such banking services. The Corporation's other segment is wealth management (including insurance, brokerage, and trust/asset management). The wealth management segment is included in "Other," along with intersegment eliminations and residual revenues and expenses, representing the difference between actual amounts incurred and the amounts allocated to operating segments. 18 Selected segment information is presented below.
Consolidated Banking Other Total ----------------------------------------------------------------------------------------- As of and for the nine months ended ($ in Thousands) September 30, 2004 Total assets $ 16,063,542 $ 72,219 $ 16,135,761 ============================================= Net interest income $ 393,912 $ 258 $ 394,170 Provision for loan losses 11,065 -- 11,065 Noninterest income 103,691 57,898 161,589 Depreciation and amortization 25,101 1,830 26,931 Other noninterest expense 212,524 38,826 251,350 Income taxes 75,911 3,071 78,982 --------------------------------------------- Net income $ 173,002 $ 14,429 $ 187,431 ============================================= As of and for the nine months ended September 30, 2003 Total assets $ 15,058,447 $ 55,722 $ 15,114,169 ============================================= Net interest income $ 383,177 $ 448 $ 383,625 Provision for loan losses 37,210 -- 37,210 Noninterest income 155,953 38,005 193,958 Depreciation and amortization 26,308 1,166 27,474 Other noninterest expense 236,501 30,573 267,074 Income taxes 72,872 (95) 72,777 --------------------------------------------- Net income $ 166,239 $ 6,809 $ 173,048 ============================================= ----------------------------------------------------------------------------------------- Consolidated Banking Other Total ----------------------------------------------------------------------------------------- As of and for the three months ended ($ in Thousands) September 30, 2004 Total assets $ 16,063,542 $ 72,219 $ 16,135,761 ============================================= Net interest income $ 133,175 $ 41 $ 133,216 Provision for loan losses -- -- -- Noninterest income 33,261 19,872 53,133 Depreciation and amortization 8,177 679 8,856 Other noninterest expense 72,292 13,858 86,150 Income taxes 27,095 882 27,977 --------------------------------------------- Net income $ 58,872 $ 4,494 $ 63,366 ============================================= As of and for the three months ended September 30, 2003 Total assets $ 15,058,447 $ 55,722 $ 15,114,169 ============================================= Net interest income $ 128,826 $ 150 $ 128,976 Provision for loan losses 12,118 -- 12,118 Noninterest income 48,766 13,158 61,924 Depreciation and amortization 8,674 526 9,200 Other noninterest expense 74,948 11,659 86,607 Income taxes 24,903 (314) 24,589 --------------------------------------------- Net income $ 56,949 $ 1,437 $ 58,386 ============================================= -----------------------------------------------------------------------------------------
19 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Special Note Regarding Forward-Looking Statements Statements made in this document and in documents that are incorporated by reference which are not purely historical are forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995, including any statements regarding descriptions of management's plans, objectives, or goals for future operations, products or services, and forecasts of its revenues, earnings, or other measures of performance. Forward-looking statements are based on current management expectations and, by their nature, are subject to risks and uncertainties. These statements may be identified by the use of words such as "believe," "expect," "anticipate," "plan," "estimate," "should," "will," "intend," or similar expressions. Shareholders should note that many factors, some of which are discussed elsewhere in this document and in the documents that are incorporated by reference, could affect the future financial results of the Corporation and could cause those results to differ materially from those expressed in forward-looking statements contained in this document or incorporated by reference in this document. These factors, many of which are beyond the Corporation's control, include the following: o operating, legal, and regulatory risks; o economic, political, and competitive forces affecting the Corporation's banking, securities, asset management, and credit services businesses; and o the risk that the Corporation's analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful. These factors should be considered in evaluating the forward-looking statements, and undue reliance should not be placed on such statements. Forward-looking statements speak only as of the date they are made. The Corporation undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Overview The following discussion and analysis is presented to assist in the understanding and evaluation of the Corporation's financial condition and results of operations. It is intended to complement the unaudited consolidated financial statements, footnotes, and supplemental financial data appearing elsewhere in this Form 10-Q and should be read in conjunction therewith. The detailed discussion focuses on the nine months ended September 30, 2004 and the comparable period in 2003. Discussion of third quarter 2004 results compared to third quarter 2003 is predominantly in section, "Comparable Third Quarter Results." The following discussion refers to the Corporation's business combination activity that may impact the comparability of certain financial data (see Note 5, "Business Combinations," of the notes to consolidated financial statements). In particular, consolidated financial results for the nine-months of 2004 reflect nine month's contribution from its April 1, 2003 acquisition of CFG and six month's contribution from its April 1, 2004 acquisition of Jabas, while consolidated financial results for 2003 reflect six month's contribution of CFG and no contribution from Jabas. On April 28, 2004, the Board of Directors declared a 3-for-2 stock split, effected in the form of a stock dividend, payable on May 12, 2004, to shareholders of record at the close of business on May 7, 2004. All share and per share information in the accompanying consolidated financial statements was restated to reflect the effect of this stock split. 20 Critical Accounting Policies In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Estimates that are particularly susceptible to significant change include the determination of the allowance for loan losses, mortgage servicing rights valuation, derivative financial instruments and hedging activities, and income taxes. The consolidated financial statements of the Corporation are prepared in conformity with U.S. generally accepted accounting principles and follow general practices within the industries in which it operates. This preparation 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, actual results could differ from the estimates, assumptions, and judgments reflected in the financial statements. 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. Management believes the following policies are both important to the portrayal of the Corporation's financial condition and results and require subjective or complex judgments and, therefore, management considers the following to be critical accounting policies. The critical accounting policies are discussed directly with the Audit Committee of the Corporation. Allowance for Loan Losses: ------------------------- Management's evaluation process used to determine the adequacy of the allowance for loan losses is subject to the use of estimates, assumptions, and judgments. The evaluation process combines several factors: management's ongoing review and grading of the loan portfolio, consideration of past loan loss experience, trends in past due and nonperforming loans, risk characteristics of the various classifications of loans, existing economic conditions, the fair value of underlying collateral, and other qualitative and quantitative factors which could affect probable credit losses. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the adequacy of the allowance, could change significantly. As an integral part of their examination process, various regulatory agencies also review the allowance for loan losses. Such agencies may require that certain loan balances be charged off when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. The Corporation believes the allowance for loan losses is adequate and properly recorded in the consolidated financial statements. See section "Allowance for Loan Losses." Mortgage Servicing Rights Valuation: ----------------------------------- The fair value of the Corporation's mortgage servicing rights asset is important to the presentation of the consolidated financial statements since the mortgage servicing rights are carried on the consolidated balance sheet at the lower of amortized cost or fair value. Mortgage servicing rights do not trade in an active open market with readily observable prices. As such, like other participants in the mortgage banking business, the Corporation relies on an internal discounted cash flow model to estimate the fair value of its mortgage servicing rights and consults periodically with third parties as to the assumptions used and that the resultant valuation is within the context of the market. In addition, the Corporation periodically reviews the assumptions underlying the valuation of mortgage servicing rights. As part of this review, beginning with the third quarter 2004 valuation of the mortgage servicing rights, the Corporation changed the external service provider of prepayment speeds to a source that management believed to provide a better representation of market value. The impact of this change was an increase in fair value of mortgage servicing rights of $0.8 million. While the Corporation believes that the values produced by its internal model are indicative of the fair value of its mortgage servicing rights portfolio, these values can change significantly depending upon the then current interest rate environment, estimated prepayment speeds of the underlying mortgages serviced, and other economic conditions. The proceeds that might be received should the Corporation actually consider a sale of the mortgage servicing rights portfolio could differ from the amounts reported at any point in time. The Corporation believes the mortgage servicing rights asset is 21 properly recorded in the consolidated financial statements. See Note 6, "Goodwill and Other Intangible Assets," of the notes to consolidated financial statements and section "Noninterest Expense." Derivative Financial Instruments and Hedge Accounting: ----------------------------------------------------- In various aspects of its business, the Corporation uses derivative financial instruments to modify exposures to changes in interest rates and market prices for other financial instruments. Substantially all of these derivative financial instruments are designated as hedges for financial reporting purposes. The application of the hedge accounting policy requires judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings, and measurement of changes in the fair value of hedged items. However, if in the future the derivative financial instruments used by the Corporation no longer qualify for hedge accounting treatment and, consequently, the change in the fair value of hedged items could be recognized in earnings, the impact on the consolidated results of operations and reported earnings could be significant. The Corporation believes hedge effectiveness is evaluated properly in the consolidated financial statements. See Note 8, "Derivatives and Hedging Activities," of the notes to consolidated financial statements. Income Tax Accounting: --------------------- The assessment of tax assets and liabilities involves the use of estimates, assumptions, interpretations, and judgments concerning certain accounting pronouncements and federal and state tax codes. There can be no assurance that future events, such as court decisions or positions of federal and state taxing authorities, will not differ from management's current assessment, the impact of which could be significant to the consolidated results of operations and reported earnings. The Corporation believes the tax assets and liabilities are adequate and properly recorded in the consolidated financial statements. See section "Income Taxes." Segment Review As described in Note 12, "Segment Reporting," of the notes to consolidated financial statements, the Corporation's primary reportable segment is banking, conducted through its bank and lending subsidiaries. Banking includes: lending and deposit gathering to businesses (including commercial and specialized lending, lease financing, and other banking services to larger businesses and metro or niche markets, as well as business-related services such as cash management and international banking services) and to consumers (including mortgages, home equity lending, and card products) and the support to deliver such banking services. The Corporation's profitability is primarily dependent on net interest income, noninterest income, the level of the provision for loan losses, noninterest expense, and taxes of its banking segment. The consolidated discussion is therefore predominantly describing the banking segment results. The critical accounting policies primarily affect the banking segment, with the exception of income tax accounting, which affects both the banking and wealth management segments (see section "Critical Accounting Policies"). Results of Operations - Summary Net income for the nine months ended September 30, 2004 totaled $187.4 million, or $1.70 and $1.68 for basic and diluted earnings per share, respectively. Comparatively, net income for the nine months ended September 30, 2003 was $173.0 million, or $1.56 and $1.55 for basic and diluted earnings per share, respectively. Year-to-date 2004 results generated an annualized return on average assets of 1.62% and an annualized return on average equity of 18.00%, compared to 1.54% and 17.82%, respectively, for the comparable period in 2003. The net interest margin for the first nine months of 2004 was 3.79% compared to 3.82% for the first nine months of 2003. 22
------------------------------------------------------------------------------------------------------------ TABLE 1 (1) Summary Results of Operations: Trends ($ in Thousands, except per share data) 3rd Qtr. 2nd Qtr. 1st Qtr. 4th Qtr. 3rd Qtr. 2004 2004 2004 2003 2003 ------------------------------------------------------------------------------------------------------------ Net income (Quarter) $ 63,366 $ 64,505 $ 59,560 $ 55,609 $ 58,386 Net income (Year-to-date) 187,431 124,065 59,560 228,657 173,048 Earnings per share - basic (Quarter) $ 0.58 $ 0.59 $ 0.54 $ 0.51 $ 0.53 Earnings per share - basic (Year-to-date) 1.70 1.13 0.54 2.07 1.56 Earnings per share - diluted (Quarter) $ 0.57 $ 0.58 $ 0.53 $ 0.50 $ 0.52 Earnings per share - diluted (Year-to-date) 1.68 1.11 0.53 2.05 1.55 Return on average assets (Quarter) 1.60% 1.67% 1.57% 1.49% 1.53% Return on average assets (Year-to-date) 1.62 1.62 1.57 1.53 1.54 Return on average equity (Quarter) 17.76% 18.87% 17.37% 16.85% 17.75% Return on average equity (Year-to-date) 18.00 18.12 17.37 17.58 17.82 Efficiency ratio (Quarter) (2) 49.37% 46.17% 50.28% 51.02% 48.83% Efficiency ratio (Year-to-date) (2) 48.58 48.18 50.28 49.84 49.47 Net interest margin (Quarter) 3.76% 3.80% 3.80% 3.81% 3.78% Net interest margin (Year-to-date) 3.79 3.80 3.80 3.84 3.82 (1) All per share financial information has been restated to reflect the effect of the 3-for-2 stock split. (2) Noninterest expense divided by sum of taxable equivalent net interest income plus noninterest income, excluding investment securities gains (losses), net, and asset sales gains (losses), net.
Net Interest Income and Net Interest Margin Net interest income on a taxable equivalent basis for the nine months ended September 30, 2004, was $413.4 million, an increase of $11.1 million or 2.7% over the comparable period last year. As indicated in Tables 2 and 3, the $11.1 million increase in taxable equivalent net interest income was attributable to favorable volume changes (with balance sheet growth and differences in the mix of average earning assets and average interest-bearing liabilities adding $19.1 million to taxable equivalent net interest income), offset partly by unfavorable rate variances (as the impact of changes in the interest rate environment reduced taxable equivalent net interest income by $8.0 million). The net interest margin for the first nine months of 2004 was 3.79%, down 3 basis points ("bp") from 3.82% for the comparable period in 2003. The decrease was attributable to a 3 bp lower contribution from net free funds (particularly reflecting the impact of the lower cost of funds in 2004 on the value of net free funds) as the interest rate spread was unchanged (the net of a 29 bp decrease in both the yield on earning assets and the cost of interest-bearing liabilities). Interest rates were relatively stable and historically low during 2003 and the first half of 2004, with one interest rate decrease of 25 bp during June 2003 compared to three interest rate increases of 25 bp each occurring in the second and third quarters of 2004. The average Federal funds rate of 1.14% for year-to-date 2004 was almost level with the 1.16% average for year-to-date 2003 (2 bp lower), however the Federal funds rate at September 30, 2004 was 1.75%, up 75 bp from 1.00% at September 30, 2003. The yield on earning assets was 5.12% for year-to-date 2004, down 29 bp from the comparable nine-month period last year. The average loan yield was down 29 bp to 5.18%, as competitive pricing on new and refinanced loans and the repricing of variable rate loans in the lower interest rate environment from June 2003 through June 2004 put downward pressure on loan yields. The average yield on investments and other earning assets decreased 22 bp to 4.96%, impacted by faster prepayments (particularly on mortgage-related securities) and increased investments in the lower rate environment. 23 The cost of interest-bearing liabilities was 1.58% for year-to-date 2004, down 29 bp compared to the first nine months of 2003, aided by the lower average rate environment during the first half of the year and a larger mix of lower costing short-term borrowings in wholesale funding. The average cost of interest-bearing deposits was 1.38%, down 29 bp from year-to-date 2003, benefiting from lower rates on interest-bearing deposit products in general, as well as from a larger mix of lower-costing transaction accounts. The cost of wholesale funding (comprised of short-term borrowings and long-term funding) was 1.94%, down 26 bp from year-to-date 2003, largely a function of mix, as higher-priced long-term advances matured and new, lower-costing funding was added. Average short-term borrowings grew to 57% of wholesale funding, at an average cost 1.27% for year-to-date 2004, compared to 51% and an average cost of 1.38% for the comparable 2003 period. Average long-term funding fell to 43% (average cost 2.83%) of wholesale funding in 2004, from 49% (average cost 3.07%) in 2003. Average earning assets increased by $466 million (3.3%) over the comparable nine-month period last year. Average investments and other earning assets were up $569 million (notably mortgage-related securities), while average loans decreased $103 million (representing 73.4% of average earning assets for year-to-date 2004 compared to 76.6% for year-to-date 2003). Decreases in average residential real estate, which includes mortgage loans held for sale, (down $282 million) and consumer loans (down $34 million) were partially offset by increases in commercial loans (up $213 million). Commercial loans grew to represent 62.9% of average loans for the first nine months of 2004 compared to 60.3% for the comparable period in 2003. Average interest-bearing liabilities increased $304 million (2.5%) over the comparable period of 2003, and net free funds increased $162 million, both supporting the growth in earning assets. Average noninterest-bearing demand deposits (a component of net free funds) increased by $106 million, or 6.4%. The growth in average interest-bearing liabilities was comprised primarily of growth in interest-bearing deposits (up $359 million, or 4.8%), which reduced the need for wholesale funding. Wholesale funding was down $55 million (representing 35.5% of average interest-bearing liabilities for year-to-date 2004 compared to 36.9% for year-to-date 2003), notably in long-term funding, which decreased $275 million to represent 15.2% of average interest-bearing liabilities for year-to-date 2004 versus 17.9% for year-to-date 2003. 24
-------------------------------------------------------------------------------------------------------------------- TABLE 2 Net Interest Income Analysis-Taxable Equivalent Basis ($ in Thousands) -------------------------------------------------------------------------------------------------------------------- Nine Months ended September 30, 2004 Nine Months ended September 30, 2003 Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate -------------------------------------------------------------------------------------------------------------------- Earning assets: Loans: (1) (2) (3) Commercial $ 6,668,508 $ 246,765 4.86% $ 6,455,171 $ 249,509 5.10% Residential real estate 3,265,419 133,842 5.46 3,547,875 154,138 5.79 Consumer 675,654 35,216 6.96 709,692 38,660 7.28 ------------------------ ------------------------ Total loans 10,609,581 415,823 5.18 10,712,738 442,307 5.47 Investments and other (1) 3,843,013 142,935 4.96 3,273,806 127,272 5.18 ------------------------ ------------------------ Total earning assets 14,452,594 558,758 5.12 13,986,544 569,579 5.41 Other assets, net 1,043,304 1,026,672 ------------ ------------ Total assets $ 15,495,898 $ 15,013,216 ============ ============ Interest-bearing liabilities: Interest-bearing deposits: Savings deposits $ 927,876 $ 2,528 0.36% $ 930,105 $ 3,997 0.57% Interest-bearing demand deposits 2,366,312 14,186 0.80 1,708,600 10,995 0.86 Money market deposits 1,530,856 9,247 0.81 1,640,707 11,694 0.95 Time deposits, excluding Brokered CDs 2,844,147 53,227 2.50 3,062,576 64,825 2.83 ------------------------ ------------------------ Total interest-bearing deposits,excluding Brokered CDs 7,669,191 79,188 1.38 7,341,988 91,511 1.67 Brokered CDs 216,371 2,213 1.37 184,494 2,364 1.71 ------------------------ ------------------------ Total interest-bearing deposits 7,885,562 81,401 1.38 7,526,482 93,875 1.67 Wholesale funding 4,347,031 64,001 1.94 4,402,081 73,406 2.20 ------------------------ ------------------------ Total interest-bearing liabilities 12,232,593 145,402 1.58 11,928,563 167,281 1.87 ------- ------- Noninterest-bearing demand deposits 1,750,576 1,644,871 Other liabilities 121,613 141,548 Stockholders' equity 1,391,116 1,298,234 ------------ ---------- Total liabilities and equity $ 15,495,898 $ 15,013,216 ============ ============ Interest rate spread 3.54% 3.54% Net free funds 0.25 0.28 ---- ---- Taxable equivalent net interest income and net interest margin $ 413,356 3.79% $ 402,298 3.82% ================= ================== Taxable equivalent adjustment 19,186 18,673 --------- --------- Net interest income $ 394,170 $ 383,625 ========= ========= (1) The yield on tax exempt loans and securities is computed on a taxable equivalent basis using a tax rate of 35% for all periods presented. (2) Nonaccrual loans and loans held for sale are included in the average balances. (3) Interest income includes net loan fees. -------------------------------------------------------------------------------------------------------------------
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------------------------------------------------------------------------------------------------------------------- TABLE 2 (continued) Net Interest Income Analysis-Taxable Equivalent Basis ($ in Thousands) ------------------------------------------------------------------------------------------------------------------- Three Months ended September 30, 2004 Three Months ended September 30, 2003 Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate ------------------------------------------------------------------------------------------------------------------- Earning assets: Loans: (1) (2) (3) Commercial $ 6,787,476 $ 85,971 4.96% $ 6,565,202 $ 83,321 4.97% Residential real estate 3,251,564 44,886 5.49 3,541,464 49,538 5.55 Consumer 669,661 11,775 6.99 707,103 12,657 7.10 ------------------------ ------------------------ Total loans 10,708,701 142,632 5.25 10,813,769 145,516 5.30 Investments and other (1) 3,980,213 48,238 4.85 3,314,933 42,468 5.12 ------------------------ ------------------------ Total earning assets 14,688,914 $ 190,870 5.14 14,128,702 187,984 5.26 Other assets, net 1,041,537 1,023,974 ------------ ------------ Total assets $ 15,730,451 $ 15,152,676 ============ ============ Interest-bearing liabilities: Interest-bearing deposits: Savings deposits $ 945,881 $ 844 0.35% $ 935,402 $ 1,113 0.47% Interest-bearing demand deposits 2,338,492 4,615 0.79 1,938,111 4,070 0.83 Money market deposits 1,516,812 3,294 0.86 1,586,092 3,430 0.86 Time deposits, excluding Brokered CDs 2,771,249 17,488 2.51 3,120,919 21,213 2.70 ------------------------ ------------------------ Total interest-bearing deposits, excluding Brokered CDs 7,572,434 26,241 1.38 7,580,524 29,826 1.56 Brokered CDs 235,844 950 1.60 146,670 501 1.36 ------------------------ ------------------------ Total interest-bearing deposits 7,808,278 27,191 1.39 7,727,194 30,327 1.56 Wholesale funding 4,573,129 24,068 2.07 4,228,226 22,516 2.09 ------------------------ ------------------------ Total interest-bearing liabilities 12,381,407 51,259 1.64 11,955,420 52,843 1.75 ------ ------ Noninterest-bearing demand deposits 1,813,279 1,757,806 Other liabilities 116,165 134,467 Stockholders' equity 1,419,600 1,304,983 ------------ ------------ Total liabilities and equity $ 15,730,451 $ 15,152,676 ============ ============ Interest rate spread 3.50% 3.51% Net free funds 0.26 0.27 ---- ---- Taxable equivalent net interest income and net interest margin $ 139,611 3.76% $ 135,141 3.78% ================= ================= Taxable equivalent adjustment 6,395 6,165 --------- --------- Net interest income $ 133,216 $ 128,976 ========= ========= -------------------------------------------------------------------------------------------------------------------
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------------------------------------------------------------------------------------------------------- TABLE 3 Volume / Rate Variance - Taxable Equivalent Basis ($ in Thousands) ------------------------------------------------------------------------------------------------------- Comparison of Nine Months ended September 30, 2004 versus 2003 Variance Attributable to Income/Expense ------------------------ Variance (1) Volume Rate ------------------------------------------------------------------------------------------------------- INTEREST INCOME: (2) Loans: Commercial $ (2,744) $ 8,391 $ (11,135) Residential real estate (20,296) (10,700) (9,596) Consumer (3,444) (1,635) (1,809) ---------------------------------------- Total loans (26,484) (3,944) (22,540) Investments and other 15,663 21,341 (5,678) ---------------------------------------- Total interest income $ (10,821) $ 17,397 $ (28,218) INTEREST EXPENSE: Interest-bearing deposits: Savings deposits $ (1,469) $ (10) $ (1,459) Interest-bearing demand deposits 3,191 3,995 (804) Money market deposits (2,447) (743) (1,704) Time deposits, excluding brokered CDs (11,598) (4,400) (7,198) ---------------------------------------- Interest-bearing deposits, excluding brokered CDs (12,323) (1,158) (11,165) Brokered CDs (151) 371 (522) ---------------------------------------- Total interest-bearing deposits (12,474) (787) (11,687) Wholesale funding (9,405) (895) (8,510) ---------------------------------------- Total interest expense (21,879) (1,682) (20,197) ---------------------------------------- Net interest income, taxable equivalent $ 11,058 $ 19,079 $ (8,021) ======================================== (1) The change in interest due to both rate and volume has been allocated proportionately to volume variance and rate variance based on the relationship of the absolute dollar change in each. (2) The yield on tax-exempt loans and securities is computed on a taxable equivalent basis using a tax rate of 35% for all periods presented. -------------------------------------------------------------------------------------------------------
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------------------------------------------------------------------------------------------------------- TABLE 3 (continued) Volume / Rate Variance - Taxable Equivalent Basis ($ in Thousands) ------------------------------------------------------------------------------------------------------- Comparison of Three Months ended September 30, 2004 versus 2003 Variance Attributable to Income/Expense ------------------------ Variance (1) Volume Rate ------------------------------------------------------------------------------------------------------- INTEREST INCOME: (2) Loans: Commercial $ 2,650 $ 2,798 $ (148) Residential real estate (4,652) (3,495) (1,157) Consumer (882) (642) (240) ---------------------------------------- Total loans (2,884) (1,339) (1,545) Investments and other 5,770 7,951 (2,181) ---------------------------------------- Total interest income $ 2,886 $ 6,612 $ (3,726) INTEREST EXPENSE: Interest-bearing deposits: Savings deposits $ (269) $ 12 $ (281) Interest-bearing demand deposits 545 793 (248) Money market deposits (136) (158) 22 Time deposits, excluding brokered CDs (3,725) (2,305) (1,420) ---------------------------------------- Interest-bearing deposits, excluding brokered CDs (3,585) (1,658) (1,927) Brokered CDs 449 346 103 ---------------------------------------- Total interest-bearing deposits (3,136) (1,312) (1,824) Wholesale funding 1,552 1,731 (179) ---------------------------------------- Total interest expense (1,584) 419 (2,003) ---------------------------------------- Net interest income, taxable equivalent $ 4,470 $ 6,193 $ (1,723) ======================================== -------------------------------------------------------------------------------------------------------
Provision for Loan Losses No provision for loan losses was recorded for the third quarter of 2004, a result of improved asset quality trends and an adequate level of the allowance for loan losses. The provision for loan losses for the first nine months of 2004 was $11.1 million, compared to $46.8 million for the year ended December 31, 2003, and $37.2 million for the nine-month period in 2003. Net charge offs were $13.7 million and $23.5 million for the nine months ended September 30, 2004 and 2003, respectively. Annualized net charge offs as a percent of average loans for year-to-date 2004 were 0.17%, compared to 0.30% for the full year 2003 and 0.29% for the comparable nine-month period in 2003. At September 30, 2004, the allowance for loan losses was $175.0 million, compared to $177.6 million at December 31, 2003, and $176.2 million at September 30, 2003. The ratio of the allowance for loan losses to total loans was 1.62%, down from 1.73% at December 31, 2003 and 1.71% at September 30, 2003. Nonperforming loans at September 30, 2004, were $91.5 million, down 25% from $121.5 million at December 31, 2003, and down 27% from $125.2 million at September 30, 2003. See Table 8. The provision for loan losses is predominantly a function of the methodology and other qualitative and quantitative factors used to determine the adequacy of the allowance for loan losses which focuses on changes in the size and character of the loan portfolio, changes in levels of impaired and other nonperforming loans, historical losses on each portfolio category, the risk inherent in specific loans, concentrations of loans to specific borrowers or industries, existing economic conditions, the fair value of underlying collateral, and other factors which could affect probable loan losses. See additional discussion under sections "Allowance for Loan Losses," and "Nonperforming Loans and Other Real Estate Owned." 28 Noninterest Income For the nine months ended September 30, 2004, noninterest income was $161.6 million, down $32.4 million or 16.7% compared to $194.0 million for year-to-date 2003. The change between comparable periods was impacted by mortgage banking income (notably lower revenue from significantly lower refinancing and production activity), the timing of a 2003 sale and services agreement relating to the Corporation's credit card merchant processing business, and partially offset by the acquisitions of CFG and Jabas, which added to retail commissions.
------------------------------------------------------------------------------------------------------------------------------ TABLE 4 Noninterest Income ($ in Thousands) ------------------------------------------------------------------------------------------------------------------------------ 3rd Qtr. 3rd Qtr. Dollar Percent YTD YTD Dollar Percent 2004 2003 Change Change 2004 2003 Change Change ------------------------------------------------------------------------------------------------------------------------------ Trust service fees $ 7,773 $ 7,001 $ 772 11.0% $ 23,684 $ 21,427 $ 2,257 10.5% Service charges on deposit accounts 13,672 13,338 334 2.5 39,210 37,611 1,599 4.3 Mortgage banking 6,593 21,671 (15,078) (69.6) 24,664 73,284 (48,620) (66.3) Credit card & other nondeposit fees 6,253 5,435 818 15.1 17,998 18,023 (25) (0.1) Retail commissions 11,925 6,830 5,095 74.6 34,444 17,540 16,904 96.4 Bank owned life insurance income 3,580 3,532 48 1.4 10,576 10,373 203 2.0 Other 3,034 3,245 (211) (6.5) 8,908 14,795 (5,887) (39.8) ------------------------------------------------------------------------------------ Subtotal $ 52,830 $ 61,052 $ (8,222) (13.5)% $ 159,484 $ 193,053 $ (33,569) (17.4)% Asset sale gains, net 309 871 (562) N/M 749 203 546 N/M Investment securities gains (losses), net (6) 1 (7) N/M 1,356 702 654 N/M ------------------------------------------------------------------------------------ Total noninterest income $ 53,133 $ 61,924 $ (8,791) (14.2)% $ 161,589 $ 193,958 $ (32,369) (16.7)% ==================================================================================== N/M - Not meaningful. ------------------------------------------------------------------------------------------------------------------------------
Trust service fees were $23.7 million, up $2.3 million, or 10.5%, between the comparable nine-month periods. The change was predominantly the result of new business, higher assets under management, and increases in the fee structure on personal trust accounts implemented in mid-2003. The market value of assets under management was $4.4 billion at September 30, 2004 compared to $3.9 billion at September 30, 2003. Service charges on deposit accounts were $39.2 million, up $1.6 million, or 4.3%, a function of both higher service charges on business accounts and higher fees on overdrafts/nonsufficient funds (due to rate increases). Mortgage banking income in 2004 was affected by slowed refinancing activity throughout the industry due to higher mortgage rates. Mortgage banking income, consisting of servicing fees, the gain or loss on sales of mortgage loans to the secondary market, and other related fees, was $24.7 million for the first nine months of 2004, down $48.6 million, or 66.3%, from the comparable period in 2003. The decrease was driven primarily by reduced secondary mortgage loan production (mortgage loan production to be sold to the secondary market) and resultant sales. Secondary mortgage loan production declined 68% between the comparable nine-month periods ($1.2 billion for the nine months ended September 30, 2004 versus $3.7 billion for the nine months ended September 30, 2003). The lower production levels impacted both gains on sales of loans and volume-related fees, collectively down $49.0 million. Servicing fees on the portfolio serviced for others were up $0.4 million between comparable periods, due largely to an increase in the portfolio serviced for others ($6.01 billion at September 30, 2004, versus $5.59 billion at September 30, 2003). Credit card and other nondeposit fees were $18.0 million for the first nine months of 2004, relatively unchanged (down 0.1%) from year-to-date 2003. The slight decrease was attributable predominantly to lower credit card fees associated with a merchant processing sale and services agreement signed in March 2003, substantially offset by increases in other commercial and retail service fees. Retail commission income (which includes commissions from insurance and brokerage product sales) was $34.4 million, up $16.9 million between comparable periods, largely impacted by the insurance agency acquisitions of CFG on April 1, 2003 and Jabas on April 1, 2004. Insurance commissions were $29.6 million, up $16.1 million (including $2.3 million increase in fixed annuities) and brokerage commissions were up $0.8 million, aided by stronger financial market performance. 29 Other noninterest income was $8.9 million for the first nine months of 2004, down $5.9 million versus the comparable period in 2003, which included a $1.5 million gain on the sale of out-of-market credit card accounts and a $3.4 million gain recognized in connection with a credit card merchant processing sale and services agreement. Asset sale gains for 2004 were $0.7 million, including a $0.3 million net premium on the sale of $7 million in deposits from one branch and a $0.7 million net gain on the sale of two other real estate owned properties, while asset sale gains for 2003 were $0.2 million, including a $1.0 million gain on the sale of an other real estate owned property and a $0.6 million loss on the sale of an other real estate owned property. The 2004 investment securities gain of $1.4 million was the net result of a $1.9 million gain on the sale of common stock holdings during first quarter, net of a second quarter $0.2 million other-than-temporary write-down on a security and a $0.4 million loss on the sale of securities. The 2003 investment securities net gain of $0.7 million was the net result of a second quarter $1.0 million gain on the sale of common stock holdings, net of a first quarter $0.3 million other-than-temporary write-down on a security. Noninterest Expense Noninterest expense was $278.3 million, down $16.3 million compared to last year, with higher costs due to including the operating expenses of the CFG and Jabas acquisitions more than offset by lower mortgage servicing rights expense, loan expense, and stationery and supplies.
-------------------------------------------------------------------------------------------------------------------------- TABLE 5 Noninterest Expense ($ in Thousands) -------------------------------------------------------------------------------------------------------------------------- 3rd Qtr. 3rd Qtr. Dollar Percent YTD YTD Dollar Percent 2004 2003 Change Change 2004 2003 Change Change -------------------------------------------------------------------------------------------------------------------------- Personnel expense $ 53,467 $ 53,080 $ 387 0.7% $ 159,355 $ 153,649 $ 5,706 3.7% Occupancy 6,939 7,101 (162) (2.3) 21,275 21,367 (92) (0.4) Equipment 3,022 3,178 (156) (4.9) 8,899 9,612 (713) (7.4) Data processing 5,865 6,322 (457) (7.2) 17,666 17,542 124 0.7 Business development & 3,990 4,113 (123) (3.0) 10,704 11,029 (325) (2.9) advertising Stationery and supplies 1,214 1,651 (437) (26.5) 3,869 4,964 (1,095) (22.1) Mortgage servicing rights expense 5,975 4,199 1,776 42.3 10,379 28,818 (18,439) (64.0) Intangible amortization expense 935 871 64 7.3 2,651 2,091 560 26.8 Loan expense 1,152 1,806 (654) (36.2) 4,208 6,104 (1,896) (31.1) Other 12,447 13,486 (1,039) (7.7) 39,275 39,372 (97) (0.2) ------------------------------------------------------------------------------------- Total noninterest expense $ 95,006 $ 95,807 $ (801) (0.8)% $ 278,281 $ 294,548 $ (16,267) (5.5)% ===================================================================================== --------------------------------------------------------------------------------------------------------------------------
Personnel expense (including salary-related expenses and fringe benefit expenses) increased $5.7 million or 3.7% over the first nine months of 2003. The increase was attributable to the CFG and Jabas acquisitions, annual merit increases, and higher commission-based compensation, but mitigated by lower costs due to lower overtime and temporary help and a reduction in full-time equivalent employees throughout the organization created by operating efficiencies and more disciplined hiring. Average full-time equivalent employees were 4,004 for the first nine months of 2004 down 3% from 4,131 for the first nine months of 2003. Excluding CFG and Jabas, average full-time equivalent employees were down 6% between the comparable growth periods. Salary-related expenses increased $4.1 million or 3.4% due principally to merit increases between the years and higher commission-based compensation. Fringe benefits were up $1.6 million or 4.7% over the comparable period of 2003, due primarily to the increased cost of premium based benefits and other benefit plans. Equipment expense declined $0.7 million, principally in equipment and computer depreciation expense, given aging equipment and lower replacement costs. Stationery and supplies were down $1.1 million and business development and advertising were down $0.3 million, both reflecting corporate initiatives to reduce selected discretionary expenses in 2004. Mortgage servicing rights expense includes both the amortization of the mortgage servicing rights asset and increases or decreases to the valuation allowance associated with the mortgage servicing rights asset. Mortgage servicing rights expense decreased by $18.4 million between the nine-month periods, with a $2.2 million recovery of the valuation allowance during year-to-date 2004 versus a $15.8 million addition to the valuation allowance for year-to-date 2003, and minimal change in the amortization of the mortgage servicing 30 rights asset. Periods of strong mortgage refinance activity, particularly seen in the first half of 2003, increased the prepayment speeds of the Corporation's mortgage portfolio serviced for others, then slowed prepayment speeds through the second half of 2003 and into 2004. While the continued reduction in refinancing activity in 2004 reduced mortgage banking income (as noted in section "Noninterest Income"), it also further slowed prepayment speeds in the servicing portfolio, supporting greater value of the mortgage servicing asset and lowering mortgage servicing rights expense. The fair value of servicing was approximately $45.6 million (representing 76 bp of loans serviced) at September 30, 2004, compared to $36.7 million (or 66 bp of loans serviced) at September 30, 2003. Estimated prepayment speeds are a key factor in the valuation of mortgage servicing rights. Mortgage servicing rights are considered a critical accounting policy given that estimating the fair value of the mortgage servicing rights involves judgment, particularly of estimated prepayment speeds of the underlying mortgages serviced and the overall level of interest rates. Loan type and note rate are the predominant risk characteristics of the underlying loans used to stratify capitalized mortgage servicing rights for purposes of measuring impairment. A valuation allowance is established to the extent the carrying value of the mortgage servicing rights exceeds the estimated fair value by stratification. Net income could be affected if management's estimates of the prepayment speeds or other factors differ materially from actual prepayments. An other-than-temporary impairment is recognized as a write-down of the mortgage servicing rights asset and the related valuation allowance (to the extent valuation allowance is available) and then against earnings. A direct write-down permanently reduces the carrying value of the mortgage servicing rights asset and valuation allowance, precluding subsequent recoveries. Mortgage servicing rights, included in other intangible assets on the consolidated balance sheet, were $45.6 million, net of a $14.9 million valuation allowance at September 30, 2004. See section "Critical Accounting Policies" and Note 6, "Goodwill and Other Intangible Assets," of the notes to consolidated financial statements. Intangible amortization expense increased $0.6 million to $2.7 million, attributable to the other intangibles acquired with the CFG and Jabas acquisitions. Loan expense was $4.2 million, down $1.9 million between comparable periods, primarily due to lower merchant processing costs, given the sale of the merchant processing during the first quarter of 2003, and lower mortgage loan expenses. Income Taxes Income tax expense for the first nine months of 2004 was $79.0 million, up $6.2 million from the comparable period in 2003. The effective tax rate (income tax expense divided by income before taxes) was unchanged at 29.6% for both year-to-date 2004 and year-to-date 2003. Income tax expense recorded in the consolidated statements of income involves the interpretation and application of certain accounting pronouncements and federal and state tax codes, and is, therefore, considered a critical accounting policy. The Corporation undergoes examination by various taxing authorities. Such taxing authorities may require that changes in the amount of tax expense or valuation allowance be recognized when their interpretations differ from those of management, based on their judgments about information available to them at the time of their examinations. See section "Critical Accounting Policies." Balance Sheet At September 30, 2004, total assets were $16.1 billion, an increase of $1.0 billion, or 6.8%, over September 30, 2003. The growth in assets was comprised principally of increases in investment securities (up $751 million, notably in mortgage-related securities) and loans (up $541 million, notably commercial loans), offset by a decrease of $318 million in loans held for sale. Commercial loans grew $424 million, or 6.5%, since September 30, 2003 to represent 64% of total loans at September 30, 2004 (compared to 63% of total loans a year ago). Home equity grew $136 million, or 14.9%, while consumer loans decreased $38 million. The growth in assets was primarily funded by short-term borrowings, which grew $907 million (primarily in federal funds purchased and securities sold under agreements to repurchase) to $3.0 billion. Total deposits of $9.7 billion at September 30, 2004 were up $42 million, or 0.4%, compared to a year ago, with a shift out of time deposits into more transaction-based deposit accounts. Interest-bearing transaction accounts (savings, interest-bearing demand, and money market) grew by $217 million (4.7%) and noninterest-bearing demand 31 deposits grew by $63 million (3.5%). Brokered CDs increased $29 million, while other time deposits declined $267 million to 29% of deposits at September 30, 2004 versus 32% at September 30, 2003, attributable primarily to scheduled maturities. Long-term funding was down $81 million since September 30, 2003, as Federal Home Loan Bank advances and bank notes matured and were replaced by short-term borrowings or smaller issuances of long-term Federal Home Loan Bank advances and repurchase agreements (see Note 7, "Long-term Funding," of the notes to consolidated financial statements). Since year-end 2003 the balance sheet increased $0.9 billion, 7.8% annualized growth, principally from growth in loans and investment securities. Loans grew $539 million, primarily in commercial loans (up $444 million) and residential real estate (up $120 million, mostly in home equity), while consumer loans decreased $25 million. Deposits decreased $116 million to $9.7 billion at September 30, 2004, attributable to a $183 million decline in other time deposits, partially offset by a $53 million increase in noninterest-bearing demand deposits and a $47 million increase in savings. Given the growth in assets and the decline in deposits and long-term funding, short-term borrowings increased. Long-term funding declined $122 million (due primarily to scheduled maturities of Federal Home Loan Bank advances). Short-term borrowings grew $1.0 billion (primarily in federal funds purchased and securities sold under agreements to repurchase). See Tables 6 and 7 for period end loan and deposit composition, respectively.
------------------------------------------------------------------------------------------------------------------------ TABLE 6 Period End Loan Composition ($ in Thousands) ------------------------------------------------------------------------------------------------------------------------ September 30, % of September 30, % of Dec. 31, % of 2004 Total 2003 Total 2003 Total ------------------------------------------------------------------------------------------------------------------------ Commercial, financial &agricultural $ 2,479,764 23% $ 2,186,214 21% $ 2,116,463 21% Real estate-construction 1,152,990 11 1,035,674 10 1,077,731 10 Commercial real estate 3,242,009 30 3,240,757 32 3,246,954 32 Lease financing 49,423 -- 37,193 -- 38,968 -- ------------------------------------------------------------------------ Commercial 6,924,186 64 6,499,838 63 6,480,116 63 Residential mortgage 2,185,732 20 2,166,187 21 2,145,227 21 Home equity 1,047,902 10 912,142 9 968,744 9 ------------------------------------------------------------------------ Residential real estate 3,233,634 30 3,078,329 30 3,113,971 30 Consumer 672,807 6 711,075 7 697,723 7 ------------------------------------------------------------------------ Total loans $ 10,830,627 100% $ 10,289,242 100% $ 10,291,810 100% ======================================================================== ------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------------ TABLE 7 Period End Deposit Composition ($ in Thousands) ------------------------------------------------------------------------------------------------------------------------ September 30, % of September 30, % of Dec. 31, % of 2004 Total 2003 Total 2003 Total ------------------------------------------------------------------------------------------------------------------------ Noninterest-bearing demand $ 1,867,905 19% $ 1,804,596 19% $ 1,814,446 18% Savings 936,975 10 924,036 9 890,092 9 Interest-bearing demand 2,334,072 24 2,086,964 22 2,330,478 24 Money market 1,516,423 16 1,559,769 16 1,573,678 16 Brokered CDs 186,326 2 156,994 2 165,130 2 Other time 2,835,572 29 3,102,997 32 3,019,019 31 ------------------------------------------------------------------------- Total deposits $ 9,677,273 100% $ 9,635,356 100% $ 9,792,843 100% ======================================================================== Total deposits, excluding Brokered CDs $ 9,490,947 98% $ 9,478,362 98% $ 9,627,713 98% ======================================================================== ------------------------------------------------------------------------------------------------------------------------
Allowance for Loan Losses The loan portfolio is the primary asset subject to credit risk. Credit risks are inherently different for each different loan type. Credit risk is controlled and monitored through the use of lending standards, a thorough review of potential borrowers, and on-going review of loan payment performance. Active asset quality administration, including early problem loan identification and timely resolution of problem loans, aids in the 32 management of credit risk and minimization of loan losses.
------------------------------------------------------------------------------------------------------ TABLE 8 Allowance for Loan Losses and Nonperforming Assets ($ in Thousands) ------------------------------------------------------------------------------------------------------ At and for the At and for the nine months ended year ended September 30, December 31, ------------------------------------------------------------------------------------------------------ 2004 2003 2003 --------------------------------------- Allowance for Loan Losses: Balance at beginning of period $ 177,622 $ 162,541 $ 162,541 Provision for loan losses 11,065 37,210 46,813 Charge offs (16,492) (26,631) (37,107) Recoveries 2,812 3,103 5,375 ------------------------------------ Net charge offs (13,680) (23,528) (31,732) ------------------------------------ Balance at end of period $ 175,007 $ 176,223 $ 177,622 ==================================== Nonperforming Assets: Nonaccrual loans $ 81,124 $ 114,067 $ 113,944 Accruing loans past due 90 days or more 10,309 11,055 7,495 Restructured loans 39 44 43 ------------------------------------ Total nonperforming loans 91,472 125,166 121,482 Other real estate owned 4,526 6,380 5,457 ------------------------------------ Total nonperforming assets $ 95,998 $ 131,546 $ 126,939 ==================================== Ratios: Allowance for loan losses to net charge offs (annualized) 9.58x 5.60x 5.60x Net charge offs to average loans (annualized) 0.17% 0.29% 0.30% Allowance for loan losses to total loans 1.62% 1.71% 1.73% Nonperforming loans to total loans 0.84% 1.22% 1.18% Nonperforming assets to total assets 0.59% 0.87% 0.83% Allowance for loan losses to nonperforming loans 191% 141% 146% ------------------------------------------------------------------------------------------------------
As of September 30, 2004, the allowance for loan losses was $175.0 million compared to $176.2 million at September 30, 2003, and $177.6 million at December 31, 2003. The allowance for loan losses at September 30, 2004 decreased $1.2 million since September 30, 2003 and $2.6 million since December 31, 2003. At September 30, 2004, the allowance for loan losses to total loans was 1.62% and covered 191% of nonperforming loans, compared to 1.71% and 141%, respectively, at September 30, 2003, and 1.73% and 146%, respectively, at December 31, 2003. Table 8 provides additional information regarding activity in the allowance for loan losses and nonperforming assets. Gross charge offs were $16.5 million for the nine months ended September 30, 2004, down from $26.6 million for the comparable period ended September 30, 2003, and $37.1 million for the year 2003, while recoveries for the corresponding periods were $2.8 million, $3.1 million and $5.4 million, respectively. The ratio of net charge offs to average loans on an annualized basis was 0.17%, 0.29%, and 0.30% for the nine-month periods ended September 30, 2004 and September 30, 2003, and for the 2003 year, respectively. Six commercial credits in various industries accounted for approximately $6.8 million of the net charge offs for the nine months ended September 30, 2004, while five commercial credits in the construction and hospitality industries accounted for approximately $13.7 million and $16.5 million of the net charge offs for the nine months ended September 30, 2003, and the year ended December 31, 2003, respectively. The allowance for loan losses represents management's estimate of an amount adequate to provide for probable credit losses in the loan portfolio at the balance sheet date. To assess the adequacy of the allowance for loan losses, an allocation methodology is applied by the Corporation, which focuses on changes in the size and character of the loan portfolio, changes in levels of impaired or other nonperforming loans, the risk 33 inherent in specific loans, concentrations of loans to specific borrowers or industries, existing economic conditions, underlying collateral, historical losses on each portfolio category, and other qualitative and quantitative factors which could affect probable credit losses. Assessing these numerous factors involves judgment. Management considers the allowance for loan losses a critical accounting policy (see section "Critical Accounting Policies"). The change in the allowance for loan losses is a function of a number of factors, including but not limited to changes in the loan portfolio (see Table 6), net charge offs and nonperforming loans (see Table 8). The allocation methods used for September 30, 2004, September 30, 2003, and December 31, 2003 were comparable, using specific allocations or factors for criticized loans and for non-criticized loan categories, as defined by the Corporation. Factors applied are reviewed periodically and adjusted to reflect changes in trends or other risks. Current economic conditions at each period end carried various uncertainties requiring management's judgment as to the impact on the business results of numerous individual borrowers and certain industries. Total loans at September 30, 2004, were up $541 million (5.3%) from September 30, 2003, primarily in the commercial portfolio, which grew $424 million, or 6.5%, to represent 64% of total loans versus 63% a year ago (see Table 6). The loan growth occurred predominantly since December 31, 2003, with total loans up $539 million compared to December 31, 2003, with commercial loans accounting for the majority of growth (up $444 million, or 9.2%, annualized). The allowance for loan losses to loans was 1.62%, 1.71% and 1.73% for September 30, 2004, and September 30, and December 31, 2003, respectively. The ratio of the allowance for loan losses to total loans was lower at September 30, 2004, primarily due to the increased loans, but the allowance for loan losses covered a greater percentage of nonperforming loans (191% at September 30, 2004) than at September 30 and December 31, 2003 (141% and 146%, respectively). Nonperforming loans were $91.5 million, or 0.84% of total loans at September 30, 2004, down from $125.2 million, or 1.22% of loans a year ago, and $121.5 million, or 1.18% of loans at year-end 2003. Approximately $25 million of the $30.0 million improvement in nonperforming loans since year-end came from paydowns on six large problem loans, as management continues to work through problem credits. Criticized commercial loans were down (11%) since December 31, 2003, as several larger loans were removed from criticized loans as loan paydowns were received (as noted above) or were upgraded to lower-risk categories given improvements in their specific business circumstances, along with fewer commercial loans classified into the criticized categories. On the other hand, potential problem loans have increased moderately (5%) since December 31, 2003 (see section "Nonperforming Loans and Other Real Estate Owned"). Management believes the allowance for loan losses to be adequate at September 30, 2004. Consolidated net income could be affected if management's estimate of the allowance for loan losses is subsequently materially different, requiring additional or less provision for loan losses to be recorded. Management carefully considers numerous detailed and general factors, its assumptions, and the likelihood of materially different conditions that could alter its assumptions. While management uses currently available information to recognize losses on loans, future adjustments to the allowance for loan losses may be necessary based on changes in economic conditions and the impact of such change on the Corporation's borrowers. As an integral part of their examination process, various regulatory agencies also review the allowance for loan losses. Such agencies may require that certain loan balances be charged off when their credit evaluations differ from those of management, based on their judgments about information available to them at the time of their examination. Nonperforming Loans and Other Real Estate Owned Management is committed to an aggressive identification philosophy for nonaccrual and problem loans. This philosophy is implemented through the ongoing monitoring and reviewing of all pools of risk in the loan portfolio to ensure that problem loans are identified quickly and the risk of loss is minimized. Table 8 provides detailed information regarding nonperforming assets, which include nonperforming loans and other real estate owned. Nonperforming assets to total assets were 0.59%, 0.87%, and 0.83% at September 30, 2004, September 30, 2003, and December 31, 2003, respectively. 34 Nonperforming loans are considered one indicator of potential future loan losses. Nonperforming loans are defined as nonaccrual loans, loans 90 days or more past due but still accruing, and restructured loans. The Corporation specifically excludes from its definition of nonperforming loans student loan balances that are 90 days or more past due and still accruing and that have contractual government guarantees as to collection of principal and interest. The Corporation had $11 million, $14 million and $13 million of nonperforming student loans at September 30, 2004, September 30, 2003, and December 31, 2003, respectively. Total nonperforming loans at September 30, 2004 were $91.5 million, down $33.7 million from September 30, 2003 and down $30.0 million from year-end 2003. The ratio of nonperforming loans to total loans was 0.84% at September 30, 2004, as compared to 1.22% and 1.18% at September 30, 2003, and year-end 2003, respectively. Compared to September 30, 2003, nonaccrual loans account for the majority of the $33.7 million decrease in nonperforming loans. Nonaccrual loans decreased $32.9 million, with the majority of the improvement attributable to the paydowns on six large problem credits (totaling approximately $25 million, in various industries, as previously mentioned), as management continues to work through problem credits. While accruing loans past due 90 or more days were down $0.7 million between September periods-ends, the September 30, 2004 balance included four loans totaling approximately $4.6 million that were subsequently resolved administratively in October, but were included as nonperforming loans in accordance with the Corporation's loan policy. Compared to December 31, 2003, nonaccrual loans also account for the majority of the $30.0 million decrease in nonperforming loans. Nonaccrual loans were down $32.8 million, with the majority of the improvement also attributable to the paydowns noted previously, while accruing loans past due 90 or more days were up $2.8 million, also attributable to the credits noted above. Other real estate owned was $4.5 million at September 30, 2004, compared to $6.4 million at September 30, 2003, and $5.5 million at year-end 2003. The change in other real estate owned was predominantly due to the addition and subsequent sale of commercial real estate properties. An $8.0 million property was added during fourth quarter 2002, three commercial properties (at $1.1 million, $1.5 million, and $2.7 million) were added during 2003, and a $1.3 million commercial property was added during first quarter 2004. The $1.5 million property was sold during the second quarter of 2003 (at a net loss of $0.6 million), the $8.0 million property was sold during the third quarter of 2003 (at a net gain of $1.0 million), the $2.7 million property was sold during the fourth quarter of 2003 (at a small gain), and the $1.1 million property was sold during the third quarter of 2004 (at a net gain of $0.4 million). Also during the fourth quarter of 2003, a $0.5 million write-down was recorded in other noninterest expense on another commercial property in other real estate owned. Potential problem loans are certain loans bearing risk ratings by management that are not in nonperforming loan status but where there are doubts as to the ability of the borrower to comply with present repayment terms. The decision of management to include performing loans in potential problem loans does not necessarily mean that the Corporation expects losses to occur but that management recognizes a higher degree of risk associated with these loans. The level of potential problem loans is a predominant factor in determining the relative level of risk in the loan portfolio and in the determination of the level of the allowance for loan losses. The loans that have been reported as potential problem loans are not concentrated in a particular industry but rather cover a diverse range of businesses. At September 30, 2004, potential problem loans totaled $257 million, down from $276 million at September 30, 2003, and up from $245 million at December 31, 2003. Liquidity The objective of liquidity management is to ensure that the Corporation has the ability to generate sufficient cash or cash equivalents in a timely and cost-effective manner to meet its commitments as they fall due. Funds are available from a number of sources, primarily from the core deposit base and from loans and securities repayments and maturities. Additionally, liquidity is provided from sales of the securities portfolio, lines of credit with major banks, the ability to acquire large and brokered deposits, and the ability to securitize or package loans for sale. The Corporation's liquidity management framework includes measurement of several key elements, such as wholesale funding as a percent of total assets and liquid assets to short-term wholesale funding. The 35 Corporation's liquidity framework also incorporates contingency planning to assess the nature and volatility of funding sources and to determine alternatives to these sources. The contingency plan would be activated to ensure the Corporation's funding commitments could be met in the event of general market disruption or adverse economic conditions. Strong capital ratios, credit quality, and core earnings are essential to retaining high credit ratings and, consequently, cost-effective access to the wholesale funding markets. A downgrade or loss in credit ratings could have an impact on the Corporation's ability to access wholesale funding at favorable interest rates. As a result, capital ratios, asset quality measurements, and profitability ratios are monitored on an ongoing basis as part of the liquidity management process. While core deposits and loan and investment portfolio repayments and maturities are principal sources of liquidity, funding diversification is another key element of liquidity management. Diversity is achieved by strategically varying depositor type, term, funding market, and instrument. The Parent Company and certain subsidiary banks are rated by Moody's, Standard and Poor's, and Fitch. These ratings, along with the Corporation's other ratings, provide opportunity for greater funding capacity and funding alternatives. The Parent Company manages its liquidity position to provide the funds necessary to pay dividends to stockholders, service debt, invest in subsidiaries, repurchase common stock, and satisfy other operating requirements. The Parent Company's primary funding sources to meet its liquidity requirements are dividends and service fees from subsidiaries, borrowings with major banks, commercial paper issuance, and proceeds from the issuance of equity. The subsidiary banks are subject to regulation and, among other things, may be limited in their ability to pay dividends or transfer funds to the Parent Company. Accordingly, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available for the payment of cash dividends to the shareholders or for other cash needs. In addition to dividends and service fees from subsidiaries, the Parent Company has multiple funding sources that could be used to increase liquidity and provide additional financial flexibility. These sources include a revolving credit facility, commercial paper, and two shelf registrations to issue debt and preferred securities or a combination thereof. The Parent Company has available a $100 million revolving credit facility with established lines of credit from nonaffiliated banks, of which $100 million was available at September 30, 2004. In addition, $200 million of commercial paper was available at September 30, 2004, under the Parent Company's commercial paper program. In May 2002, the Parent Company filed a "shelf" registration statement under which up to $300 million of trust preferred securities may be offered. In May 2002, $175 million of trust preferred securities were issued, bearing a 7.625% fixed coupon rate. At September 30, 2004, $125 million was available under the trust preferred shelf. In May 2001, the Parent Company filed a "shelf" registration statement whereby the Parent Company may offer up to $500 million of any combination of the following securities, either separately or in units: debt securities, preferred stock, depositary shares, common stock, and warrants. In August 2001, the Parent Company obtained $200 million in a subordinated note offering, bearing a 6.75% fixed coupon rate and 10-year maturity. At September 30, 2004, $300 million was available under the shelf registration. Investment securities are an important tool to the Corporation's liquidity objective. As of September 30, 2004, all securities are classified as available for sale and are reported at fair value on the consolidated balance sheet. Of the $4.2 billion investment portfolio at September 30, 2004, $2.3 billion were pledged to secure certain deposits or for other purposes as required or permitted by law. The remaining securities could be pledged or sold to enhance liquidity, if necessary. The bank subsidiaries have a variety of funding sources (in addition to key liquidity sources, such as core deposits, loan sales, loan and investment portfolio repayments and maturities, and loan and investment portfolio sales) available to increase financial flexibility. A bank note program associated with Associated Bank, National Association, was established during 2000. Under this program, short-term and long-term debt 36 may be issued. As of September 30, 2004, $300 million of long-term bank notes and $200 million of short-term bank notes were outstanding. At September 30, 2004, $1.1 billion was available under this program. The banks have also established federal funds lines with major banks and the ability to borrow from the Federal Home Loan Banks ($0.8 billion was outstanding at September 30, 2004). In addition, the bank subsidiaries from time to time accept Eurodollar deposits, issue institutional certificates of deposit, and offer brokered certificates of deposit. For the nine months ended September 30, 2004, net cash provided from operating and financing activities was $269.8 million and $697.1 million, respectively, while investing activities used net cash of $1.0 billion, for a net decrease in cash and cash equivalents of $39.6 million since year-end 2003. In the first nine months of 2004 maturities of time deposits occurred (down $183 million or 8% annualized) and net asset growth since year-end 2003 was strong (up $888 million or 8% annualized), particularly in loans and investments. Therefore, other funding sources were utilized, particularly short-term borrowings, to fund asset growth, replenish the net decrease in deposits, provide for the repayment of long-term debt and common stock repurchases, and payment of cash dividends to the Corporation's stockholders. For the nine months ended September 30, 2003, net cash provided from operating activities was $146.5 million, while investing activities and financing activities used net cash of $171.6 million and $53.7 million, respectively, for a net decrease in cash and cash equivalents of $78.8 million since year-end 2002. Generally, during year-to-date 2003, deposit growth was strong, while net asset growth since year-end 2002 was moderate (up approximately 1% annualized). Thus, the reliance on other funding sources was reduced, particularly short-term borrowings. The deposit growth also provided for the repayment of short-term borrowings and long-term debt, common stock repurchases, and the payment of cash dividends to the Corporation's stockholders. Capital On April 28, 2004, the Board of Directors declared a 3-for-2 stock split, effected in the form of a stock dividend, payable on May 12, 2004, to shareholders of record at the close of business on May 7, 2004. All share and per share information in the accompanying consolidated financial statements has been restated to reflect the effect of this stock split. In January 2004, the Board of Directors, with subsequent approval of the Corporation's shareholders, approved an amendment to the Articles of Incorporation of the Corporation to increase the number of authorized shares of the Corporation's common stock from 100 million to 250 million shares. Stockholders' equity at September 30, 2004 increased to $1.5 billion, up $152.5 million compared to September 30, 2003. The increase in equity between the two periods was primarily composed of the retention of earnings and the exercise of stock options, with partially offsetting decreases to equity from the payment of dividends and the repurchase of common stock. Additionally, stockholders' equity at September 30, 2004, included $49.3 million of accumulated other comprehensive income versus $36.3 million at September 30, 2003. The increase in accumulated other comprehensive income was predominantly related to a change in the additional pension obligation and lower unrealized losses on cash flow hedges, partially offset by a decrease in unrealized gains on securities available for sale, net of the tax effect. The ratio of stockholders' equity to assets was 9.01% and 8.61% at September 30, 2004 and 2003, respectively. Stockholders' equity grew $105.0 million since year-end 2003. The increase in equity between the two periods was primarily composed of the retention of earnings and the exercise of stock options, with partially offsetting decreases to equity from the payment of dividends and the repurchase of common stock. Additionally, stockholders' equity at year-end 2003 included $52.1 million of accumulated other comprehensive income versus $49.3 million at September 30, 2004. The decrease in accumulated other comprehensive income was predominantly related to lower unrealized gains on securities available for sale, partially offset by lower unrealized losses on cash flow hedges, net of the tax effect. Stockholders' equity to assets at September 30, 2004 was 9.01%, compared to 8.84% at December 31, 2003. 37 Cash dividends of $0.7267 per share were paid in year-to-date 2004, compared to $0.6600 per share in year-to-date 2003, representing an increase of 10.1%. The Board of Directors has authorized management to repurchase shares of the Corporation's common stock each quarter in the market, to be made available for issuance in connection with the Corporation's employee incentive plans and for other corporate purposes. For the Corporation's employee incentive plans, the Board of Directors authorized the repurchase of up to 3.0 million shares in 2004 (750,000 shares per quarter) and up to 2.4 million shares (600,000 shares per quarter) in 2003. Of these authorizations, 697,000 shares were repurchased for $20.1 million during the first nine months of 2004 at an average cost of $28.91 per share, while none were repurchased during 2003. Additionally, under two separate actions in 2000 and one action in 2003, the Board of Directors authorized the repurchase and cancellation of the Corporation's outstanding shares, not to exceed approximately 16.5 million shares on a combined basis. Under these authorizations no shares were repurchased during the first nine months of 2004, while approximately 2.9 million shares were repurchased during year-to-date 2003 at an average cost of $23.81 per share. At September 30, 2004, approximately 5.6 million shares remain authorized to repurchase. The repurchase of shares will be based on market opportunities, capital levels, growth prospects, and other investment opportunities. The adequacy of the Corporation's capital is regularly reviewed to ensure that sufficient capital is available for current and future needs and is in compliance with regulatory guidelines. The assessment of overall capital adequacy depends on a variety of factors, including asset quality, liquidity, stability of earnings, changing competitive forces, economic conditions in markets served and strength of management. The capital ratios of the Corporation and its banking affiliates are greater than minimums required by regulatory guidelines. The Corporation's capital ratios are summarized in Table 9.
---------------------------------------------------------------------------------------------------------------------- TABLE 9 (1) Capital Ratios (In Thousands, except per share data) ---------------------------------------------------------------------------------------------------------------------- September 30, June 30, March 31, December 31, September 30, 2004 2004 2004 2003 2003 ---------------------------------------------------------------------------------------------------------------------- Total stockholders' equity $ 1,453,465 $ 1,378,894 $ 1,395,293 $ 1,348,427 $ 1,300,948 Tier 1 capital 1,317,752 1,275,924 1,255,142 1,221,647 1,189,657 Total capital 1,678,543 1,631,109 1,607,707 1,572,770 1,538,751 Market capitalization 3,536,712 3,260,722 3,289,616 3,137,330 2,774,558 ----------------------------------------------------------------------- Book value per common share $ 13.18 $ 12.53 $ 12.67 $ 12.26 $ 11.84 Cash dividend per common share 0.2500 0.2500 0.2267 0.2267 0.2267 Stock price at end of period 32.07 29.63 29.86 28.53 25.26 Low closing price for the quarter 28.81 27.09 28.08 25.87 24.75 High closing price for the quarter 32.19 30.13 30.37 28.75 25.93 ----------------------------------------------------------------------- Total equity / assets 9.01% 8.89% 9.00% 8.84% 8.61% Tier 1 leverage ratio 8.52 8.37 8.36 8.37 7.98 Tier 1 risk-based capital ratio 10.98 11.06 11.00 10.86 10.64 Total risk-based capital ratio 13.99 14.14 14.10 13.99 13.76 ----------------------------------------------------------------------- Shares outstanding (period end) 110,281 110,048 110,168 109,966 109,840 Basic shares outstanding (average) 110,137 110,116 110,294 109,965 110,209 Diluted shares outstanding (average) 111,699 111,520 111,830 111,499 111,485 (1) All share and per share financial information has been restated to reflect the effect of the 3-for-2 stock split. -----------------------------------------------------------------------------------------------------------------------
Contractual Obligations, Commitments, Off-Balance Sheet Risk, and Contingent Liabilities The Corporation utilizes a variety of financial instruments in the normal course of business to meet the financial needs of its customers and to manage its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, commitments to originate residential mortgage loans held for sale, commercial letters of credit, standby letters of credit, forward commitments to sell residential mortgage loans, interest rate swaps, and interest rate caps. Please refer to the Corporation's Annual Report on Form 10-K for the year ended December 31, 2003, for discussion with respect to the Corporation's 38 quantitative and qualitative disclosures about its fixed and determinable contractual obligations. Items disclosed in the Annual Report on Form 10-K have not materially changed since that report was filed. The Corporation's derivative instruments at September 30, 2004, are included in Note 8, "Derivatives and Hedging Activities," of the notes to consolidated financial statements and the Corporation's commitments are included in Note 9, "Contractual Obligations, Commitments, Off-Balance Sheet Risk, and Contingent Liabilities," of the notes to consolidated financial statements. Comparable Third Quarter Results Net income for third quarter 2004 was $63.4 million, up $5.0 million or 8.5% from third quarter 2003 net income of $58.4 million with notably lower mortgage banking income more than offset by a reduction in the provision for loan losses and growth in other revenue sources. Return on average equity was 17.76%, up 1 bp from the third quarter of 2003, while return on average assets increased by 7 bp to 1.60%. See Tables 1 and 10. Taxable equivalent net interest income for the third quarter of 2004 was $139.6 million, $4.5 million higher than the third quarter of 2003. Volume variances favorably impacted taxable equivalent net interest income by $6.2 million (principally from growth of investments and other earning assets), while rate variances were unfavorable by $1.7 million (as the unfavorable rate variance on earning assets was greater than the favorable rate variance on interest-bearing liabilities). See Tables 2 and 3. Growth in average earning assets (up $560 million to $14.7 billion) was funded by increases in interest-bearing liabilities (up $426 million to $12.4 billion) and net free funds (up $134 million). Average investments grew $665 million (primarily mortgage-related securities) to $4.0 billion, while average loans were $10.7 billion, down $105 million between the comparable third quarter periods. Decreases in residential real estate loans (down $290 million) and consumer loans (down $37 million) were largely offset by an increase in commercial loans (up $222 million) Average interest-bearing deposits grew $81 million; however, the mix shifted from non-brokered time deposits and money market deposits to interest-bearing demand deposits and brokered certificates of deposit. Wholesale funding increased $345 million to $4.6 billion (which represented 36.9% of interest-bearing liabilities for the third quarter of 2004 compared to 35.4% for the third quarter of 2003), with a shift to short-term borrowings (which represented 57.3% versus 50.5% of wholesale funding for the third quarters of 2004 and 2003, respectively). The net interest margin of 3.76% was down 2 bp from 3.78% for the third quarter of 2003, the result of a 1 bp decline in the interest rate spread (i.e., a 12 bp drop in the earning asset yield, net of an 11 bp decrease in the average cost of interest-bearing liabilities) and a 1 bp lower contribution from net free funds. The 12 bp decline in the earning asset yield was comprised of a 5 bp decrease in loan yields and a 27 bp drop in investments, primarily a function of mix (as the growth in both loans and investments occurred in categories with lower yields). On the funding side, total interest-bearing deposits cost 1.39% on average for third quarter 2004, down 17 bp from the comparable quarter in 2003, and the rate on wholesale funding was down 2 bp. No provision for loan losses was recorded for the third quarter of 2004, a result of improved asset quality trends and an adequate level of the allowance for loan losses, versus a provision for loan losses for the third quarter of 2003 of $12.1 million. The allowance for loan losses to loans at September 30, 2004 was 1.62% compared to 1.71% at September 30, 2003. Net charge offs were $3.0 million for the three months ended September 30, 2004 and $8.3 million for the comparable quarter in 2003. Annualized net charge offs as a percent of average loans for third quarter were 0.11% versus 0.31% for the comparable quarter of 2003. Total nonperforming loans were $91.5 million, down 27% from $125.2 million at September 30, 2003. See Tables 6 and 8 and discussion under sections "Provision for Loan Losses," "Allowance for Loan Losses," and "Nonperforming Loans and Other Real Estate Owned." Noninterest income was $53.1 million for the third quarter of 2004, down $8.8 million from the third quarter of 2003 (see Table 4), with notably lower mortgage banking income offset in part by an increase in retail commission income. Mortgage banking income was down $15.1 million, reflecting the industry-wide 39 slowdown in refinancing activity (secondary mortgage production decreased to $254 million for the third quarter of 2004 versus $1.4 billion for the third quarter of 2003). Excluding mortgage banking income, noninterest income was up $6.3 million versus the comparable quarter in 2003. Retail commissions were up $5.1 million, primarily in insurance and fixed annuities, positively impacted by the Jabas acquisition. Credit card and other nondeposit fees increased $0.8 million, particularly from higher volumes leading to stronger credit card inclearing fees, and trust service fees grew $0.8 million, in line with the growth in assets under management. Noninterest expense for the third quarter of 2004 was down $0.8 million from the third quarter of 2003 (see Table 5), reflecting declines in most noninterest expense categories, partially offset by higher mortgage servicing rights expense and the inclusion of Jabas operating expenses. Mortgage servicing rights expense was up $1.8 million, primarily the result of a $2.0 million addition to the valuation allowance in the third quarter of 2004 versus none in the third quarter of 2003. Tightly controlled discretionary spending more than offset the above increases. Other expense was down $1.0 million (primarily in legal and professional fees), loan expense was down $0.7 million, and data processing was down $0.5 million. Income taxes were up $3.4 million between comparable quarters due to higher income before income taxes. The effective tax rate was 30.6% for the third quarter of 2004 compared to 29.6% for the third quarter of 2003. Sequential Quarter Results Net income for the third quarter of 2004 was $63.4 million, down $1.1 million from second quarter 2004 net income of $64.5 million with unfavorable changes in mortgage banking income and mortgage servicing rights expense largely offset by lower provision for loan losses. Return on average equity was 17.76%, down from 18.87% for the second quarter of 2004, while return on average assets decreased 7 bp to 1.60%. See Tables 1 and 10.
------------------------------------------------------------------------------------------------------------------------------ TABLE 10 Selected Quarterly Information ($ in Thousands) ------------------------------------------------------------------------------------------------------------------------------ For the Quarter Ended ------------------------------------------------------------------------------- September 30, June 30, March 31, December 31, September 30, 2004 2004 2004 2003 2003 ------------------------------------------------------------------------------------------------------------------------------ Summary of Operations: Net interest income $ 133,216 $ 131,879 $ 129,075 $ 127,137 $ 128,976 Provision for loan losses --- 5,889 5,176 9,603 12,118 Noninterest income 53,133 55,497 52,959 52,477 61,924 Noninterest expense 95,006 89,619 93,656 94,120 95,807 Income taxes 27,977 27,363 23,642 20,282 24,589 --------------- -------------- --------------- -------------- -------------- Net income $ 63,366 $ 64,505 $ 59,560 $ 55,609 $ 58,386 =============== ============== =============== ============== ============== Taxable equivalent net interest income $ 139,611 $ 138,266 $ 135,479 $ 133,367 $ 135,141 Net interest margin 3.76% 3.80% 3.80% 3.81% 3.78% Average Balances: Assets $ 15,730,451 $ 15,498,005 $ 15,261,277 $ 14,852,390 $ 15,152,676 Earning assets 14,688,914 14,480,701 14,185,569 13,828,992 14,128,702 Interest-bearing liabilities 12,381,407 12,231,733 12,083,003 11,637,646 11,955,420 Loans 10,708,701 10,685,542 10,433,411 10,354,726 10,813,769 Deposits 9,621,557 9,701,945 9,585,074 9,679,789 9,485,000 Stockholders' equity 1,419,600 1,374,632 1,378,804 1,309,167 1,304,983 Asset Quality Data: Allowance for loan losses to total loans 1.62% 1.69% 1.69% 1.73% 1.71% Allowance for loan losses to nonperforming loans 191% 207% 190% 146% 141% Nonperforming loans to total loans 0.84% 0.81% 0.89% 1.18% 1.22% Nonperforming assets to total assets 0.59% 0.60% 0.65% 0.83% 0.87% Net charge offs to average loans (annualized) 0.11% 0.21% 0.20% 0.31% 0.31% ------------------------------------------------------------------------------------------------------------------------------
Taxable equivalent net interest income for the third quarter of 2004 was $139.6 million, $1.3 million higher than second quarter 2004. Volume variances impacted taxable equivalent net interest income favorably by $2.0 million (primarily from growth in investments and commercial loans), while rate variances were unfavorable by $0.7 million (as an unfavorable rate variance on interest-bearing liabilities exceeded the favorable rate variance on earning assets). The net interest margin of 3.76% for the third quarter of 2004 was down 4 bp from the second quarter of 2004, reflecting a 6 bp decrease in interest rate spread (i.e., an 11 bp increase in the average cost of interest-bearing liabilities, net of a 5 bp increase in the earning asset yield), partially offset by a 2 bp higher contribution from net free funds. Average earning assets increased $208 million (5.7% annualized) between the sequential quarters, attributable to a $185 million increase in average investments (primarily in mortgage-related securities) and a $23 million increase in average loans (the net of a $103 million increase in commercial loans, a $3 million increase in consumer loans, and an $83 million decrease in residential real estate loans). The earning asset growth was funded by higher levels of average interest-bearing liabilities and net free funds. Average interest-bearing liabilities were up $150 million, reflecting a $270 million increase in wholesale funding (predominantly in long-term funding) and a $120 million decrease in interest-bearing deposits (with declines in interest-bearing demand and time deposits). Net free funds were up $59 million, led by increased average demand deposits (up $40 million). No provision for loan losses was recorded for the third quarter of 2004, a result of sustained improvement in asset quality trends and an adequate level of the allowance for loan losses, versus a provision for loan losses for the second quarter of 2004 of $5.9 million. The allowance for loan losses to loans was 1.62% at September 30, 2004, versus 1.69% at June 30, 2004. Net charge offs were $3.0 million for third quarter 2004, compared to $5.6 million for second quarter 2004. Annualized net charge offs as a percent of average loans for third quarter were 0.11% versus 0.21% for second quarter 2004. Total nonperforming loans were $91.5 million, up from $85.9 million at June 30, 2004, attributable to increases in accruing loans past due 90 or more days (four loans totaling approximately $4.6 million were resolved administratively during October, however these loans were reported as nonperforming loans at September 30, 2004, in accordance with the Corporation's loan policy). See discussion under sections "Provision for Loan Losses," "Allowance for Loan Losses," and "Nonperforming Loans and Other Real Estate Owned." Noninterest income decreased $2.4 million to $53.1 million between sequential quarters. Mortgage banking income was down $2.5 million, in line with the decrease in secondary mortgage production (at $254 million for the third quarter compared to $579 million for the second quarter). Excluding mortgage banking income, noninterest income was $46.5 million for both the third and second quarters of 2004. Retail commission income was down $1.2 million, predominantly in insurance and fixed annuities. Service charges on deposit accounts grew $0.5 million, attributable to seasonally higher volumes in overdrafts/nonsufficient funds. The $0.6 million favorable change in investment securities gains (losses) was due to a $0.2 million other-than-temporary write-down on a security and a $0.4 million loss on the sale of treasury securities during second quarter. On a sequential quarter basis, noninterest expense increased $5.4 million. Mortgage servicing rights expense increased $8.3 million, predominantly due to a $2.0 million addition to the valuation allowance in the third quarter compared to a $6.6 million recovery of the valuation allowance in the second quarter. Excluding mortgage servicing rights expense, noninterest expense of $89.0 million in the third quarter was $3.0 million lower than the second quarter. Tightly controlled discretionary spending partially offset the above increase, other expense was down $2.0 million (primarily in legal and professional fees) and loan expense was down $0.5 million. Income taxes were up $0.6 million between sequential quarters, primarily due to changes in net operating losses and the corresponding valuation allowances. The effective tax rate was 30.6% for the third quarter compared to 29.8% for the second quarter. 40 Recent Accounting Pronouncements The recent accounting pronouncements have been described in Note 3, "New Accounting Pronouncements," of the notes to consolidated financial statements. Subsequent Events On October 29, 2004, the Corporation consummated its acquisition of 100% of the outstanding shares of First Federal Capital Corp ("First Federal"), based in La Crosse, Wisconsin. The acquisition will be accounted for under the purchase method and was, therefore, appropriately not included in the consolidated financial statements herewith, but will be included in the Corporation's financial results effective upon the date of acquisition and thereafter. The Corporation is in the process of recording the transaction and assigning fair values of the assets acquired and liabilities assumed. The excess cost of the acquisition over the fair value of the net assets acquired will be allocated to the identifiable intangible assets with the remainder then allocated to goodwill. Thus, at the time of this filing it is not practicable to provide detailed updated financial information on the transaction. Any specific transaction results should be considered to be the best estimates available at the time of this filing and subject to change upon the completion of the recording of the transaction. See Note 5, "Business Combinations," of the notes to consolidated financial statements. On October 28, 2004, the Board of Directors declared a $0.25 per share dividend payable on November 15, 2004, to shareholders of record as of November 8, 2004. This cash dividend has not been reflected in the accompanying consolidated financial statements. ITEM 3. Quantitative and Qualitative Disclosures About Market Risk The Corporation has not experienced any material changes to its market risk position since December 31, 2003, from that disclosed in the Corporation's 2003 Form 10-K Annual Report. ITEM 4. Controls and Procedures The Corporation maintains a system of internal controls and procedures designed to provide reasonable assurance as to the reliability of its published financial statements and other disclosures included in this report. Within the 90-day period prior to the date of this report, the Corporation evaluated the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Rule 13a-14 of the Securities Exchange Act of 1934. Based upon that evaluation, the Corporation's Chief Executive Officer and Chief Financial Officer concluded that the Corporation's disclosure controls and procedures are effective in timely alerting them to material information relating to the Corporation required to be included in this quarterly report on Form 10-Q. There have been no significant changes in the Corporation's internal controls or in other factors which could significantly affect internal controls subsequent to the date of such evaluation. 41 ASSOCIATED BANC-CORP PART II - OTHER INFORMATION ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds Following are the Corporation's monthly common stock purchases during the first nine months of 2004 (in thousands, expect per share data). For a detailed discussion of the common stock repurchase authorizations and repurchases during the period, see section "Capital." Period Total Number of Average Price Paid Shares Purchased per Share ----------------------------------------------------------------------------- January 1, 2004 - January 31, 2004 15,000 $ 28.90 February 1, 2004 - February 29, 2004 121,500 28.80 March 1, 2004 - March 31, 2004 355,500 29.51 April 1, 2004 - April 30, 2004 --- --- May 1, 2004 - May 31, 2004 195,000 27.88 June 1, 2004 - June 30, 2004 10,000 28.97 July 1, 2004 - July 31, 2004 --- --- August 1, 2004 - August 31, 2004 --- --- September 1, 2004 - September 30, 2004 --- --- ----------------------------------------- Total 697,000 $ 28.91 ========================================= ITEM 6: Exhibits Exhibit 11, Statement regarding computation of per-share earnings. See Note 4 of the notes to consolidated financial statements in Part I Item I. Exhibit (31.1), Certification Under Section 302 of Sarbanes-Oxley by Paul S. Beideman, Chief Executive Officer, is attached hereto. Exhibit (31.2), Certification Under Section 302 of Sarbanes-Oxley by Joseph B. Selner, Chief Financial Officer, is attached hereto. Exhibit (32), Certification by the Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of Sarbanes-Oxley is attached hereto. 42 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. ASSOCIATED BANC-CORP (Registrant) Date: November 5, 2004 /s/ Paul S. Beideman -------------------------------------- Paul S. Beideman President and Chief Executive Officer Date: November 5, 2004 /s/ Joseph B. Selner -------------------------------------- Joseph B. Selner Chief Financial Officer