Item 1. Business
General
Provident Bankshares Corporation (“the Corporation”), a Maryland corporation, is the bank holding company for Provident Bank (“Provident” or “the Bank”), a Maryland chartered stock commercial bank. At December 31, 2005, the Bank was the second largest independent commercial bank (based on the FDIC market share report), in asset size, headquartered in Maryland, with $6.4 billion in assets. Provident is a regional bank serving Maryland and Virginia, with emphasis on the key urban centers within these states-the Baltimore, Washington and Richmond metropolitan areas.
Provident’s principal business is to acquire deposits from individuals and businesses and to use these deposits to fund loans to individuals and businesses. Provident also offers related financial services through wholly owned subsidiaries. Securities brokerage, investment management and related insurance services are available through Provident Investment Company (“PIC”) and leases through Court Square Leasing and Provident Lease Corporation.
Available Information
The Corporation’s Internet website is www.provbank.com. The Corporation makes available free of charge on or through its website its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after the Corporation electronically files such material with, or furnishes it to, the Securities and Exchange Commission (“SEC”).
Market Area
With banking offices throughout most of Maryland and a growing presence in Virginia, Provident serves one of the most vibrant regions in the country. As of June 30, 2005 (the most recently available statewide deposit share data report from the FDIC), Provident ranked eighth among commercial banks operating in Maryland with a 3.84% share of statewide deposits and eighteenth in Virginia with a 0.38% market share.
Maryland’s economy is performing at or above national levels, based on the most current data on unemployment and job growth. As a result of the announcement of Base Realignment and Closure 2005 from the U.S. Department of Defense, Maryland would gain nearly 10,000 military and civilian relocations in the near future. In addition, Maryland has the fourth (2003-2004, U.S. Census Bureau) highest median household income at $55,519 in the country.
Metropolitan Baltimore is a regional center for the shipping and trucking industries given its deepwater harbor and proximity to Interstate 95. As a consequence, it is also a major provider of warehouse operations for retail distribution and logistics providers. More importantly, this metropolitan area is diversifying from a blue-collar to a white-collar business environment. It is gaining from such major employers as John Hopkins University and Health Systems, Northrop Grumman, Verizon, Constellation Energy and the University of Maryland Medical Systems.
To complement its presence in the attractive Maryland market, Provident has expanded into Virginia. Northern Virginia is the fastest growing area in Virginia and is home to nearly two million people. The technology sector, one of the largest in the United States, has been growing vigorously in the region. Residential construction continues to highlight Northern Virginia’s economic strengths. At nearly $83,000, the Northern Virginia region also has one of the highest median incomes in the country.
Important to both Maryland and Virginia is the accessibility to other key neighboring markets such as Philadelphia, New York and Pittsburgh, as well as the ports in Baltimore and Norfolk. In addition, the Baltimore-Washington corridor gains from the presence and employment stability of the federal government and related service industries. The market has benefited from increased federal spending, particularly in the defense and homeland security sectors. In addition, the region stands to expand economically through anticipated growth in health care and educational spending in the near term.
Business Strategy
Provident is well positioned in its region to provide the products and services of its largest competitors, while delivering the level of service provided by the best community banks. Over the past several years, the Corporation’s focus has been on the consistent execution of a group of fundamental business strategies: to broaden its presence and customer base in the Virginia and metropolitan Washington D.C. markets; to grow its commercial business in all of its markets; to focus its resources in core business lines; and to improve financial fundamentals.
These strategies were consistent with the merger with Southern Financial Bancorp, Inc. of Warrenton, Virginia (“Southern Financial”), which was finalized on April 30, 2004. The addition of Southern Financial’s 30 banking office franchise supports the Bank’s strategy to expand in the Virginia and metropolitan Washington markets. The merger also complemented the Bank’s strategy to enhance its consumer and commercial business lines, as Southern Financial’s commercial banking strength was combined with Provident’s ability to attract consumer loans and low cost deposits.
Provident’s mission is to exceed customer expectations by delivering superior service, products and banking convenience. Every employee’s commitment to serve its customers in this fashion will establish Provident as the primary bank of choice of individuals, families, small businesses and middle market businesses throughout its chosen markets. To achieve this mission, the strategic focus of the organization is to:
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Maximize Provident’s position as the right size bank in the marketplace
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Grow and deepen consumer and small business relationships in Maryland and Virginia
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Grow and deepen commercial and real estate relationships in Maryland and Virginia
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Move from a product driven organization to a customer relationship focused sales culture
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Create a high performance culture that focuses on employee development and retention
The objective of these strategies is the improvement in financial fundamentals. The Corporation offers consumer and commercial banking products and services through the Consumer Banking group and the Commercial Banking group.
Consumer banking services include a broad array of consumer and small business loan, lease, deposit and investment products offered to retail and commercial customers through Provident’s banking office network and Provident Direct, the Bank’s direct channel sales center that serves consumers via the Internet and in-bound and out-bound telephone operations. The small business segment is further supported by relationship managers who provide comprehensive business product and sales support to expand existing customer relationships and acquire new clients.
Commercial Banking provides an array of commercial financial services to middle market commercial customers. The Bank has an experienced team of relationship officers with expertise in real estate and business lending to companies in various industries in the region. Within our Commercial Banking group, the Real Estate Lending department provides the lending expertise for construction and permanent financing options on a variety of property types, including, office buildings, retail centers, apartment buildings, warehouse and flex space. The Bank also has a suite of cash management products managed by responsive account teams that deepen customer relationships through consistently priced deposit based services.
The cornerstone of the Bank’s ability to serve its customers is its banking office network, which consists of 91 traditional banking office locations and 61 in-store banking offices at December 31, 2005. Today, the network of 61 in-store banking offices is located in a broad range of supermarkets and national retail superstores. The Bank’s primary agreements are with four premier store partners: SUPERVALU to operate banking offices in their Shoppers Food Warehouse supermarkets in Maryland and Virginia, WalMart and BJs Wholesale Club to operate banking offices in selected Baltimore and Washington, D.C. metropolitan stores, and SuperFresh to operate banking offices in selected Maryland stores.
Of the 152 banking offices at December 31, 2005, 43% are located in the Baltimore metropolitan region and 57% are located in the metro Washington and Virginia regions, reflecting the successful development of the Bank into a highly competitive regional commercial bank. The merger with Southern Financial added 30 traditional banking offices in the Washington, Central Virginia and Richmond metropolitan areas. These offices complement Provident’s existing network of in-store banking offices in the Washington region. Provident opened one new in-store banking office and two traditional banking offices during 2005. Additional banking office opportunities complementary to existing locations may be sought when the cost of entry is reasonable. The Bank has several new banking offices in various stages of planning. Provident also offers its customers 24-hour banking services through ATMs, telephone banking and the Internet. The network of 251 ATMs enhances the banking office network by providing customers increased opportunities to access their funds.
Lending Activities
Loan Composition
Provident offers a diversified mix of residential and commercial real estate, business and consumer loans and leases. The following table sets forth information concerning the Bank’s loan portfolio by type of loan at December 31.
Loan Portfolio Summary:
Contractual Loan Principal Repayments
The following table presents contractual loan maturities and interest rate sensitivity at December 31, 2005. The cash flow from loans is expected to significantly exceed contractual maturities due to refinances and early payoffs.
Loan Maturities and Rate Sensitivity:
Consumer Lending
A wide range of loans including installment loans secured by real estate, boats, or automobiles, home equity lines, and unsecured personal lines of credit are available to consumers. At December 31, 2005, consumer loans represented 49% of the total loan portfolio. Of these loans, 75% are secured by residential real estate, 23% by boats or automobiles, and 2% are unsecured.
The banking office network and Provident Direct are the origination sources for new home equity loans and lines and other direct consumer loans, representing 25% of total loans. For the origination of marine loans, representing 11% of total loans, the Bank utilizes a network of correspondent brokers as the source of loan applications from key boating areas across the country. Provident individually underwrites each loan, including both credit and loan to value considerations.
The Bank also periodically purchases portfolios of loans (consisting of first mortgages, home equity loans and lines) secured by residential real estate from other financial services companies. All acquired portfolios go through a due diligence process prior to a purchase commitment. Over the past several years, the Bank has increased its credit quality requirements for new acquisitions and shifted its lien position focus from predominantly second lien position to entirely first lien position. At December 31, 2005, approximately 84% of the acquired portfolio was in first lien position. Over the past 12 months, the Bank purchased $10.2 million in residential loans. Management currently intends to reduce this wholesale portfolio and replace it with internally generated loan production.
The residential real estate mortgage portfolio consists of loans originated by a subsidiary of the Bank prior to 2001, as well as loans originated by Southern Financial prior to its merger with the Bank. The Bank currently provides mortgages to its consumer customers through a third party loan processor, and does not retain any of the mortgages originated from that process. At December 31, 2005, the portfolio of residential real estate mortgage loans represented 4% of consumer loans.
Commercial Real Estate Lending
The Bank’s commercial real estate lending focus has been on financing commercial and residential construction, as well as on intermediate-term commercial mortgages. Properties securing these loans include office buildings, shopping centers, apartment complexes, warehouses, hotels and tract developments. These portfolios totaled $1.2 billion at December 31, 2005, or 33% of total loans.
Commercial Business Lending
Provident makes business loans primarily to small and medium sized businesses in the Baltimore, Maryland and Washington, D.C. metropolitan areas. Within this context, the Bank is well diversified from an industry perspective with no major concentrations in any industry. Commercial business loans represent 19% of the Bank’s total loans, and consist of term loans, equipment leases and revolving lines of credit for the purpose of current asset financing, equipment purchases, owner occupied real estate financing and business expansion. Commercial business loans are originated directly from offices in Baltimore City and Montgomery County, Maryland, Fairfax County and Richmond, Virginia, as well as the Bank’s banking office network. Leases originated by Court Square Leasing, which utilizes a network of vendors to source small equipment leases, and Provident Lease Corporation, which originates general equipment leases, represented 18% of the commercial business portfolio at December 31, 2005.
Other Lending
At December 31, 2005, the Bank had $50.9 million of loans syndicated by other financial institutions, which qualified as a shared national credit, of which $30.0 million was included in commercial business loans and $20.9 million was included in commercial real estate loans. The Bank has no exposure to highly leveraged transactions (“HLTs”), which are loans to borrowers for the purpose of purchasing or recapitalizing a business in which the loans represent a majority of the borrower’s liabilities.
Non-Performing Assets and Delinquent Loans
Non-performing assets include non-accrual loans, renegotiated loans and real estate and other assets that have been acquired through foreclosure or repossession. The Corporation’s credit procedures require monitoring of commercial credits to determine the collectibility of contractually due principal and interest to assess the need for providing for inherent losses. If a loan is identified as impaired, it is placed on non-accrual status. At December 31, 2005, commercial loans totaling $17.8 million were considered to be impaired.
Delinquencies occur in the normal course of business. The Corporation focuses its efforts on the management of loans that are in various stages of delinquency. These include loans that are 90 days or more delinquent that are still accruing interest because they are well secured and in the process of collection. Closed-end consumer loans secured by non-residential collateral are generally charged off to the collateral’s fair value less costs to sell (“net fair value”) at 120 days delinquent. Unsecured open-end consumer loans are charged off in full at 180 days delinquent. Demand deposit overdrafts that have been reclassified as loans generally are charged off in full at 60 days delinquent. Loans secured by residential real estate are placed on non-accrual status at 120 days delinquent, unless well secured and in the process of collection. Any portion of an outstanding loan balance secured by residential real estate in excess of the net fair value is charged-off when it is no more than 180 days delinquent. Regardless of collateral value, with isolated exceptions, these loans are placed on non-accrual status at 210 days delinquent. Commercial loans are placed on non-accrual status at 90 days delinquent unless well secured and in the process of collection. Charge-offs of delinquent loans secured by commercial real estate are generally recognized when losses are reasonably estimable and probable.
Deposit Activities
The table below presents the average deposit balances and rates paid for the three years ended December 31, 2005.
Average Deposits:
Average deposits obtained from customers (rather than brokers) represented over 90% of the Bank’s deposit funding for the past three years achieving management’s strategic goal to shift the mix of deposits to customer deposits. Customer deposits are generated by cross sales and calling efforts of the banking office and commercial cash management sales force. At December 31, 2005, deposits reached a bank record high $4.1 billion, a $344 million increase over year-end 2004. At December 31, 2005, deposits were relatively balanced between transaction accounts, savings accounts and time deposits. As a result of the banking office expansion efforts, including the Southern Financial merger, approximately 40% of customer deposit balances at year-end were from Virginia and the Washington metropolitan area. Further, the percentage of commercial deposits continued to increase, with commercial deposit balances representing 25% of customer deposits at year-end and compared to 22% at December 31, 2004.
Transaction accounts remain a key part of the Bank’s deposit gathering strategy. Transaction accounts not only serve as an important cross-sell tool in terms of deepening customer relationships, but also are an important source of fee income to the Bank. “Totally Free Checking,” a product that Provident introduced to the Baltimore area in 1993, remains the Bank’s most popular checking account product. Management believes its checking account products, combined with the Bank’s service options available through both traditional and in-store banking offices, ensure that Provident remains a regional leader in the deposit gathering process.
Provident has determined that it competes most effectively by seeking to be the “right size” bank. Management believes Provident is the “right size” bank because it continues to provide the products and services of its largest competitors, while seeking to deliver the level of service found in only the best community banks.
Treasury Activities
The Treasury Division manages the wholesale segments of the balance sheet, including investments, purchased funds, long-term debt and derivatives. Management’s objective is to achieve the maximum level of stable earnings over the long term, while controlling the level of interest rate and liquidity risk, and optimizing capital utilization. Treasury strategies and activities are overseen by the Bank’s Asset / Liability Committee (“the ALCO”), which also reviews all trades. ALCO activities are summarized and reviewed monthly with the Corporation’s Board of Directors.
Investments
At December 31, 2005, the investment securities portfolio was $1.9 billion, or 30% of total assets. The portfolio objective is to obtain the maximum sustainable interest margin over match-funded borrowings, subject to liquidity, credit and interest rate risk; as well as capital, regulatory and economic considerations. Typically, management classifies securities as available for sale to maximize management flexibility, although securities may be purchased with the intention of holding to maturity.
The following table sets forth information concerning the Corporation’s investment securities portfolio at December 31 for the periods indicated.
Investment Securities Summary:
The following table presents the expected cash flows and interest yields of the Bank’s investment securities portfolio at December 31, 2005.
Investment Securities Portfolio:
* Yields do not give effect to changes in fair value that are reflected as a component of stockholders’ equity.
To achieve its stated objective, the Corporation invests predominantly in U.S. Treasury and Agency securities, mortgage-backed securities (“MBS”) and other debt securities, which include corporate bonds and asset-backed securities. At December 31, 2005, 54% of the investment portfolio was invested in MBS. The Corporation believes that the MBS portfolio is well diversified with respect to issuer, both agency and non-agency; structure, including passthroughs and collateralized mortgage obligations (“CMOs”); and re-pricing specifications, which employ fixed rate bonds as well as monthly, annual, and 3 to 7 year reset adjustable rate mortgages (“ARMs”). Issuer, coupon, vintage, maturity, and average loan size further diversify the agency MBS portfolio. The asset-backed securities (“ABS”) portfolio, representing 31% of the total portfolio, consists predominantly of Aaa and single A rated tranches of pooled trust preferred securities. Other debt securities representing 15% of the portfolio at December 31, 2005, are primarily invested in U.S. agency, municipal, or corporate securities rated investment grade by Moody’s and S&P rating agencies.
The primary risk in the investment portfolio is duration risk. Duration measures the expected change in the market value of an investment for a 100 basis point (or 1%) change in interest rates. The higher an investment’s duration, the longer the time until its rate is reset to current market rates. The Bank’s risk tolerance, as measured by the duration of the investment portfolio, is typically between 2% and 3%. In the current economic environment, the duration is targeted for the middle of that range. In 2005, $223 million of floating rate ABS were added to the portfolio to reduce the overall portfolio duration risk and increase asset sensitivity to short-term rate changes. Another risk in the investment portfolio is credit risk. At December 31, 2005, approximately 68% of the entire investment portfolio was rated AAA, 31% was investment grade below AAA, and 1% was rated below investment grade or was not rated. The AAA rated percentage declined from December 31, 2004 due to the increased allocation to ‘A’ and ‘AA’ rated floating rate ABS.
Investment securities are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized. The Corporation had a limited number of securities in a continuous loss position for 12 months or more at December 31, 2005. Because the declines in fair value were due to changes in market interest rates, not in estimated cash flows, no other than temporary impairment was recorded at December 31, 2005.
Borrowings
Provident’s funds management objectives are two-fold: to minimize the cost of borrowings while assuring sufficient funding availability to meet current and future customer requirements; and to contribute to interest rate risk management goals through match-funding loan or investment activity. Management utilizes a variety of sources to raise borrowed funds at competitive rates, including federal funds purchased (“fed funds”), Federal Home Loan Bank (“FHLB”) borrowings, securities sold under repurchase agreements (“repos”), and brokered and jumbo certificates of deposit (“CDs”). FHLB borrowings and repos typically are borrowed at rates approximating the LIBOR rate for the equivalent term because they are secured with investments or high quality real estate loans. Fed funds, which are generally overnight borrowings, are typically purchased at the Federal Reserve target rate. Brokered CDs are generally added when market conditions permit issuance at rates more favorable than other funding sources.
The Corporation formed wholly owned statutory business trusts in 1998, 2000 and 2003. In 2004, the Corporation acquired three wholly owned statutory business trusts from Southern Financial as part of the merger. In all cases, the trusts issued trust preferred securities that were sold to outside third parties. The junior subordinated debentures issued by the Corporation to the Trusts are presented net of unamortized issuance costs as long-term debt in the Consolidated Statements of Condition and are includable in Tier 1 capital for regulatory capital purposes, subject to certain limitations. See Note 12 for a description of the remaining outstanding issuances. Any of the junior subordinated debentures are redeemable at any time in whole, but not in part, from the date of issuance on the occurrence of certain events. On February 28, 2005, the Corporation announced the redemption of $30 million aggregate value of capital securities issued by Provident Trust II at an annual rate of 10%. The redemption occurred on March 31, 2005. On July 15, 2005, Provident redeemed Southern Financial Capital Trust I, a $5 million issuance paying an 11% annual dividend. There are no issuances callable in 2006.
Employees
At December 31, 2005, the Corporation and its subsidiaries had 1,934 full-time equivalent employees. The Corporation currently maintains what management considers to be a comprehensive, competitive employee benefits program. A collective bargaining unit does not represent employees and management considers its relationship with its employees to be good.
Competition
The Corporation encounters substantial competition in all areas of its business. There are eleven bank holding companies or other banking institutions in Maryland with commercial banks that have deposits in Maryland in excess of $1 billion, three are headquartered in Maryland and eight are headquartered in other states. There are seventeen bank holding companies or other banking institutions in Virginia with commercial banks that have deposits in Virginia in excess of $1 billion, ten are headquartered in Virginia and seven are headquartered in other states. The Bank also faces competition from savings and loans, savings banks, mortgage banking companies, credit unions, insurance companies, consumer finance companies, money market and mutual fund firms and various other financial services institutions.
Current federal law allows the merger of banks by bank holding companies nationwide. Further, federal and Maryland laws permit interstate banking. Legislation has broadened the extent to which financial services companies, such as investment banks and insurance companies, may control commercial banks. As a consequence of these developments, competition in the Bank’s principal markets may increase, and a further consolidation of financial institutions in Maryland may occur.
Regulation
The Corporation is registered as a bank holding company under the Bank Holding Company Act of 1956 (“HOLA”). As such, the Corporation is subject to regulation and examination by the Federal Reserve Board, and is required to file periodic reports and any additional information that the Federal Reserve Board may require. HOLA imposes certain restrictions upon the Corporation regarding the merger of substantially all of the assets, or direct or indirect ownership or control, of any bank of which it is not already the majority owner; or, with certain exceptions, of any company engaged in non-banking activities.
The Bank is subject to supervision, regulation and examination by the Commissioner of the Division of Financial Regulation of the State of Maryland and the Federal Deposit Insurance Corporation (“FDIC”). Asset growth, deposits, reserves, investments, loans,
consumer law compliance, issuance of securities, payment of dividends, establishment of banking offices, mergers and consolidations, changes in control, electronic funds transfer, management practices and other aspects of operations are subject to regulation by the appropriate federal and state supervisory authorities. The Bank is also subject to various regulatory requirements of the Federal Reserve Board applicable to FDIC insured depository institutions.
The Gramm-Leach-Bliley Act of 1999 authorizes a bank holding company that meets specified conditions to become a “financial holding company” and thereby engage in a broader array of financial activities than previously permitted. Such activities may include insurance underwriting and investment banking. The Gramm-Leach-Bliley Act also authorizes banks to engage through “financial” subsidiaries in certain of the activities permitted for financial holding companies. To date, the Corporation has not elected financial holding company status.
Monetary Policy
The Corporation and the Bank are affected by fiscal and monetary policies of the federal government, including those of the Federal Reserve Board, which regulates the national money supply in order to mitigate recessionary and inflationary pressures. Among the techniques available to the Federal Reserve Board are engaging in open market transactions of U.S. Government securities, changing the discount rate and changing reserve requirements against bank deposits. These techniques are used in varying combinations to influence the overall growth of bank loans, investments and deposits. Their use may also affect interest rates charged on loans and paid on deposits. The effect of governmental policies on the earnings of the Corporation and the Bank cannot be predicted.
Regulatory Capital
Banks are required to maintain a sufficient level of capital in order to sustain growth, absorb unforeseen losses and meet regulatory requirements. The standards used by federal bank regulators to evaluate capital adequacy are the leverage ratio and risk-based capital guidelines. The Corporation’s core (or tier 1) capital is equal to total stockholders’ equity less net Accumulated Other Comprehensive Income (Loss) (“OCI”) plus capital securities less intangible assets. Total regulatory capital consists of core capital plus the allowance for loan losses, subject to certain limitations. The trust preferred securities are considered capital securities, and accordingly, are includable as tier 1 capital, subject to certain limitations.
The leverage ratio represents core capital divided by quarterly average total assets. Guidelines for the leverage ratio require the ratio to be 100 to 200 basis points above a 3% minimum, depending on risk profiles and other factors. Risk-based capital ratios measure core and total regulatory capital against risk-weighted assets. Risk-weighted assets are determined by applying a weighting to asset categories as prescribed by regulation and certain off-balance sheet commitments based on the level of credit risk inherent in the assets. At December 31, 2005, the Corporation exceeded all regulatory capital requirements.
Item 1A.
Item 1A. Risk Factors
Rising interest rates may reduce the Corporation’s net income and future cash flows.
Interest rates were recently at historically low levels. However, since June 30, 2004, the U.S. Federal Reserve has increased its target for the federal funds rate fourteen times from 1.00% to 4.5%. While these short-term market interest rates (which the Corporation uses as a guide to price its loans and deposits) have increased, longer-term market interest rates (which the Corporation uses as a guide to price its longer-term loans and deposits) have not. If short-term market interest rates continue to rise, and if rates on the Corporation’s deposits and borrowings reprice upwards faster than the rates on the Corporation’s long-term loans and investments, the Corporation would experience compression of its interest rate spread and net interest margin, which would have a negative effect on the Corporation’s profitability.
Recent and possible future acquisitions could involve risks and challenges that could adversely affect the Corporation’s ability to achieve its profitability goals for acquired businesses or realize anticipated benefits of those acquisitions.
The Corporation has experienced moderate growth in the past several years and its strategy of future growth includes the possible acquisition of banking branches, other financial institutions and other financial services companies. Most recently, the Corporation completed its merger with Southern Financial on April 30, 2004. However, the Corporation cannot assure investors that it will be able to identify suitable future acquisition opportunities or finance and complete any particular acquisition, combination or other transaction on acceptable terms and prices. All acquisitions involve a number of risks and challenges that could adversely affect the Corporation’s ability to achieve anticipated benefits of acquisitions.
The Corporation’s allowance for loan losses may be inadequate, which could hurt the Corporation’s earnings.
The Corporation’s allowance for loan losses may not be adequate to cover actual loan losses and if the Corporation is required to increase its allowance, current earnings may be reduced. When borrowers default and do not repay the loans that the Bank makes to them, the Corporation may lose money. The Corporation’s experience shows that some borrowers either will not pay on time or will not pay at all, which will require the Corporation to cancel or “charge-off” the defaulted loan or loans. The Corporation provides for losses by reserving what it believes to be an adequate amount to absorb any probable inherent losses. A “charge-off” reduces the Corporation’s allowance for loan losses. If the Corporation’s allowance were insufficient, it would be required to increase the allowance by recording a larger provision for loan losses, which would reduce earnings for that period.
Changes in economic conditions could cause an increase in delinquencies and non-performing assets, including loan charge-offs, which in turn may negatively affect the Corporation’s income and growth.
The Corporation’s loan portfolio includes many real estate secured loans, demand for which may decrease during economic downturns as a result of, among other things, an increase in unemployment, a decrease in real estate values or increases in interest rates. These factors could depress the Corporation’s earnings and consequently its financial condition because:
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customers may not want or need the Corporation’s products and services;
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borrowers may not be able to repay their loans;
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the value of the collateral securing the Corporation’s loans to borrowers may decline; and
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the quality of the Corporation’s loan portfolio may decline.
Any of the latter three scenarios could cause an increase in delinquencies and non-performing assets or require the Corporation to “charge-off” a percentage of its loans and/or increase the Corporation’s provisions for loan losses, which would reduce the Corporation’s earnings.
Because the Corporation competes primarily on the basis of the interest rates it offers depositors and the terms of loans it offers borrowers, the Corporation’s margins could decrease if it were required to increase deposit rates or lower interest rates on loans in response to competitive pressure.
The Corporation faces intense competition both in making loans and attracting deposits. The Corporation competes primarily on the basis of its depository rates, the terms of the loans it originates and the quality of the Corporation’s financial and depository services. This competition has made it more difficult for the Corporation to make new loans and at times has forced the Corporation to offer higher deposit rates in its market area. The Corporation expects competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, enabled banks to expand their geographic reach by providing services over the Internet and enabled non-depository institutions to offer products and services that traditionally have been provided by banks. Recent changes in federal banking law permit affiliation among banks, securities firms and insurance companies, which also will change the competitive environment in which the Corporation conducts business. Some of the institutions with which the Corporation competes are significantly larger than the Corporation and, therefore, have significantly greater resources.
Business Continuity
The Corporation is subject to events that could impact or disrupt its business, although its goal is to ensure continuous service delivery to its customers. The Corporation has undertaken an enterprise-wide Business Continuity Plan in order to respond to and guard against this risk. However, no plan can fully eliminate such risk and there can be no assurance that the Corporation’s Plan will be successful.
Provident Bank operates in a highly regulated environment and may be adversely affected by changes in laws and regulations.
Provident Bank is subject to regulation, supervision and examination by the Commissioner of the Division of Financial Regulation of the State of Maryland, its chartering authority, and by the Federal Deposit Insurance Corporation, as insurer of its deposits. Such regulation and supervision govern the activities in which a commercial bank and its holding company may engage and are intended primarily for the protection of the deposit insurance funds and depositors. These regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of a bank, the classification of assets by a bank and the adequacy of a bank’s allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, or legislation, could have a material impact on Provident Bank, the Corporation and their operations.
The Corporation’s operations are also subject to extensive regulation by other federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of its operations. The Corporation believes that it is in substantial compliance in all material respects with applicable federal, state and local laws, rules and regulations. Because its business is highly regulated, the Corporation may be subject to changes in such laws, rules and regulations that could have a material impact on its operations.
The Corporation is subject to security and operational risks relating to use of its technology that could damage its reputation and business.
Security breaches in the Corporation’s internet banking activities could expose it to possible liability and damage its reputation. Any compromise of the Corporation’s security also could deter customers from using its internet banking services that involve the transmission of confidential information. The Corporation relies on standard internet security systems to provide the security and authentication necessary to effect secure transmission of data. These precautions may not protect its systems from compromises or breaches of its security measures that could result in damage to its reputation and business. Additionally, the Corporation outsources its data processing to a third party. If the Corporation’s third party provider encounters difficulties or if the Corporation has difficulty in communicating with such third party, it will significantly affect the Corporation’s ability to adequately process and account for customer transactions, which would significantly affect its business operations.
Various factors could hinder or prevent takeover attempts.
Provisions of the Corporation’s Articles of Incorporation and Bylaws and federal and state regulations make it difficult and expensive to pursue a takeover attempt that management opposes. These provisions also make the removal of the current board of directors or management, or the appointment of new directors, more difficult. For example, the Corporation’s Articles of Incorporation and Bylaws contain provisions that could impede a takeover or prevent the Corporation from being acquired, including a classified board of directors and limitations on the ability of the Corporation’s stockholders to remove a director from office without cause. The Corporation’s board of directors may issue additional shares of common stock or establish classes or series of preferred stock with rights, preferences and limitations as determined by the board of directors without stockholder approval. These factors give the board of directors the ability to prevent, or render more difficult or costly, the completion of a takeover transaction that the Corporation’s stockholders might view as being in their best interests.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
The Corporation has 167 offices from which it conducts, or intends to conduct, business which are located in the Maryland, Virginia and southern Pennsylvania. The Bank owns 21 and leases 146 of these offices. Most of these leases provide for the payment of property taxes and other costs by the Bank, and include one or more renewal options ranging from five to ten years. Some of the leases also contain a purchase option.
Item 3.
Item 3. Legal Proceedings
Litigation
The Corporation is involved in various legal actions that arise in the ordinary course of its business. In April 2005, the Corporation became a party to litigation where a former employee alleges a breach by the Corporation of a previously executed employment contract. The former employee claims that, under the terms of the contract, he is due a so-called “imputed interest payment” valued at approximately $2 million. Further, under a theory of damages put forth, he asserts that he is owed a multiple of the imputed interest payment. The aggregate damage award sought against the Corporation in this action is approximately $6 million. The litigation is currently in the discovery phase and no trial date has been set. The Corporation believes it has meritorious defenses against this action and is vigorously and actively contesting the allegations against it.
All other active lawsuits entail amounts which management believes, in the aggregate, are immaterial to the financial condition and the results of operations of the Corporation.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The common stock of Provident Bankshares Corporation is traded over-the-counter and is quoted in the NASDAQ National Market. Such over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. The NASDAQ symbol is PBKS. At March 2, 2006, there were approximately 4,000 holders of record of the Corporation’s common stock.
For the year ended 2005, the Corporation declared and paid dividends of $1.09 per share of common stock outstanding. Declarations or payments of dividends are subject to a determination by the Corporation’s Board of Directors, which takes into account the Corporation’s financial condition, results of operations, economic conditions and other factors, including the regulatory restrictions which affect the payment of dividends by the Bank to the Corporation. No assurances can be given, however, that any dividends will be paid or, if commenced, will continue to be paid. See “Item 7.-Management’s Discussion and Analysis of Financial Condition and Results of Operations-Financial Condition-Liquidity” for a future discussion of the restrictions on the Corporation’s paying of dividends.
As of December 31, 2005, the Corporation had approximately 4,046 holders of record (excluding the number of persons or entities holding stock in street name through various brokerage firms), and 32,933,118 shares outstanding.
The following table sets forth high and low sales prices for each quarter during the years ended December 31, 2005 and 2004 for the Corporation’s common stock and the corresponding quarterly dividends paid per share.
During 1998, the Corporation initiated a stock repurchase program for its outstanding stock. Under this plan, the Corporation approved the repurchase of a specific amount of shares without any specific expiration date. As the Corporation fulfilled each specified repurchase amount, additional amounts were approved. Most recently, on June 17, 2005, the Corporation approved an additional stock repurchase of up to 1.3 million shares from time to time subject to market conditions. Currently, the maximum number of shares remaining to be purchased under this plan is 1,237,865. All shares have been repurchased pursuant to the publicly announced plan. The repurchase plan will continue until completed or terminated by the Board of Directors. No plans expired during the three months ended December 31, 2005. The Corporation currently has no plans to terminate the stock repurchase program prior to its expiration.
The following table provides certain information with regard to shares repurchased by the Corporation in the fourth quarter of 2005.
On January 18, 2005, the Corporation’s Stockholder Protection Rights Agreement, together with any rights issued in connection with the Stockholder Protection Rights Agreement, lapsed. The Corporation has made no determination with respect to the reinstatement of a similar agreement in the future.
Item 6.
Item 6. Selected Financial Data
The Corporation has derived the following selected consolidated financial and other data of the Corporation in part from the consolidated financial statements and notes appearing elsewhere in this Form 10-K and from consolidated financial statements previously filed.
(1) Tax-advantaged income has been adjusted to a tax-equivalent basis using the combined statutory federal and state income tax rate in effect for all years presented.
(2) Common equity excludes net accumulated OCI.
(3) Exclusive of the cumulative change in accounting principle, return on average assets and return on average equity for 2001 would have been 0.83% and 14.50%, respectively.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
FINANCIAL REVIEW
The principal objective of this Financial Review is to provide an overview of the financial condition and results of operations of Provident Bankshares Corporation and its subsidiaries for the three years ended December 31, 2005. This discussion and tabular presentations should be read in conjunction with the accompanying Consolidated Financial Statements and Notes as well as the other information herein, particularly the information regarding the Corporation’s business operations as described in Item 1.
Overview of Income and Expenses
Income
The Corporation has two primary sources of pre-tax income. The first is net interest income. Net interest income is the difference between interest income - which is the income that the Corporation earns on its loans and investments-and interest expense-which is the interest that is paid on its deposits and borrowings.
The second principal source of pre-tax income is non-interest income-the compensation received from providing products and services. The majority of the non-interest income comes from service charges on deposit accounts. The Corporation also earns income from insurance commissions, mortgage banking fees and other fees and charges.
The Corporation recognizes gains or losses as a result of sales of investment securities or the disposition of loans, foreclosed property or fixed assets. These gains and losses are not a regular part of the Corporation’s income. In addition, the Corporation also recognizes gains or losses on its outstanding derivative financial instruments.
Expenses
The expenses the Corporation incurs in operating its business consist of salaries and employee benefits expense, occupancy expense, furniture and equipment expense, external processing fees, deposit insurance premiums, advertising expenses, and other miscellaneous expenses.
Salaries and benefits expense consists primarily of the salaries and wages paid to employees, fees paid to directors and expenses for retirement and other employee benefits.
Occupancy expense, which are fixed or variable costs associated with building and equipment, consist primarily of lease payments, real estate taxes, depreciation charges, maintenance and cost of utilities.
Furniture and equipment and external processing include fees paid to third-party data processing services and expenses and depreciation charges related to office and banking equipment. Depreciation of premises and equipment is computed using the straight-line and accelerated methods based on the useful lives of related assets. Estimated lives are 2 to 40 years for building and improvements, and 2 to 15 years for furniture and equipment.
Other expenses include expenses for attorneys, accountants and consultants, payroll taxes, franchise taxes, charitable contributions, insurance, office supplies, postage, telephone, merger expense and other miscellaneous operating expenses.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of the Corporation, which are prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities for the reporting periods. Management evaluates estimates on an on-going basis, and believes the following represent its more significant judgments and estimates used in preparation of its consolidated financial statements: allowance for loan losses, non-accrual loans, other real estate owned, estimates of fair value and intangible assets associated with mergers, other than temporary impairment of investment securities, pension and post-retirement benefits, asset prepayment rates, goodwill and intangible assets, stock-based compensation, derivative financial instruments, recourse liabilities, litigation and income taxes. Management bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. It is at least reasonably possible that each of the Corporation’s estimates could change in the near term and the effect of the change could be material to the Corporation’s Consolidated Financial Statements.
Management believes the following critical accounting policies affect its most significant judgments and estimates used in preparation of its consolidated financial statements: allowance for loan losses, other than temporary impairment of investment securities, derivative financial instruments, goodwill and intangible assets, asset prepayment rates, and income taxes. Each estimate is discussed on pages 16-18. The financial impact of each estimate, to the extent significant to financial results, is discussed in the applicable sections of Management’s Discussion and Analysis.
Allowance for Loan Losses
The Corporation maintains an allowance for loan losses (“the allowance”), which is intended to be management’s best estimate of probable inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charges to earnings to bring the total allowance to a level considered necessary by management.
The allowance is based on management’s continuing review and evaluation of the loan portfolio. This process provides an allowance consisting of two components, allocated and unallocated. To arrive at the allocated component of the allowance, the Corporation combines estimates of the allowances needed for loans analyzed individually and on a pooled basis. The allocated component of the allowance is supplemented by an unallocated component.
The portion of the allowance that is allocated to individual internally criticized and non-accrual loans is determined by estimating the inherent loss on each problem credit after giving consideration to the value of underlying collateral. Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. The Corporation’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of uncollectibility. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan.
In addition to being used to categorize risk, the Bank’s internal ten-point risk rating system is used to determine the allocated allowance for the commercial portfolio. Reserve factors, based on the actual loss history for a 5-year period for criticized loans, are assigned. If the factor, based on loss history for classified credits is lower than the minimum established factor, the higher factor is applied. For loans with satisfactory risk profiles, the factors are based on the rating profile of the portfolio and the consequent historic losses of bonds with equivalent ratings.
For the consumer portfolios, the determination of the allocated allowance is conducted at an aggregate, or pooled, level. Each quarter, historical rolling loss rates for homogenous pools of loans in these portfolios provide the basis for the allocated reserve. For any portfolio where the Bank lacks sufficient historic experience, industry loss rates are used. If recent history is not deemed to reflect the inherent losses existing within a portfolio, older historic loss rates during a period of similar economic or market conditions are used.
The Bank’s credit administration group adjusts the indicated loss rates based on qualitative factors. Factors that are considered in adjusting loss rates include risk characteristics, credit concentration trends and general economic conditions, including job growth and unemployment rates. For commercial and real estate portfolios, additional factors include the level and trend of watched and criticized credits within those portfolios; commercial real estate vacancy, absorption and rental rates; and the number and volume of syndicated credits, construction loans, or other portfolio segments deemed to carry higher levels of risk. Upon completion of the qualitative adjustments, the overall allowance is allocated to the components of the portfolio based on the adjusted loss factors.
The unallocated component of the allowance exists to mitigate the imprecision inherent in management’s estimates of expected credit losses and includes its judgmental determination of the amounts necessary for concentrations, economic uncertainties and other subjective factors that may not have been fully considered in the allocated allowance. The relationship of the unallocated component to the total allowance may fluctuate from period to period. Although management has allocated the majority of the allowance to specific loan categories, the evaluation of the allowance is considered in its entirety.
Lending management meets at least quarterly with executive management to review the credit quality of the loan portfolios and to evaluate the allowance. The Corporation has an internal risk analysis and review staff that continuously reviews loan quality and reports the results of its reviews to executive management and the Board of Directors. Such reviews also assist management in establishing the level of the allowance.
Management believes that it uses relevant information available to make determinations about the allowance and that it has established its existing allowance in accordance with GAAP. If circumstances differ substantially from the assumptions used in
making determinations, adjustments to the allowance may be necessary and results of operations could be affected. Because events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above.
The FDIC examines the Bank periodically and, accordingly, as part of this exam, the allowance is reviewed for adequacy utilizing specific guidelines. Based upon their review, the regulators may from time to time require reserves in addition to those previously provided.
Other Than Temporary Impairment of Investment Securities
Securities are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.
Derivative Financial Instruments
The Corporation uses various derivative financial instruments as part of its interest rate risk management strategy to mitigate the exposure to changes in market interest rates. The derivative financial instruments used separately or in combination are interest rate swaps, caps and floors. Derivative financial instruments are required to be measured at fair value and recognized as either assets or liabilities in the financial statements. Fair value represents the payment the Corporation would receive or pay if the item were sold or bought in a current transaction. Fair values are generally based on market quotes. The accounting for changes in fair value (gains or losses) of a derivative is dependent on whether the derivative is designated and qualifies for “hedge accounting.” In accordance with Statement of Financial Accounting Standards No. 133, “ Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), the Corporation assigns derivatives to one of these categories at the purchase date: fair value hedge, cash flow hedge or non-designated derivatives. SFAS No. 133 requires an assessment of the expected and ongoing hedge effectiveness of any derivative designated a fair value hedge or cash flow hedge. Derivatives are included in other assets and other liabilities in the Consolidated Statements of Condition.
Fair Value Hedges-For derivatives designated as fair value hedges, the derivative instrument and related hedged item are marked-to-market through the related interest income or expense, as applicable, except for the ineffective portion which is recorded in non-interest income.
Cash Flow Hedges-For derivatives designated as cash flow hedges, mark-to-market adjustments are recorded net of income taxes as a component of other comprehensive income (“OCI”) in stockholders’ equity, except for the ineffective portion which is recorded in non-interest income. Amounts recorded in OCI are recognized into earnings concurrent with the hedged items’ impact on earnings.
Non-Designated Derivatives-Certain economic hedges are not designated as cash flow or as fair value hedges for accounting purposes. As a result, changes in the fair value are recorded in non-interest income in the Consolidated Statements of Income. Interest income or expense related to non-designated derivatives is also recorded in non-interest income.
All qualifying relationships between hedging instruments and hedged items are fully documented by the Corporation. Risk management objectives, strategies and the projected effectiveness of the chosen derivatives to hedge specific risks are also documented. At inception of the hedging relationship and periodically as required under SFAS No. 133, the Corporation evaluates the effectiveness of its hedging instruments. For hedges qualifying for “short-cut” treatment at inception, the ongoing effectiveness testing includes a review of the hedge and the hedged item to determine if the hedge continues to qualify for short-cut treatment. An assumption of no hedge ineffectiveness is allowed for derivatives qualifying for short-cut treatment. For all other derivatives qualifying for hedge accounting, a quantitative assessment of the effectiveness of the hedge is required at each reporting date. The Corporation performs effectiveness testing quarterly for all of its hedges. The Corporation uses benchmark interest rates such as LIBOR to hedge the interest rate risk associated with interest-earning assets or interest-bearing liabilities. Using benchmark rates and complying with specific criteria set forth in SFAS No.133, the Corporation has concluded that for qualifying hedges, changes in fair value or cash flows that are attributable to risks being hedged will be highly effective at the hedge’s inception and on an ongoing basis.
When it is determined that a derivative is not, or ceases to be effective as a hedge, the Corporation discontinues hedge accounting prospectively. When a fair value hedge is discontinued due to ineffectiveness, the Corporation continues to carry the derivative on
the Consolidated Statements of Condition at its fair value as a non-designated derivative, but discontinues marking-to-market the hedged asset or liability for changes in fair value. Any previous mark-to-market adjustments recorded to the hedged item are amortized over the remaining life of the asset or liability. All ineffective portions of fair value hedges are reported in and affect net income immediately. When a cash flow hedge is discontinued due to termination of the derivative, the Corporation continues to carry the previous mark-to-market adjustments in accumulated OCI and recognizes the amount into earnings in the same period or periods during which the hedged item affects earnings. If the cash flow hedge is discontinued due to ineffectiveness, the derivative would be considered a non-designated hedge and would continue to be marked-to-market in the Consolidated Statements of Condition as an asset or liability, in the Consolidated Statements of Income with any changes in the mark-to-market recorded through current period earnings and not through OCI.
Counter-party credit risk associated with derivatives is controlled by dealing with well-established brokers that are highly rated by credit rating agencies and by establishing exposure limits for individual counter-parties. Market risk on interest rate swaps is minimized by using these instruments as hedges and by continually monitoring the positions to ensure ongoing effectiveness. Credit risk is controlled by entering into bilateral collateral agreements with brokers, in which the parties pledge collateral to indemnify the counter-party in the case of default. The Corporation’s hedging activities and strategies are monitored by the Bank’s Asset / Liability Committee (“ALCO”) as part of its oversight of the treasury function.
Goodwill and Intangible Assets
For acquisitions, the Corporation records the assets acquired, including identified intangible assets, and liabilities assumed at their fair value, which in many instances involves estimates based on third party valuations, such as appraisals, or valuations based on discounted cash flow analyses or other valuation techniques. The determination of the useful lives of intangible assets is subjective, as is the appropriate amortization period for such intangible assets. These estimates also include the establishment of various accruals and allowances based on planned facilities dispositions and employee severance considerations, among other acquisition-related items. In addition, purchase acquisitions typically result in goodwill, which represents the excess of the purchase price over the fair value of the net assets acquired by the Corporation. The Corporation tests goodwill annually for impairment. Such tests involve the use of estimates and assumptions. Intangible assets other than goodwill, such as deposit-based intangibles which are determined to have finite lives, are amortized over their estimated useful lives, which is approximately 8 years.
Asset Prepayment Rates
The Corporation purchases amortizing loan pools and investment securities in which the underlying assets are residential mortgage loans subject to prepayments. The actual principal reduction on these assets varies from the expected contractual principal reduction due to principal prepayments resulting from borrowers elections to refinance the underlying mortgages based on market and other conditions. Prepayment rate projections utilize actual prepayment speed experience and available market information on like-kind instruments. The prepayment rates form the basis for income recognition of premiums or discounts on the related assets. Changes in prepayment estimates may cause the earnings recognized on these assets to vary over the term that the assets are held, creating volatility in the net interest margin. Prepayment rate assumptions are monitored and updated monthly to reflect actual activity and the most recent market projections.
Income Taxes
The Corporation accounts for income taxes under the asset/liability method. Deferred tax assets and liabilities are recognized for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carry forwards. A valuation allowance is established against deferred tax assets when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. It is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred taxes could change in the near term.
FINANCIAL CONDITION
The financial condition of the Corporation reflects the continued balance sheet transition towards growing loans and deposits in the Bank’s core business segments. The expanded market presence, as a direct result of the Southern Financial merger, has augmented the number of banking relationship opportunities in the Corporation’s key markets in Baltimore, Washington, D.C. and Richmond. The Corporation acquired Southern Financial on April 30, 2004, and accordingly, the results of operations of Southern Financial for the year ended 2004 include eight months subsequent to the acquisition. At December 31, 2005, total assets were $6.4 billion, a decrease of $215 million from December 31, 2004. The decrease in total assets was mainly a result of management’s decision to reduce the Corporation’s total investment portfolio.
Earning Assets
Total average earning asset balances increased to $5.7 billion in 2005, an increase of $178 million, or 3%, from 2004. The following table summarizes the composition of the Bank’s average earning assets for the periods indicated.
Average Earning Assets:
Total average loan balances increased to $3.6 billion in 2005, an increase of $320 million, or 10%, from 2004. The Corporation’s expanded presence in the Baltimore-Washington metropolitan regions was the primary contributor to the achievement of the 10% growth in average loans. The average loan growth of $320 million is comprised of $299 million, or 20.2%, in commercial loans and $21 million, or 1.1%, in consumer loans. At December 31, 2005 there is a balanced mix of revenue sources between the two product segments with $1.8 billion, or 50.7%, in consumer loans, and $1.8 billion, or 49.3%, in commercial loans.
Commercial banking, which is a key component to the Corporation’s regional presence in its market area, grew $299 million, or 20.2%, over 2004. This growth was positively impacted by having Southern Financial’s commercial loans for twelve months compared to eight months in 2004. Residential and commercial construction loans posted increases during the year of $122 million and $43 million, respectively, reflecting strong regional demand for construction loans in the Bank’s markets. In addition, commercial mortgages increased $52 million, or 12.1%, while commercial business grew $82 million, or 14.0%.
The growth in average consumer loans of $21 million included planned reductions in originated and acquired residential mortgages of $148 million. Excluding the planned reductions, average consumer loans increased 15.4%, or $169 million. Home equity lending is the main contributor to this growth. The home equity loan suite of products has been a key component of the Bank’s strategy to deepen its customer relationships. This market strategy resulted in the $203 million, or 33.9%, increase in home equity average balances. The production of direct consumer loans, primarily home equity loans and lines, are generated by the Bank’s retail banking offices, phone centers and internet unit. Origination of consumer loan and line commitments, primarily home equity in the Washington and Virginia market, grew 46% from 2004 to 2005. Average consumer loans from the Washington market grew 27% in 2005, reflecting continued expansion into the market. Other consumer loans, which make up 25% of consumer loans, had a $35 million decline in 2005. The Corporation’s marine lending loan growth was restricted due to low pricing margins in the industry and was the main reason for the decline in other consumer loans.
The Corporation’s portfolio of originated and acquired residential mortgage loans (consisting of first mortgages, home equity loans and lines) represented 16% of average total loans in 2005, compared to 22% in 2004. Over the past several years, the Bank has increased its credit quality requirements for new acquisitions and shifted its lien position focus from predominantly second lien position to entirely first lien position. In 2005, the Corporation only purchased $10.2 million of residential mortgage loans as the focus was to fund loan growth in its internally generated loan portfolios and away from wholesale portfolios. At December 31, 2005, approximately 84% of the acquired portfolio was in first lien position. Average balances in the originated residential mortgage portfolio continued to decline during 2005, to $84 million, since the Bank does not retain new residential mortgage loan originations.
The investment portfolio average balance declined by $141 million in 2005 as management executed its strategy of replacing non-core investments with core loans. From year-end 2004 to year-end 2005, Provident’s investment portfolio declined by $395.7 million. In particular, management acted to reduce the investment portfolio allocation to mortgage-backed securities, shrinking that portfolio from $1.6 billion or 72% of the investment portfolio, to $1.0 billion, or 54% of the portfolio. In contrast, the allocation to floating rate asset-backed securities was increased, from $377 million, or 16% of investments at year-end 2004, to $600 million, or 31% of investments at year-end 2005.
Asset Quality
The following table presents information with respect to non-performing assets and 90-day delinquencies for the years indicated.
Asset Quality Summary:
(1) Consumer non-accrual loans are comprised entirely of credits secured by residential property and other secured loans, primarily purchased loans. Consumer loans secured by nonresidential property and unsecured consumer loans are not placed in non-accrual status but are charged-off at 120 and 180 days, respectively.
The asset quality within the Corporation’s loan portfolios remained strong in 2005. Strong asset quality within the Corporation’s loan portfolio is a reflection of management’s credit policies and strategy of shifting the balance sheet to core portfolios. In addition, regional credit conditions were favorable for 2005. Non-performing assets were $27.5 million at December 31, 2005, up slightly from the level at December 31, 2004, but down as a percentage of loans, from 0.77% to 0.74%. The level of non-performing assets at December 31, 2005 is consistent with historical trends. Of the total non-performing assets, $7.9 million are in the consumer and residential mortgage loan portfolios, which are collateralized by 1 to 4 family residences. Non-performing commercial business loans include $1.5 million of loans that have U.S. government guarantees. With the vast majority of non-performing loans already written down to net fair value, management expects little further loss on those loans. During 2005, the Corporation sold $5.2 million of its non-performing acquired residential loan portfolio.
The overall asset quality ratios of the Corporation remain favorable to pre-merger levels. No assurances can be given regarding the level of non-performing assets in the future.
Total 90-day delinquencies decreased $4.1 million in 2005, and as a result, total delinquencies as a percentage of total loans outstanding were 0.22% in 2005 compared to 0.34% in 2004. Presented below is interest income that would have been recorded on all non-accrual loans if such loans had been paid in accordance with their original terms and the interest income on such loans that was actually received and recorded for the year.
Interest Income Lost Due to Non-Accrual Loans:
Allowance for Loan Losses
The following table reflects the allowance for loan losses and the activity during each of the periods indicated.
Loan Loss Experience Summary:
The following table reflects the allocation of the allowance at December 31 to the various loan categories. The entire allowance is available to absorb losses from any type of loan.
Allocation of Allowance for Loan Losses:
The application of Provident’s collection and credit standards and the continuation of reasonably strong economic conditions resulted in lower net charge-offs compared to 2004. Net charge-offs for 2005 were $5.6 million compared to $9.0 million in 2004. For 2005, net charge-offs exceeded the provision for loan losses by $530 thousand. The allowance as a percentage of loans outstanding decreased from 1.30% at December 31, 2004 to 1.24% at December 31, 2005. The allowance coverage remained fairly consistent, with coverage of 178% of non-performing loans at December 31, 2005, compared to 180% at December 31, 2004. Portfolio-wide net charge-offs represented 0.15% of average loans in 2005, down from 0.27% in 2004. For consumer portfolios that experienced losses, the twelve-month rolling loss rates in each of the portfolios continued to be at their lowest levels in several years. As a result of the acquisition of Southern Financial in 2004, the Corporation recorded an additional allowance of $12.1 million, or approximately 1.7% of the loans acquired.
Management believes that the allowance at December 31, 2005 represents its best estimate of probable losses inherent in the portfolio and that it uses relevant information available to make such determinations. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance may be necessary and results of operations could be affected. Based on information currently available to the Corporation, management believes it has established its existing allowance in accordance with GAAP. Because events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above.
Sources of Funds
The following table summarizes the composition of the Corporation’s average deposit and borrowing balances for the periods indicated.
Average Deposits and Borrowings:
Average deposits increased $249 million, or 7%, in 2005. The deposit growth came from all the deposit sources (consumer, commercial and brokered) in 2005 and was positively impacted by having Southern Financial’s deposit base for twelve months compared to eight months in 2004. Deposits from consumers grew $56 million, or 2%, while deposits from commercial businesses grew $117 million, or 16%. Brokered deposits increased by 25%, or $76 million, since it was a less expensive alternative to borrowing.
Average borrowings declined by $49 million, or 2.6% from 2004 to 2005. However, the Corporation does not believe that the average year over year decline is necessarily reflective of the Corporation’s current use of borrowings as a source of funding because borrowings in 2004 increased significantly due to the acquisition of Southern Financial. In contrast, total borrowings declined throughout 2005. From December 31, 2004 to December 31, 2005, borrowings fell by $556 million, from $2.1 billion at December 2004 to $1.6 billion at December 31, 2005. The reductions were accompanied by a $216 million reduction in total assets and a $344 million increase in deposits over the same time period in 2004. The decrease in borrowing balances was widespread: short-term borrowings were reduced by $270 million and long term by $286 million. These reductions reflect management’s strategy to reduce lower spread non-core assets and liabilities.
Liquidity
An important component of the Bank’s asset/liability structure is the level of liquidity available to meet the needs of customers and creditors. Traditional sources of bank liquidity include deposit growth, loan repayments, investment maturities, asset sales, borrowings and interest received. Management believes the Bank has sufficient liquidity to meet funding needs for the foreseeable future.
The Bank’s primary source of liquidity beyond the traditional sources is the assets it possesses, which can either be pledged as collateral for secured borrowings or sold outright. The Bank’s primary sources for raising secured borrowings are the FHLB and securities broker/dealers. At December 31, 2005, $1.2 billion of secured borrowings were employed, with sufficient collateral available to immediately raise an additional $900 million. An excess liquidity position of $691 million remains after covering $233 million of unsecured funds that mature in the next three months. Additionally, over $300 million of assets are maintained as collateral with the Federal Reserve that are available as a contingent funding source.
The Bank also has several unsecured funding sources available should the need arise. At December 31, 2005, the Bank possessed over $900 million of overnight borrowing capacity, of which only $185 million was in use at year-end. The brokered CD and unsecured debt markets, which generally are more expensive than secured funds of similar maturity, are also viable funding alternatives. In 2005, the Bank issued $167 million of brokered CDs at favorable pricing levels.
As an alternative to raising secured funds, the Bank can raise liquidity through asset sales. At December 31, 2005, over $500 million of the Bank’s investment portfolio was immediately saleable at a market value equaling or exceeding its amortized cost basis. Investment portfolio liquidity has been enhanced by the addition of approximately $500 million of LIBOR floating rate securities over 2004 and 2005, primarily replacing fixed rate MBS. Additionally, over a 90-day time frame, a majority of the Bank’s $1.8 billion consumer and residential loan portfolios are saleable in an efficient market.
A significant use of the Corporation’s liquidity is the dividends it pays to shareholders. The Corporation is a one-bank holding company that relies upon the Bank’s performance to generate capital growth through Bank earnings. A portion of the Bank’s earnings is passed to the Corporation in the form of cash dividends. As a commercial bank under the Maryland Financial Institution Law, the Bank may declare cash dividends from undivided profits or, with the prior approval of the Commissioner of Financial Regulation, out of paid-in capital in excess of 100% of its required capital stock, and after providing for due or accrued expenses, losses, interest and taxes. These dividends paid to the holding company are utilized to pay dividends to stockholders, repurchase shares and pay interest on trust preferred securities. The Corporation and the Bank, in declaring and paying dividends, are also limited insofar as minimum capital requirements of regulatory authorities must be maintained. The Corporation and the Bank comply with such capital requirements. If the Corporation or the Bank were unable to comply with the minimum capital requirements, it could result in regulatory actions that could have a material impact on the Corporation.
Contractual Obligations, Commitments and Off-Balance Sheet Arrangements
The Corporation has various contractual obligations, such as long-term borrowings, that are recorded as liabilities in the Consolidated Financial Statements. Other items, such as certain minimum lease payments for the use of banking and operations offices under operating lease agreements, are not recognized as liabilities in the Consolidated Financial Statements, but are required to be disclosed. Each of these arrangements affects the Corporation’s determination of sufficient liquidity.
The following table summarizes significant contractual obligations and commitments at December 31, 2005 and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal payments on outstanding borrowings. Additional details regarding these obligations are provided in the Notes to the Consolidated Financial Statements, as referenced in the following table.
Arrangements to fund credit products or guarantee financing take the form of loan commitments (including lines of credit on revolving credit structures) and letters of credit. Approvals for these arrangements are obtained in the same manner as loans. Generally, cash flows, collateral value and a risk assessment are considered when determining the amount and structure of credit arrangements. Commitments to extend credit in the form of consumer, commercial real estate and business loans at December 31, 2005 were as follows:
Historically, many of the commitments expire without being fully drawn; therefore, the total commitment amounts do not necessarily represent future cash requirements. Obligations also take the form of commitments to purchase loans. At December 31, 2005, the Corporation did not have any firm commitments to purchase loans.
Contingencies and Risk
The Corporation enters into certain transactions that may either contain risks or represent contingencies. These risks or contingencies may take the form of concentrations of credit risk or litigation. Disclosure of these arrangements is found in Note 15 to the Consolidated Financial Statements.
Risk Management
The nature of the banking business, which involves paying interest on deposits at varying rates and terms and charging interest on loans at other rates and terms, creates interest rate risk. As a result, earnings and the market value of assets and liabilities are subject to fluctuations, which arise due to changes in the level and directions of interest rates. Management’s objective is to minimize the fluctuation in the net interest margin caused by changes in interest rates using cost-effective strategies and tools. The Bank manages several forms of interest rate risk, including asset/liability mismatch, basis and prepayment risk.
The Corporation purchases amortizing loan pools and investment securities in which the underlying assets are residential mortgage loans subject to prepayments. The actual principal reduction on these assets varies from the expected contractual principal reduction due to principal prepayments resulting from borrowers’ elections to refinance the underlying mortgages based on market and other conditions. Prepayment rate projections utilize actual prepayment speed experience and available market information on like-kind instruments. The prepayment rates form the basis for income recognition of premiums or discounts on the related assets. Changes in prepayment estimates may cause the earnings recognized on these assets to vary over the term that the assets are held, creating volatility in the net interest margin. Prepayment rate assumptions are monitored and updated monthly to reflect actual activity and the most recent market projections.
Management continually monitors Prime/LIBOR basis risk and asset/liability mismatch. Basis risk exists as a result of having much of the Bank’s earning assets priced from the Prime rate while much of the liability portfolio is priced using the CD yield curve or LIBOR yield curve. These different yield curves are highly correlated but do not move in lock-step with one another. Additionally, management routinely monitors and limits the gap between assets and liabilities subject to repricing on a monthly, quarterly, semiannual and annual basis.
Measuring and managing interest rate risk is a dynamic process that management performs continually to meet the objective of maintaining a stable net interest margin. This process relies chiefly on simulation modeling of shocks to the balance sheet under a variety of interest rate scenarios, including parallel and non-parallel rate shifts, such as the forward yield curves for both short and long term interest rates. The results of these shocks are measured in two forms: first, the impact on the net interest margin and earnings over one and two year time frames; and second, the impact on the market value of equity. In addition to measuring the basis risks and prepayment risks noted above, simulations also quantify the earnings impact of rate changes and the cost / benefit of hedging strategies.
The following table shows the anticipated effect on net interest income in parallel shift (up or down) interest rate scenarios. These shifts are assumed to begin on January 1, 2005 for the December 31, 2004 data and on January 1, 2006 for the December 31, 2005 data and evenly ramp-up or down over a six-month period. The effect on net interest income would be for the next twelve months. Given the interest environment in the periods presented, a 200 basis point drop in rate is unlikely and has not been shown.
The projected outcomes presented below are based on a balance sheet growth forecast and parallel shifts in interest rates, i.e. all interest rates moving by the same amount. Management models many non-parallel rate change scenarios as well, including several yield-curve flattening scenarios. The results of each scenario differ; however, the results below are an accurate indication of the magnitude and direction of the Corporation’s interest rate risk.
The percentage changes displayed in the table above relate to the Corporation’s projected net interest income. Management’s intent is for derivative interest income to mitigate risk to the Corporation’s net interest income stemming from changes in interest rates. For comparison purposes, these projections include all interest earned on derivatives in net interest income. The analysis includes the interest income and expense relating to non-designated interest rate swaps that is classified in non-interest income as net cash settlement on swaps.
The isolated modeling environment, assuming no action by management, shows that the Corporation’s net interest income volatility is less than 3.5% under probable single direction scenarios. The Corporation’s one-year forward earnings are slightly asset sensitive, which will result in net interest income moving in the same direction as future interest rates. The Corporation’s interest rate risk profile is little changed from 2004 to 2005, reflecting management’s intentions to maintain a low level of interest rate risk and to benefit modestly from a rising rate environment.
The Corporation maintains an overall interest rate management strategy that incorporates structuring of investments, purchased funds, variable rate loan products, and derivatives in order to minimize significant fluctuations in earnings or market values. The Bank continues to employ hedges to mitigate interest rate risk. Borrowings totaling $299 million have been employed which reset their rates monthly or quarterly based on the level of long-term interest rates - specifically, the 10-year constant maturity swap rate - rather than short-term rates, to offset the effect of mortgage prepayments on asset yields. There is a high correlation between changes in the 10-year constant maturity swap rate and the 30-year mortgage rate. Additionally, $168 million notional amount in interest rate swaps were in force to reduce interest rate risk, and $165 million of interest rate caps were employed to protect the interest margin from rising interest rates in the future.
Capital Resources
Total stockholders’ equity was $630 million at December 31, 2005, an increase of $12.1 million from December 31, 2004. The change in stockholders’ equity for the year was attributable to $73.0 million in earnings that was partially offset by dividends paid of $35.7 million. Net accumulated other comprehensive loss increased by $15.6 million during the year primarily due to the impact of rising rates and the market value of the debt securities; capital was also reduced by $22.6 million from the repurchase of 684,962 shares of the Corporation’s common stock at an average price of $32.97. The Corporation is authorized to repurchase an additional 1,237,865 shares under its stock repurchase program.
The Corporation is required to maintain minimum amounts and ratios of core capital to adjusted quarterly average assets (“leverage ratio”) and of tier 1 and total regulatory capital to risk-weighted assets. The actual regulatory capital ratios and required ratios for capital adequacy purposes under FIRREA and the ratios to be categorized as “well capitalized” under prompt corrective action regulations are summarized in the following table.
On March 31, 2005, the Corporation redeemed $30.0 million in aggregate principal amount of 10% Junior Subordinated Debentures issued to Provident Trust II. The Junior Subordinated Debentures had a final stated maturity of March 31, 2030, but were callable at par beginning on March 31, 2005. Additionally, on July 15, 2005, the Corporation redeemed $5.0 million in aggregate principal amount of 11% Junior Subordinated Debentures issued to Southern Financial Capital Trust I. The Junior Subordinated Debentures were callable beginning July 15, 2005 and had a final stated maturity of July 15, 2030. As of December 31, 2005, the Corporation is considered “well capitalized” for regulatory purposes.
RESULTS OF OPERATIONS
For the Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
Financial Highlights
Provident reported record earnings of $73 million or $2.17 per diluted share for the year ended December 31, 2005 compared to $62 million and $2.00 per diluted share for the year ended December 31, 2004. Earnings for 2005 included the negative impact of $0.02 per share associated with a change in lease accounting. Increases of $19 million in the net interest margin after provision for loan losses and $11.5 million in non-interest income more than offset a $17 million increase in non-interest expense and a $2.6 million increase in income tax expense, resulting in an $11.0 million increase in net income. Return on assets increased from 1.02% to 1.14% for 2005 while return on common equity decreased from 12.1% to 11.6% in 2005. The financial results in 2005 reflect the Corporation’s continued commitment to produce positive core results by executing the business strategies of broadening its presence and customer base in the Virginia and metropolitan Washington markets, growing commercial business in all markets, and enhancing core business results in all markets.
Net Interest Income
The Corporation’s principal source of revenue is net interest income, the difference between interest income on earning assets and interest expense on deposits and borrowings. Interest income is presented on a tax-equivalent basis to recognize associated tax benefits in order to provide a basis for comparison of yields with taxable earning assets. The following table presents information regarding the average balance of assets and liabilities, as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing income or expense by the average balances of assets or liabilities, respectively, for the periods presented. Nonaccrual loans are included in average balances, however, accrued interest income has been excluded from these loans. The tables on the following pages also analyze the reasons for the changes from year-to-year in the principal elements that comprise net interest income. Rate and volume variances presented for each component will not total the variances presented on totals of interest income and interest expense because of shifts from year-to-year in the relative mix of interest-earning assets and interest-bearing liabilities.
Consolidated Average Balances and Analysis of Changes in Tax Equivalent Net Interest Income:
Notes:
(1) Average non-accrual balances and related income are included in their respective categories.
(2) Tax-advantaged income has been adjusted to a tax-equivalent basis using the combined statutory federal and state income tax rate in effect for all years presented.
(3) Impact of designated hedging strategies on interest income and interest expense has been included in the appropriate classifications above.
(4) Tax-equivalent basis.
Consolidated Average Balances and Analysis of Changes in Tax Equivalent Net Interest Income (Continued):
Notes:
(1) Average non-accrual balances and related income are included in their respective categories.
(2) Tax-advantaged income has been adjusted to a tax-equivalent basis using the combined statutory federal and state income tax rate in effect for all years presented.
(3) Impact of designated hedging strategies on interest income and interest expense has been included in the appropriate classifications above.
(4) Tax-equivalent basis.
The net interest margin, on a tax-equivalent basis, increased 18 basis points to 3.52% and was driven by the continuation of the balance sheet transitioning and by the solid growth in core lending activities. Management’s strategy to replace lower net interest-earning assets with higher net interest-earning assets has been very successful. The Corporation has seen solid loan growth in its home equity and construction loan portfolios since the same period a year ago. Growth in these portfolios was offset by planned declines in non-core investments, originated and acquired residential portfolios. Overall, average earning assets increased $178.2 million to $5.7 billion, augmented by net loan growth of $319.5 million offset by a $140.7 million reduction in investment securities. The yields on investments and loans grew 38 and 63 basis points, respectively. The yield increase in the portfolio was the result of a balance sheet restructuring program which placed greater emphasis on variable rate securities, as well as a decline in prepayments. Interest-bearing liabilities increased $123.1 million while the average rate paid increased 47 basis points. The increase in the average rate paid was primarily due to rising interest rates that impacted interest-bearing demand deposits, money market deposits, short-term borrowings and long-term debt. Interest expense benefited from a $77 million increase in average noninterest-bearing deposit balances during the year.
The 5.57% yield on earning assets correspondingly increased as a result of rising interest rates and the product mix of loans that more than offset the increased funding costs of 2.37%. Net interest income on a tax-equivalent basis was $199 million in 2005, compared to $183 million in 2004. Total interest income increased $42 million and total interest expense increased $25 million resulting in the growth in net interest income of $16 million.
The Corporation has an ongoing risk management strategy of using derivative transactions to maintain a stable net interest margin. As a result of derivative transactions undertaken to mitigate the affect of interest rate risk on the Corporation, interest income decreased by $583 thousand and interest expense increased by $896 thousand, for a total decrease of $1.5 million in net interest income relating to derivative transactions for the year ended December 31, 2005.
Future growth in net interest income will depend upon consumer and commercial loan demand, growth in deposits and the general level of interest rates.
Provision for Loan Losses
The Corporation continued to emphasize quality underwriting as well as aggressive management of charge-offs and potential problem loans, resulting in a provision for loan losses of $5.0 million in 2005 compared to $7.5 million in 2004. Net charge-offs were $5.6 million, or 0.15% of average loans in 2005, compared to $9.0 million, or 0.27% of average loans, in 2004. Total consumer loan net charge-offs as a percentage of average total consumer loans were 0.11% in 2005 compared to 0.30% in 2004. During 2005, net charge-offs in the originated and acquired residential mortgage portfolio declined from 0.56% in 2004 to 0.16% in 2005. Other consumer loans net charge-offs declined from 0.14% in 2004 to 0.09% in 2005. Both consumer portfolios experienced an improvement in net charge-offs as a percentage of average loans in their respective portfolios. Total commercial net charge-offs as a percentage of average commercial loans were 0.20%, a decrease from 0.24% in 2004. The decline in charge-offs in both the consumer and commercial portfolios is a reflection of management’s credit policies and strategy of shifting the balance sheet to core loan portfolios.
Non-Interest Income
The following table presents a comparative summary of the major components of non-interest income for years ended December 31.
Non-Interest Income Summary:
Total non-interest income increased $11.5 million to $112.5 million in 2005. Total non-interest income, excluding the net gains (losses) and derivative gains (losses) described below, increased 10.8% to $115.6 million in 2005.
The improvement in non-interest income continues to be driven by deposit fee income, which increased $6.6 million, or 8.1%, to $88.5 million in 2005. The increase in deposit fee income is mainly in consumer deposit fees, which were a result of implementing a number of fundamental processing changes along with the addition of new branches via de-novo expansion and the acquisition of Southern Financial. Approximately $1.7 million of the increase in deposit fees was from the addition of Southern Financial for twelve months in 2005 compared to eight months in 2004. In addition, de-novo expansion represented the full year effect of one new banking office opened in 2004, as well as three new banking offices opened in 2005. This expansion increased deposit fees by $201 thousand over 2004. The remaining $4.7 million was a result of the processing changes mentioned above along with an increase in debit card usage.
Commissions and fees improved 9.1%, or $419 thousand, to $5.0 million in 2005 due to increased sales by PIC, the Bank’s wholly owned subsidiary which offers securities brokerage through an affiliation with a securities broker-dealer, as well as insurance products as an agent. Other non-interest income increased $4.2 million to $18.5 million, due to income associated with bank owned life insurance, mortgage banking fees and other fees.
The Corporation recorded $1.3 million in net gains in 2005, compared to net losses of $5.8 million in 2004. The net gains in 2005 were composed primarily of $818 thousand in net gains on the sales of securities and $525 thousand net gains from the disposition of loans, foreclosed property and fixed assets. The net losses in 2004 were composed of $2.4 million in losses on the extinguishment of debt and $3.2 million in losses on the sale of securities. The disposition of loans, foreclosed property and fixed assets that occur in the ordinary course of business had minimal impact in 2004. In 2005 and 2004, certain derivative transactions did not qualify for hedge accounting treatment and as a result, the gains and losses associated with the derivatives were recorded in non-interest income. Derivative losses on swaps were $4.4 million for the year ending December 31, 2005, compared to a $2.4 million gain in 2004.
Net cash settlement on swaps, representing interest income and expense on non-designated interest rate swaps was $3.5 million for each of the years ending December 31, 2004 and 2005.
Non-Interest Expense
The following table presents a comparative summary of the major components of non-interest expense for the years ended December 31.
Non-Interest Expense Summary:
Non-interest expense of $200.7 million for 2005 was $17.0 million higher than 2004. Approximately $4.6 million of this increase was attributable to the Corporation’s merger with Southern Financial in April 30, 2004, resulting in twelve months of expense in 2005 while 2004 includes only eight months. In addition, 2004 included a merger expense of $3.5 million. The current year includes a reduction to salaries and employee benefits of $1.2 million related to the Corporation’s termination of a post-retirement benefit plan. This amount was offset by a $537 thousand non-recurring charge to the Company’s benefit plans relating to the Corporation’s 401K plan and the acceleration of stock options. In addition, occupancy expense for 2005 includes a one-time charge of $1.0 million to account for escalating lease payments. The Bank’s de-novo banking expansion activity increased non-interest
expense by $1.2 million in 2005, impacting salaries and employee benefits, occupancy and premises and equipment. Professional services included a $4.1 million in costs related to corporate governance compliance efforts, including Sarbanes-Oxley and other regulatory requirements. External processing included a reduction of $1.6 million relating to renegotiated contracts with external processing vendors. Additional items contributing to this increase were employee incentives, a mutual separation agreement with an executive who departed the Corporation along with costs associated with the infrastructure changes necessary to support the larger geographic region, as well as variable costs associated with loan and deposit growth.
Income Taxes
The Corporation accounts for income taxes under the asset/liability method. Deferred tax assets and liabilities are recognized for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carry forwards. A valuation allowance is established against deferred tax assets when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. It is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred taxes could change in the near term. The valuation allowance was approximately $2.2 million at December 31, 2005 versus $1.7 million at December 31, 2004. The valuation allowance relates to additional state net operating losses that are unlikely to be utilized in the foreseeable future.
In 2005, the Corporation recorded income tax expense of $32.5 million on pre-tax income of $105.5 million, an effective tax rate of 30.8%. In 2004, the Corporation recorded income tax expense of $29.9 million on pre-tax income of $91.9 million, an effective tax rate of 32.6%. The decline in the effective tax rate for 2005 was mainly due to higher tax-advantaged income and low income housing credits.
Consolidated Quarterly Summary Results of Operations for 2005 and 2004:
RESULTS OF OPERATIONS
For the Year Ended December 31, 2004 Compared to Year Ended December 31, 2003
Comparative Summary Statements of Income:
Financial Highlights
Provident’s banking growth, including the Southern Financial merger, translated to record earnings for 2004. The Corporation recorded net income of $62.0 million in 2004, a 20.5% increase over 2003. Diluted earnings per share were $2.00 and $2.05 for 2004 and 2003, respectively. Earnings for 2004 included the negative impacts of $0.18 per share in net securities losses associated with the balance sheet restructure in the second quarter and $0.07 per share of merger costs. Increases of $36.9 million in the net interest margin after provision for loan losses and $12.6 million in non-interest income more than offset a $26.5 million increase in non-interest expense and a $12.5 million increase in income tax expense, resulting in a $10.5 million increase in net income. Return on assets and return on common equity decreased from 1.03% and 16.47%, respectively, for 2003 to 1.02% and 12.09%, respectively, for 2004. The decrease in return on equity was a result of the issuance of additional common equity in the Southern Financial merger in 2004. The financial results in 2004 reflect the Corporation’s commitment to produce positive core results by executing the business strategies of broadening its presence and customer base in the Virginia and metropolitan Washington markets, growing commercial business in all markets, and enhancing core business results in all markets.
Net Interest Income
Net interest income on a tax-equivalent basis increased $33.4 million to $183.0 million in 2004 from $149.6 million in 2003. The net interest margin expanded to 3.34% from 3.21%, despite a challenging rate environment. Total interest income increased $33.0 million while total interest expense declined $421 thousand. The overall improvement in net interest income and the net yield is partially a result of the addition of Southern Financial’s assets and liabilities for the last eight months of 2004.
While total interest income increased $33.0 million from 2003 to 2004, the yield on earning assets declined to 4.99% in 2004 compared to 5.17% in 2003. The 18 basis point reduction in net yield reflects the impact of repayments and refinancings caused generally by the lower interest rates that prevailed during 2004. The effects of the lower rates on net interest income were mitigated by the addition of loans associated with the Southern Financial merger and the organic Provident loan growth in the year. The restructure of the balance sheet in the second quarter of 2004, in which $415 million in low margin securities were liquidated coincident with the merger, had a positive impact on the margin. Interest income lost from non-accruing loans was $1.3 million in 2004, compared to $1.1 million in 2003.
The average rate paid on interest-bearing liabilities declined to 1.90% in 2004 from 2.21% in 2003. The primary cause of the 31 basis point decline came from the rates paid on brokered time deposits whose average rate paid declined from 6.17% in 2003 to 5.26% in 2004. The rate paid on interest-bearing liabilities also benefited from the extinguishment of $265 million in debt and lower rates paid on direct time deposits. The debt was substantially replaced with borrowings bearing lower interest rates. The $197 million increase in noninterest-bearing deposits also had a positive impact on the net yield as an interest free source of funds.
As a result of derivative transactions undertaken to mitigate the effect of interest rate risk on the Bank, interest income decreased by $1.6 million and interest expense increased by $896 thousand, resulting in a decrease of $2.4 million in net interest income relating to derivative transactions for the year ending December 31, 2004.
Provision for Loan Losses
The Corporation emphasized quality underwriting as well as aggressive management of charge-offs and potential problem loans, resulting in a provision for loan losses of $7.5 million in 2004 compared to $11.1 million in 2003. Net charge-offs were $9.0 million, or 0.27% of average loans, in 2004 compared to $8.7 million, or 0.34% of average loans in 2003. Consumer loan net charge-offs as a percentage of average consumer loans were 0.30% in 2004 compared to 0.50% in 2003. During 2004, net charge-offs in the acquired residential mortgage and other consumer loans declined $1.8 million and $800 thousand, respectively. Both portfolios experienced an improvement in net charge-offs as a percentage of average loans in their respective portfolios. Beginning in late 2004, the Corporation changed its policy with respect to net charge-offs of demand deposit overdrafts reclassified as loans. Previously, net charge-offs were reflected in other non-interest expense. These net charge-offs are now part of the allowance for loan losses, in order to be consistent with the treatment of all other loans.
Commercial business net charge-offs as a percentage of average commercial business loans were 0.44%, an increase from 0.21% in 2003. As part of the transition, Provident concentrated its efforts on converting the commercial loan portfolio of Southern Financial to Provident’s processing systems, strengthening loan file documentation and consolidating operations. As the portfolio was assimilated into Provident’s processing and credit culture, the level of charge-offs for the remainder of the year was higher than Provident’s pre-merger levels, reflecting the blended net charge-off rate of the two institutions.
Non-Interest Income
Total non-interest income increased to $101.0 million in 2004. Total non-interest income, excluding the net losses and derivative gains described below, increased 12.5% to $104.3 million in 2004.
The improvement in non-interest income continued to be driven by deposit service charges, which increased $5.9 million, or 7.8%, to $81.9 million in 2004. The increase in deposit fees was primarily the result of continued strong retail and commercial deposit account growth. Approximately $2.7 million of the increase in deposit fees was from the addition of the Southern Financial account base for eight months and $1.1 million was from Provident’s de-novo banking office expansion. De-novo expansion represented the full year effect of nine net new banking offices opened in 2003, as well as one new banking office opened in 2004. The remaining $2.1 million was the result of continued deposit account growth combined with increased debit card usage.
Commissions and fees of $4.6 million were flat in 2004 due to continued compression in the commission rates received by PIC. Other non-interest income increased $2.1 million to $14.4 million, due to income associated with bank owned life insurance.
The Corporation recorded $5.8 million in net losses in 2004, compared to net losses of $4.4 million in 2003. The net losses in 2004 were composed primarily of $3.2 million in net losses on the sales of securities and $2.4 million in losses on the extinguishment of debt. The net losses in 2003 were composed of $15.3 million in losses on the extinguishment of debt that were partially offset by $9.1 million in net gains on the sales of securities. The disposition of loans, foreclosed property and fixed assets that occur in the ordinary course of business had minimal impact in 2004 and resulted in a $1.8 million net gain in 2003. Net derivative gains on swaps were $2.4 million for the year ended December 31, 2004. In 2004, certain derivative transactions did not qualify for hedge accounting treatment and as a result, the gains associated with the derivatives were recorded in non-interest income.
Net cash settlement on swaps, representing interest income and expense on non-designated interest rate swaps was $3.5 million for the year ended December 31, 2004. As a result of losing hedge accounting treatment in 2004, the net cash settlements on non-designated interest rate swaps were recorded as part of non-interest income. In 2003, the net cash settlements were included as part of net interest income.
Non-Interest Expense
Non-interest expense of $183.7 million for 2004 was $26.5 million higher than 2003. Approximately $18 million of this increase was directly attributable to the Corporation’s merger with Southern Financial. This represented non-recurring merger expenses (including severance payments, conversion costs and customer communications) of $3.5 million and normal operating expenses for eight months (including the amortization of deposit-based intangibles) of $14.5 million. Another $1.5 million of the increase was directly attributable to the Bank’s de-novo banking office expansion activity, impacting salaries and employee benefits, occupancy and premises and equipment expense. External processing fees and professional services included $860 thousand in costs related to corporate governance compliance efforts, including Sarbanes-Oxley and other regulatory requirements. The growth in non-interest
expense, other than that which was impacted by the above items was contained to a growth rate of approximately 4% and was related to infrastructure changes necessary to support a larger geographic region, as well as variable costs associated with loan and deposit growth.
Income Taxes
In 2004, the Corporation recorded income tax expense of $29.9 million on pre-tax income of $91.9 million, an effective tax rate of 32.6%. In 2003, the Corporation recorded income tax expense of $17.4 million on pre-tax income of $68.9 million, an effective tax rate of 25.3%. The effective tax rate for 2003 was impacted by the recognition of a non-recurring state tax benefit. Exclusive of this item, the effective tax rate in 2003 would have been approximately 32.3%.
RECENT ACCOUNTING DEVELOPMENTS
In December 2004, the FASB issued SFAS No. 123R (a revision of SFAS No. 123) “Share-Based Payment” (“SFAS No. 123R”) effective for interim and annual periods beginning after June 15, 2005. In April 2005, the Securities and Exchange Commission (“SEC”) deferred the effective date of the provisions of SFAS No. 123R until the beginning of the first annual period beginning after June 15, 2005. SFAS No. 123R requires companies to recognize the grant-date fair value of stock options and other equity-based compensation issued to employees as costs of employee services in the Consolidated Statements of Income. The cost will be recognized over the period during which an employee is required to provide service in exchange for the award (usually the vesting period). At December 31, 2005 all stock options were vested. Management has evaluated the potential impact of SFAS No. 123R and determined that it will result in additional compensation expense in 2006 based upon the number and fair value of options granted in the future.
On December 30, 2005, the Corporation approved the accelerated vesting of all currently outstanding unvested stock options to purchase 612,732 shares of the Corporation’s common stock granted through 2005. As a result of the accelerated vesting, these stock options, which otherwise would have vested from time to time through February 2008, became immediately exercisable. The acceleration included options held by directors and executive officers as well as employees of the Corporation. Of the 612,732 stock options for which vesting was accelerated, all except 7,500 were “in the money” options having exercise prices from $27.46 to $33.66 per share. The options not in the money were issued under strike prices ranging from $35.11 to $36.06 per share. Based upon the closing price of the Corporation’s common stock as of December 30, 2005, the Corporation recognized a pre-tax charge of $158,000 in 2005.
The acceleration of vesting was undertaken in an attempt to eliminate compensation expense that the Corporation would otherwise be required to recognize with respect to these unvested stock options upon adoption of SFAS No. 123R. The accelerated vesting of these options eliminated potential pre-tax compensation expense recognition in future periods of approximately $2.7 million. Therefore, pro forma amounts may not be representative of future expense since the estimated fair value of stock options is amortized to expense over the various vesting periods and additional options may be granted in future periods.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Correction” (“SFAS No. 154”), which is effective for accounting changes and corrections of errors made in years beginning after December 15, 2005. SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. The adoption of SFAS No. 154 will not have any impact on the results of operations of the Corporation.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
See “Risk Factors” on page 10 and “Risk Management” on page 24 and refer to the disclosures on derivatives and investment securities in Item 8
Item 8. Financial Statements and Supplementary Data
Index to Consolidated Financial Statements
Provident Bankshares Corporation and Subsidiaries
Page
Reports of Independent Registered Public Accounting Firm
Consolidated Statements of Condition at December 31, 2005 and 2004
For the three years ended December 31, 2005, 2004 and 2003:
Consolidated Statements of Income
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Provident Bankshares Corporation:
We have audited the accompanying consolidated statements of condition of Provident Bankshares Corporation and subsidiaries as of December 31, 2005 and 2004 and the related consolidated statements of income, changes in stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Provident Bankshares Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Provident Bankshares Corporation’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 15, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Baltimore, Maryland
March 15, 2006
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Provident Bankshares Corporation:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that Provident Bankshares Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Management of Provident Bankshares Corporation is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Corporation’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Provident Bankshares Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Provident Bankshares Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of condition of Provident Bankshares Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2005, and our report dated March 15, 2006 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Baltimore, Maryland
March 15, 2006
Provident Bankshares Corporation and Subsidiaries
Consolidated Statements of Condition
The accompanying notes are an integral part of these statements.
Provident Bankshares Corporation and Subsidiaries
Consolidated Statements of Income
The accompanying notes are an integral part of these statements.
Provident Bankshares Corporation and Subsidiaries
Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income
The accompanying notes are an integral part of these statements.
Provident Bankshares Corporation and Subsidiaries
Consolidated Statements of Cash Flows
The accompanying notes are an integral part of these statements.
Provident Bankshares Corporation and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 2005
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Provident Bankshares Corporation (“the Corporation”), a Maryland corporation, is the bank holding company for Provident Bank (“the Bank”), a Maryland chartered stock commercial bank. The Bank serves individuals and businesses through a network of banking offices and ATMs in Maryland, Virginia, and southern York County, Pennsylvania. Related financial services are offered through its wholly owned subsidiaries. Securities brokerage, investment management and related insurance services are available through Provident Investment Company and leases through Court Square Leasing and Provident Lease Corporation.
The accounting and reporting policies of the Corporation conform with U.S. generally accepted accounting principles (“GAAP”) and prevailing practices within the banking industry. The following summary of significant accounting policies of the Corporation is presented to assist the reader in understanding the financial and other data presented in this report.
Principles of Consolidation and Basis of Presentation
The Consolidated Financial Statements include the accounts of the Corporation and its wholly owned subsidiary, Provident Bank and its subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation. Results of operations from purchased companies are included from the date of merger. Assets and liabilities of purchased companies are stated at estimated fair values at the date of merger.
Certain prior years’ amounts in the Consolidated Financial Statements have been reclassified to conform to the presentation used for the current year. These reclassifications have no effect on stockholders’ equity or net income as previously reported.
Use of Estimates
The Consolidated Financial Statements of the Corporation are prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities for the reporting periods. Management evaluates estimates on an on-going basis and believes the following represent its more significant judgments and estimates used in preparation of its consolidated financial statements: allowance for loan losses, non-accrual loans, other real estate owned, estimates of fair value and intangible assets associated with mergers, other than temporary impairment of investment securities, pension and post-retirement benefits, asset prepayment rates, goodwill and intangible assets, stock-based compensation, derivative financial instruments, recourse liabilities, litigation and income taxes. Management bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Each estimate and its financial impact, to the extent significant to financial results, is discussed in the Consolidated Financial Statements. It is at least reasonably possible that each of the Corporation’s estimates could change in the near term or that actual results may differ from these estimates under different assumptions or conditions, resulting in a change that could be material to the Corporation’s Consolidated Financial Statements.
Asset Prepayment Rates
The Corporation purchases amortizing loan pools and investment securities in which the underlying assets are residential mortgage loans subject to prepayments. The actual principal reduction on these assets varies from the expected contractual principal reduction due to principal prepayments resulting from borrowers elections to refinance the underlying mortgages based on market and other conditions. Prepayment rate projections utilize actual prepayment speed experience and available market information on like-kind instruments. The prepayment rates form the basis for income recognition of premiums or discounts on the related assets. Changes in prepayment estimates may cause the earnings recognized on these assets to vary over the term that the assets are held, creating volatility in the net interest margin. Prepayment rate assumptions are monitored and updated monthly to reflect actual activity and the most recent market projections.
Investment Securities
The Corporation classifies investments as either held to maturity or available for sale at the time of purchase. Securities that the Corporation has the intent and ability to hold to maturity are classified as held to maturity and are carried at cost, adjusted for amortization of premiums and accretion of discounts using the interest method. Securities that the Corporation intends to hold for an indefinite period of time, but may sell to respond to changes in interest rates, prepayment risks, liquidity needs or other similar factors, are classified as available for sale. Available for sale securities are reported at fair value with any unrealized appreciation
or depreciation in value reported net of tax as a separate component of stockholders’ equity as net accumulated other comprehensive income (loss) (“OCI”). Gains and losses from the sales of securities are recognized by the specific identification method and are reported in net gains (losses). Investment securities are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.
Mortgage Loans Held for Sale
The Corporation underwrites and originates mortgage loans with the intent to sell them. A contract exists between the Corporation and a third party in which the third party processes the loan then purchases the settled loan at a set fee. Amounts reflected as loans held for sale bear no market risk with regards to their sale price as the third party purchases the loans at their face amount, and are carried at cost. Net fee income is recognized in net gains (losses). At December 31, 2005 and 2004, the Corporation did not retain any servicing on mortgage loans sold.
Loans
All interest on loans, including direct financing leases, is accrued at the contractual rate and credited to income based upon the principal amount outstanding. Loans are reported at the principal amount outstanding, net of unearned income. Unearned income includes deferred loan origination fees, net of deferred direct incremental loan origination costs. Purchased loans are reported at the principal amount outstanding net of purchase premiums or discounts. Unearned income associated with originated loans and premiums and discounts associated with purchased loans are amortized over the expected life of the loans using the interest method and recognized in interest income as a yield adjustment.
Management places a commercial loan on non-accrual status and discontinues the accrual of interest and reverses previously accrued but unpaid interest when the quality of a commercial credit has deteriorated to the extent that collectibility of all interest and/or principal cannot be reasonably expected, or when it is 90 days past due, unless the loan is well secured and in the process of collection.
Consumer credit secured by residential property is evaluated for collectibility at 120 days past due. If the loan is in a first lien position and the ratio of the loan balance to net fair value exceeds 84%, the loan is placed on non-accrual status and all accrued but unpaid interest is reversed against interest income. If the loan is in a junior lien position, all other liens are considered in calculating the loan to value ratio. With limited exceptions, no loan continues to accrue interest after reaching 210 days past due. Charge-offs of delinquent loans secured by residential real estate are recognized when losses are reasonably estimable and probable. Generally, no later than 180 days delinquent, any portion of an outstanding loan balance in excess of the collateral’s net fair value is charged-off. Subsequent to any partial charge-offs, loans are carried on non-accrual status until the collateral is liquidated or the loan is charged-off in its entirety. Properties with partial charge-offs are periodically evaluated to determine whether additional charge-offs are warranted. Upon liquidation of the property, any deficiencies between proceeds and the recorded balance of the loan result in additional charge-offs. Generally, closed-end consumer loans secured by non-residential collateral that become 120 days past due are charged-off down to their net fair value. Unsecured open-end consumer loans are charged-off in full at 180 days past due.
Individual loans are considered impaired when, based on available information, it is probable that the Corporation will be unable to collect principal and interest when due in accordance with the contractual terms of the loan agreement. All non-accrual loans are considered impaired loans. The measurement of impaired loans is based on the present value of expected cash flows discounted at the historical effective interest rate, the market price of the loan or the fair value of the underlying collateral. Impairment criteria are applied to the loan portfolio exclusive of smaller balance homogeneous loans, such as residential mortgage and consumer loans, which are evaluated collectively for impairment.
In cases where a borrower experiences financial difficulties and the Corporation makes certain concessionary modifications to contractual terms, the loan is classified as a restructured loan. Loans restructured at a rate equal to or greater than that of a new loan with comparable risk at the time the contract is modified may cease to be considered impaired loans in the calendar years subsequent to the restructuring. Generally, a non-accrual loan that is restructured remains on non-accrual status for a period of six months to demonstrate that the borrower can meet the restructured terms. However, performance prior to the restructuring, or significant events that coincide with the restructuring, are included in assessing whether the borrower can meet the new terms and may result in being returned to accrual status at the time of restructuring or after a shorter performance period. If the borrower’s ability to meet the revised payment schedule is uncertain, the loan remains classified as a non-accrual loan.
An analysis of impaired loans is incorporated in the evaluation of the allowance for loan losses. Collections of interest and principal on all impaired loans are generally applied as a reduction to the outstanding principal balance of the loan. Once future collectibility has been established, interest income may be recognized on a cash basis.
Allowance for Loan Losses
The Corporation maintains an allowance for loan losses (“the allowance”), which is intended to be management’s best estimate of probable inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charges to earnings to bring the total allowance to a level considered necessary by management.
The allowance is based on management’s continuing review and evaluation of the loan portfolio. This process provides an allowance consisting of two components, allocated and unallocated. To arrive at the allocated component of the allowance, the Corporation combines estimates of the allowances needed for loans analyzed individually and on a pooled basis. The allocated component of the allowance is supplemented by an unallocated component.
The portion of the allowance that is allocated to individual internally criticized and non-accrual loans is determined by estimating the inherent loss on each problem credit after giving consideration to the value of underlying collateral. Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. The Corporation’s lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrower’s circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of uncollectibility. Each commercial loan is assigned a grade based upon an assessment of the borrower’s financial capacity to service the debt and the presence and value of collateral for the loan.
In addition to being used to categorize risk, the Bank’s internal ten-point risk rating system is used to determine the allocated allowance for the commercial portfolio. Reserve factors, based on the actual loss history for a 5-year period for criticized loans, are assigned. If the factor, based on loss history for classified credits is lower than the minimum established factor, the higher factor is applied. For loans with satisfactory risk profiles, the factors are based on the rating profile of the portfolio and the consequent historic losses of bonds with equivalent ratings.
For the consumer portfolios, the determination of the allocated allowance is conducted at an aggregate, or pooled, level. Each quarter, historical rolling loss rates for homogenous pools of loans in these portfolios provide the basis for the allocated reserve. For any portfolio where the Bank lacks sufficient historic experience, industry loss rates are used. If recent history is not deemed to reflect the inherent losses existing within a portfolio, older historic loss rates during a period of similar economic or market conditions are used.
The Bank’s credit administration group adjusts the indicated loss rates based on qualitative factors. Factors that are considered in adjusting loss rates include risk characteristics, credit concentration trends and general economic conditions, including job growth and unemployment rates. For commercial and real estate portfolios, additional factors include the level and trend of watched and criticized credits within those portfolios; commercial real estate vacancy, absorption and rental rates; and the number and volume of syndicated credits, construction loans, or other portfolio segments deemed to carry higher levels of risk. Upon completion of the qualitative adjustments, the overall allowance is allocated to the components of the portfolio based on the adjusted loss factors.
The unallocated component of the allowance exists to mitigate the imprecision inherent in management’s estimates of expected credit losses and includes its judgmental determination of the amounts necessary for concentrations, economic uncertainties and other subjective factors that may not have been fully considered in the allocated allowance. The relationship of the unallocated component to the total allowance may fluctuate from period to period. Although management has allocated the majority of the allowance to specific loan categories, the evaluation of the allowance is considered in its entirety.
Lending management meets at least monthly to review the credit quality of the loan portfolios and at least quarterly with executive management to evaluate the allowance. The Corporation has an internal risk analysis and review staff that continuously reviews loan quality and reports the results of its reviews to executive management and the Board of Directors. Such reviews also assist management in establishing the level of the allowance.
Management believes that it uses relevant information available to make determinations about the allowance and that it has established its existing allowance in accordance with GAAP. If circumstances differ substantially from the assumptions used in making determinations, adjustments to the allowance may be necessary and results of operations could be affected. Because events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate.
The FDIC examines the Bank periodically and, accordingly, as part of this examination, the allowance is reviewed for adequacy utilizing specific guidelines. Based upon their review, the regulators may from time to time require reserves in addition to those previously provided.
Residual Values
Lease financing provided by the Corporation involves the use of estimated residual values of the leased asset. Significant assumptions used in estimating residual values include estimated cash flows over the remaining lease term and results of future re-marketing. Periodically, the residual values associated with these leases are reviewed for impairment. Impairment losses, which are charged to interest income, are recognized if the carrying amount of the residual values exceeds the fair value and is not recoverable.
Premises and Equipment
Premises, equipment and leasehold improvements are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets or, for leasehold improvements, the lives of the related leases, if shorter. Major improvements are capitalized, while maintenance and repairs are charged to expense as incurred.
The Corporation leases small office, medical and construction equipment to customers and accounts for the leases as operating leases. The equipment is reflected as premises and equipment on the Consolidated Statements of Condition. Operating lease rental income is recognized on a straight-line basis and reflected as other non-interest income in the Consolidated Statements of Income. Related depreciation expense is recorded on a straight-line basis over the life of the lease, taking into account the estimated residual value of the leased asset. On a periodic basis, leased assets are reviewed for impairment. Impairment losses are recognized if the carrying amount of leased assets exceeds fair value and is not recoverable and reflected as net gains (losses). The carrying amount of leased assets is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the lease payments and the estimated residual value upon the eventual disposition of the equipment.
Goodwill and Intangible Assets
For acquisitions, the Corporation records the assets acquired, including identified intangible assets, and liabilities assumed at their fair value, which in many instances involves estimates based on third party valuations, such as appraisals, or valuations based on discounted cash flow analyses or other valuation techniques. The determination of the useful lives of intangible assets is subjective, as is the appropriate amortization period for such intangible assets. These estimates also include the establishment of various accruals and allowances based on planned facilities dispositions and employee severance considerations, among other acquisition-related items. In addition, purchase acquisitions typically result in goodwill, which represents the excess of the purchase price over the fair value of the net assets acquired by the Corporation. Goodwill is tested at least annually for impairment. Such tests involve the use of estimates and assumptions. Intangible assets other than goodwill, such as deposit-based intangibles, which are determined to have finite lives are amortized over their estimated remaining useful lives which are approximately 8 years.
Mortgage Servicing Rights
Mortgage servicing rights are reflected as a separate asset when the rights are acquired through the sale or purchase of financial assets, such as mortgage loans. Loans sold have a portion of the cost of originating the loan allocated to the servicing right based on the relative fair value which is based on the market prices for comparable mortgage servicing contracts or a valuation model that calculates the present value of estimated future servicing income. The valuation model incorporates assumptions such as cost to service, discount rate, ancillary income, prepayment speeds and default rates and losses. Capitalized servicing rights are reported in other assets and are amortized into non-interest income in proportion to, and over the period of, estimated future net servicing income of the underlying financial assets. Servicing fee income, which is fees earned for servicing loans, is based on a contractual percentage of the outstanding principal or a fixed amount per loan and is recorded as earned. The amortization of mortgage servicing rights is netted against loan servicing fee income. Servicing rights are evaluated for impairment on a periodic basis based on the fair value of the rights compared to the amortized cost. Impairment is recognized through a charge to non-interest income.
Other Real Estate Owned
At the time a loan is determined to be uncollectible, the underlying collateral is repossessed. At the time of repossession, the loan is reclassified as other real estate owned and carried at lower of cost or fair market value of the collateral less cost to sell (“net fair value”), establishing a new cost basis. The difference between the loan balance and the net fair value at time of foreclosure is recorded as a charge-off. Management periodically performs valuations on these assets. Revenue and expenses from the operation of other real estate owned, if applicable, and changes in the valuation allowance are included in results of operations. Gains or losses on the eventual disposition of these assets are included in net gains (losses).
Variable Interest Entities
In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN No. 46”) effective for fiscal years ending after December 31, 2003. FIN No. 46 provides guidance on identifying a variable interest entity (“VIE”) and determining when a company must consolidate the assets, liabilities, and results of activities of a VIE in its financial statements. A company is required to consolidate a VIE if it is determined to be the primary beneficiary of the VIE. The primary beneficiary is the party that absorbs a majority of the VIE’s expected losses, receives a majority of its expected residual returns, or both. In December 2003, FIN No. 46 was revised (“FIN No. 46R”) by modifying and clarifying certain provisions of FIN No. 46.
The provisions of FIN No. 46R modified the Corporation’s status as the primary beneficiary of the trusts associated with the Corporation’s borrowing arrangements involving trust preferred securities. Accordingly, the Corporation deconsolidated these trusts as of January 1, 2004. The deconsolidation was not material to the Corporation’s Statement of Condition and did not affect net income.
The Corporation holds variable interests of less than 50% in certain special purpose entities formed to provide affordable housing. At December 31, 2005, the Corporation had invested $22.7 million in these entities. These investments in low income housing provide the Corporation with certain guaranteed tax credits and other related tax benefits which offset amortization of the invested amounts over the life of the tax credits. The Corporation completed an analysis of its low income housing investments and concluded that consolidation is not required under the provisions of FIN No. 46R, as the Corporation is not the primary beneficiary in these arrangements.
Income Taxes
The Corporation accounts for income taxes under the asset/liability method. Deferred tax assets and liabilities are recognized for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period indicated by the enactment date. A valuation allowance is established against deferred tax assets when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. The judgment about the level of future taxable income is dependent to a great extent on matters that may at least in part, be beyond the Bank’s control. It is at least reasonably possible that management’s judgment about the need for a valuation allowance for deferred taxes could change in the near term.
Derivative Financial Instruments
The Corporation uses various derivative financial instruments as part of its interest rate risk management strategy to mitigate the exposure to changes in market interest rates. The derivative financial instruments used separately or in combination are interest rate swaps, caps and floors. Derivative financial instruments are required to be measured at fair value and recognized as either assets or liabilities in the financial statements. Fair value represents the payment the Corporation would receive or pay if the item were sold or bought in a current transaction. Fair values are generally based on market quotes. The accounting for changes in fair value (gains or losses) of a derivative is dependent on whether the derivative is designated and qualifies for hedge accounting. In accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), the Corporation assigns derivatives to one of these categories at the purchase date: fair value hedge, cash flow hedge or non-designated derivative. SFAS No. 133 requires an assessment of the expected and ongoing hedge effectiveness of any derivative designated a fair value hedge or cash flow hedge. Derivatives are included in other assets and other liabilities in the Consolidated Statements of Condition.
Fair Value Hedges-For derivatives designated as fair value hedges, the derivative instrument and related hedge item are marked-to-market through the related interest income or expense, as applicable, except for the ineffective portion which is recorded in non-interest income.
Cash Flow Hedges-For derivatives designated as cash flow hedges, mark-to-market adjustments are recorded net of income taxes as a component of other comprehensive income (“OCI”) in stockholders’ equity, except for the ineffective portion which is recorded in non-interest income. Amounts recorded in OCI are recognized into earnings concurrent with the hedged items’ impact on earnings.
Non-Designated Derivatives-Certain economic hedges are not designated as cash flow or as fair value hedges for accounting purposes. As a result, changes in the fair value are recorded in non-interest income in the Consolidated Statements of Income. Interest income or expense related to non-designated derivatives is also recorded in non-interest income.
All qualifying relationships between hedging instruments and hedged items are fully documented by the Corporation. Risk management objectives, strategies and the projected effectiveness of the chosen derivatives to hedge specific risks are also documented. At inception of the hedging relationship and periodically as required under SFAS No. 133, the Corporation evaluates the effectiveness of its hedging instruments. For hedges qualifying for “short-cut” treatment at inception, the ongoing effectiveness testing includes a review of the hedge and the hedged item to determine if the hedge continues to qualify for short-cut treatment. An assumption of no hedge ineffectiveness is allowed for derivatives qualifying for short-cut treatment. For all other derivatives qualifying for hedge accounting, a quantitative assessment of the effectiveness of the hedge is required at each reporting date. The Corporation performs effectiveness testing quarterly for all of its hedges. The Corporation uses benchmark interest rates such as LIBOR to hedge the interest rate risk associated with interest-earning assets or interest-bearing liabilities. Using benchmark rates and complying with specific criteria set forth in SFAS No.133, the Corporation has concluded that for qualifying hedges, changes in fair value or cash flows that are attributable to risks being hedged will be highly effective at the hedge’s inception and on an ongoing basis.
When it is determined that a derivative is not, or ceases to be effective as a hedge, the Corporation discontinues hedge accounting prospectively. When a fair value hedge is discontinued due to ineffectiveness, the Corporation continues to carry the derivative on the Consolidated Statements of Condition at its fair value as a non-designated derivative, but discontinues marking-to-market the hedged asset or liability for changes in fair value. Any previous mark-to-market adjustments recorded to the hedged item are amortized over the remaining life of the asset or liability. All ineffective portions of fair value hedges are reported in and affect net income immediately. When a cash flow hedge is discontinued due to termination of the derivative, the Corporation continues to carry the previous mark-to-market adjustments in accumulated OCI and recognizes the amount into earnings in the same period or periods during which the hedged item affects earnings. If the cash flow hedge is discontinued due to ineffectiveness, the derivative is considered a non-designated derivative and continues to be marked-to-market in the Consolidated Statements of Condition as an asset or liability, in the Consolidated Statements of Income with any changes in the mark-to-market through current period earnings and not through OCI.
Counter-party credit risk associated with derivatives is controlled by dealing with well-established brokers that are highly rated by credit rating agencies and by establishing exposure limits for individual counter-parties. Market risk on interest rate swaps is minimized by using these instruments as hedges and by continually monitoring the positions to ensure ongoing effectiveness. Credit risk is controlled by entering into bilateral collateral agreements with brokers, in which the parties pledge collateral to indemnify the counter-party in the case of default. The Corporation’s hedging activities and strategies are monitored by the Bank’s Asset / Liability Committee (“ALCO”) as part of its oversight of the treasury function.
Off-Balance Sheet Credit Related Financial Instruments
In the ordinary course of business, the Corporation enters into commitments to extend credit, including commitments under financial letters of credit and performance standby letters of credit. Such financial instruments are recorded as loans when they are funded. A liability has been established for credit losses related to these letters of credit through a charge to earnings.
Pension Plan
The Corporation has a defined benefit pension plan that covers substantially all employees. The cost of this non-contributory pension plan is computed and accrued using the projected unit credit method. The Corporation accounts for the defined benefit pension plan using an actuarial model required by SFAS No. 87, “Employers’ Accounting for Pensions.” This model allocates pension costs over the service period of employees in the plan. One of the principal components of the net periodic pension calculation is the expected long-term rate of return on plan assets. The use of an expected long-term rate of return on plan assets may cause recognition of plan income returns that are different than the actual returns of plan assets in any given year. The expected long-term rate of return is designed to approximate the actual long-term rate of return over time. To determine if the expected rate of return is reasonable, management considers the actual return earned on plan assets, historical rates of return on the various asset classes in the plan portfolio, projections of returns on various asset classes, and current/prospective capital market conditions and economic forecasts. Differences between actual and expected returns are monitored periodically to determine if adjustments are necessary.
The discount rate determines the present value of future benefit obligations. Beginning December 31, 2005, the discount rate used for the 2005 year-end disclosure and the expense in the upcoming year was determined by constructing a hypothetical bond portfolio whose cash flows from coupons and maturities match the year-by-year, projected benefit cash flow from the Corporation’s qualified pension plan. The hypothetical bond portfolio uses available bonds with a quality rating of AA or higher under either Moody’s or S&P. Callable bonds are eliminated with the exception of those with that issuers may call at par plus a premium, as these bonds would be prohibitively expensive for an issuer to call. Cash flows from the bonds may exceed the projected benefits for a particular period. Such excesses are used to meet future cash flow needs in the succeeding year and are assumed to be reinvested at the one-year forward rates.
Prior service cost is amortized using the straight-line method over the average remaining service period of employees expected to receive benefits under the plan. Annual contributions may be made to the plan in an amount equal to the minimum requirements, but no greater than the maximum allowed by regulatory authorities.
The excess of the pension benefit obligation over the fair market value of the plan assets is recognized as an accrued liability. A portion of this accrued liability, if applicable, is reflected, net of taxes, in OCI.
In December 2003, the FASB issued SFAS No. 132 (revised 2003), “Employer’s Disclosures about Pensions and Other Postretirement Benefits” (“SFAS No. 132”) effective for fiscal years ending after December 15, 2003. SFAS No. 132 revised disclosures about pension plans and other postretirement benefit plans but does not change the measurement or recognition of these plans. SFAS No. 132 required additional disclosures about plan assets, obligations, cash flows and net periodic benefit cost of deferred benefit plans. The adoption of SFAS No. 132 did not have any impact on the Corporation’s earnings, financial condition or equity. The required disclosures are included in Note 21.
Stock-Based Compensation
The Corporation may grant employees and/or directors stock-based compensation in the form of stock options or restricted stock priced at the fair market value on the grant date. The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations including SFAS Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation (“FIN No. 44”), an interpretation of APB Opinion No. 25,” to account for its fixed-plan stock options. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”) and SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of SFAS No. 123,” (“SFAS No. 148”) established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As permitted by existing accounting standards, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123, as amended.
The Corporation recognized pre-tax compensation expense of $455 thousand and $209 thousand relating to restricted stock grants for the years ended December 31, 2005 and 2004, respectively.
During the second quarter of 2005, as part of a voluntary separation agreement, the Corporation modified the terms of previously awarded stock options to an executive who left the Corporation. Under the provisions of FIN No. 44, these stock options were remeasured at the intrinsic value as of the date of separation. Accordingly, the Corporation immediately recognized compensation expense of $525 thousand.
The following table illustrates the pro forma effect on net income and earnings per share if the Corporation had applied the fair value provisions of SFAS No. 123 to stock-based compensation for the periods indicated.
In December 2004, the FASB issued SFAS No. 123R (a revision of SFAS No. 123) “Share-Based Payment” (“SFAS No. 123R”) effective for interim and annual periods beginning after June 15, 2005. In April 2005, the Securities and Exchange Commission
(“SEC”) deferred the effective date of the provisions of SFAS No. 123R until the beginning of the first annual period beginning after June 15, 2005. SFAS No. 123R requires companies to recognize the grant-date fair value of stock options and other equity-based compensation issued to employees as a cost of employee services in the Consolidated Statements of Income. The cost will be recognized over the period during which an employee is required to provide service in exchange for the award (usually the vesting period). Management has evaluated the potential impact of SFAS No. 123R and determined that it will result in additional compensation expense in 2006 based upon the number and fair value of options granted in the future. Management intends to utilize the modified prospective method of adoption.
On December 30, 2005, the Corporation approved the accelerated vesting of all currently outstanding unvested stock options to purchase 612,732 shares of the Corporation’s common stock granted through 2005. As a result of the accelerated vesting, these stock options, which otherwise would have vested from time to time through February 2008, became immediately exercisable. The acceleration included options held by directors and executive officers as well as employees of the Corporation. Of the 612,732 stock options for which vesting was accelerated, all except 7,500 were “in the money” options having exercise prices from $27.46 to $33.66 per share. The options not in the money were issued under strike prices ranging from $35.11 to $36.06 per share. Based upon the closing price of the Corporation’s common stock as of December 30, 2005, the Corporation recognized a pre-tax charge of $158,000 in 2005.
The acceleration of vesting was undertaken in an attempt to eliminate compensation expense that the Corporation would otherwise be required to recognize with respect to these unvested stock options upon adoption of SFAS No. 123R. The accelerated vesting of these options eliminated potential pre-tax compensation expense recognition in future periods of approximately $2.7 million. Therefore, pro forma amounts may not be representative of future expense since the estimated fair value of stock options is amortized to expense over the various vesting periods and additional options may be granted in future periods.
Statement of Cash Flows
For purposes of reporting cash flows, cash equivalents are composed of cash and due from banks and short-term investments.
Other Changes in Accounting Principles
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Correction” (“SFAS No. 154”), which is effective for accounting changes and corrections of errors made in years beginning after December 15, 2005. SFAS No. 154 provides guidance on the accounting for and reporting accounting changes and error corrections. The adoption of SFAS No. 154 will not have any impact on the results of operations of the Corporation.
NOTE 2-BUSINESS COMBINATION
On April 30, 2004, the Corporation acquired 100 percent of the outstanding common shares of Southern Financial Bancorp, Inc. (“Southern Financial”), headquartered in Warrenton, Virginia, which was the holding company for Southern Financial Bank. Southern Financial had previously completed the acquisition of Essex Bancorp, Inc., based in Norfolk, Virginia. Southern Financial operated 33 banking offices in the northern Virginia counties of Fairfax, Loudoun and Prince William; as well as Richmond, Charlottesville and the Tidewater areas.
Southern Financial was merged with and into the Corporation. Southern Financial shareholders received 1.0875 shares of the Corporation’s common stock and $11.125 in cash for each Southern Financial share outstanding. As a result, Southern Financial’s shareholders received 8.2 million shares of the Corporation’s common stock amounting to $251.2 million and $83.8 million in cash, for an aggregate purchase price of $335.1 million. The cash portion of the purchase price was substantially funded by $71 million in trust preferred securities which were issued in the fourth quarter of 2003. The value of the shares issued was based on the average market closing price of the Corporation’s common stock from October 29, 2003 through November 6, 2003.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed for Southern Financial at the merger date.
The merger with Southern Financial resulted in the recognition of $260.1 million of intangible assets, of which $12.8 million was allocated to a deposit-based intangible. The remaining intangible was allocated to goodwill. The results of operations from Southern Financial have been included in the Consolidated Financial Statements since the date of merger.
On October 15, 2004, the Corporation sold three of the Norfolk/Tidewater area branch offices (formerly of Essex Bancorp, Inc.) and their associated deposits. On December 1, 2004, the Corporation sold its 24.99% interest in Loan Care, a mortgage servicer. There was no gain or loss associated with the settlement of these transactions as their fair value was considered in the determination of goodwill.
NOTE 3-RESTRICTIONS ON CASH AND DUE FROM BANKS
The Federal Reserve requires banks to maintain cash reserves against certain categories of deposit liabilities. Such reserves averaged $66.9 million and $62.4 million during the years ended December 31, 2005 and 2004, respectively.
In order to cover the cost of services provided by correspondent banks, the Corporation maintains compensating balance arrangements at these correspondent banks or elects to pay a fee in lieu of such arrangements. During 2005 and 2004, the Corporation maintained average compensating balances of $3.6 million and $3.3 million, respectively. In addition, the Corporation paid fees totaling $829 thousand in 2005, $874 thousand in 2004 and $858 thousand in 2003 in lieu of maintaining compensating balances.
NOTE 4-INVESTMENT SECURITIES
The following table presents the aggregate amortized cost and fair values of the investment securities portfolio at the periods indicated:
During 2004, the Corporation reclassified $108 million of other debt securities from available for sale to held to maturity. The securities were transferred upon determination that the Corporation had the intent and ability to hold these securities until maturity. The unrealized gains of $7.4 million associated with these securities were included in net accumulated other comprehensive loss at the date of transfer, net of tax, and will continue to be reflected in stockholders’ equity. Both the remaining premium on the securities transferred and the amount reflected in net accumulated other comprehensive loss are being amortized over the remaining life of the securities using the interest method. These amortization amounts will offset with no net income impact on the Corporation.
The aggregate amortized cost and fair values of the investment securities portfolio by contractual maturity at December 31 for the periods indicated are shown below. Expected cash flows on mortgage-backed securities may differ from the contractual maturities as borrowers have the right to prepay the obligation without prepayment penalties.
The following table shows the unrealized gross losses and fair values of investment securities at December 31, 2005, by length of time that individual securities in each category have been in a continuous loss position.
Management reviews the investment portfolio on a periodic basis to determine the cause of declines in the fair value of each security. Thorough evaluations of the causes of the unrealized losses are performed to determine whether the impairment is temporary or other than temporary in nature. Considerations such as recoverability of invested amount over a reasonable period of time, the length of time the security is in a loss position and receipt of amounts contractually due, for example, are applied in determining other than temporary impairment.
At December 31, 2005, $1.3 billion of the Corporation’s investment securities had unrealized losses that are considered temporary. Of this amount, 82% are Aaa rated and 17% are A or BBB rated. Seven securities, totaling $16.2 million, are unrated. The portfolio contained 86 securities, with a fair value of $677 million, that had unrealized losses for twelve months or longer. All of the investment securities with unrealized losses were mortgage-backed securities and asset-backed securities, which declined in value due to the interest rate environment during 2005. Because the declines in fair value were due to changes in market interest rates and not in estimated cash flows, no other than temporary impairment was recorded at December 31, 2005.
The table below provides the sales proceeds and the components of net securities gains (losses) from the securities available for sale portfolio for each of the three years ended December 31. The net securities gains (losses) are included in net gains (losses).
At December 31, 2005, a net unrealized after-tax loss of $14.9 million on the securities portfolio was reflected in net accumulated other comprehensive loss, compared to a net unrealized after-tax gain of $2.2 million at December 31, 2004.
Securities with a market value of $927.3 million and $1.3 billion at December 31, 2005 and 2004, respectively, were pledged as collateral for public funds, certain short-term borrowings and for other purposes required by law.
NOTE 5-LOANS
A summary of loans outstanding at December 31 for each of the periods indicated is shown in the table below. Outstanding loan balances at December 31 are net of unearned income, including net deferred loan fees of $18.1 million and $15.9 million, respectively.
NOTE 6-ALLOWANCE FOR LOAN LOSSES
The following table reflects the activity in the allowance for loan losses during each of the three years ended December 31.
At December 31, 2005, 2004 and 2003, the recorded investment in commercial loans that were on non-accrual status, and therefore considered impaired, totaled $17.8 million, $15.1 million and $3.2 million, respectively. There was no additional allowance required for these loans. Had these loans performed in accordance with their original terms, interest income of $1.2 million in 2005, $659 thousand in 2004 and $21 thousand in 2003 would have been recorded. No interest income was recognized on these loans during 2005. The average recorded investment in impaired commercial loans was approximately $14.4 million in 2005 and $9.2 million in 2004.
NOTE 7-PREMISES AND EQUIPMENT
Real estate and equipment holdings at December 31 are presented in the table below. Real estate owned and used by the Corporation consists of 21 branch offices and other facilities in Maryland and Virginia that are used primarily for the operations of the Bank.
During 2001, the Corporation, as lessor, entered into a land lease for the property adjacent to the Corporation’s headquarters with an initial lease term of six years supplemented by thirteen, seven year extensions. Under the agreement, the lessee constructed office and parking facilities on the property. The lease provides for discounted parking for the Corporation’s employees in addition to office space adequate to meet the Corporation’s future incremental operational requirements. The lease provides for annual payments of $347 thousand, with an annual escalation provision of 1% per annum.
In 1990, the Corporation entered into a sale and leaseback agreement whereby its headquarters building was sold to an unrelated third party that then leased the building back to the Corporation. During 2000, the lease was renegotiated and at December 31, 2005 has six years remaining on the term.
The Corporation also maintains non-cancelable operating leases associated with Bank premises. Most of the leases provide for the payment of property taxes and other costs by the Bank and include one or more renewal options ranging up to twenty years. Annual rental commitments under all long-term non-cancelable operating lease agreements consisted of the following at December 31, 2005.
Rental expense for premises and equipment was $14.4 million in 2005, $12.4 million in 2004 and $10.4 million in 2003.
NOTE 8-INTANGIBLE ASSETS
The table below presents an analysis of the goodwill and deposit-based intangible activity for the years ended December 31, 2005 and 2004.
Adjustments to goodwill during 2005 are primarily due to the resolution of income tax uncertainties related to the respective mergers.
The following table reflects the expected amortization schedule for the deposit-based intangible at December 31, 2005.
The annual impairment evaluation of goodwill did not identify any potential impairment in 2005 or 2004.
NOTE 9-MORTGAGE BANKING ACTIVITIES
The Corporation acquired $2.1 million of mortgage servicing rights concurrent with the merger of Southern Financial. The following is an analysis of the mortgage loan servicing rights balance, net of accumulated amortization, during 2005. This balance is included in other assets.
Unpaid principal balances of loans serviced for others not included in the Consolidated Statements of Condition were $173.4 million and $200.1 million at December 31, 2005 and 2004, respectively.
NOTE 10-DEPOSITS
A comparative summary of deposits and respective weighted average rates at December 31 follows:
The contractual maturities of certificates of deposit at December 31, 2005 are shown in the following table.
Time deposits with a denomination of $100,000 or more were $252.9 million and $201.4 million at December 31, 2005 and 2004, respectively. The contractual maturities of these deposits at December 31, 2005 are shown in the following table.
Demand deposit overdrafts that have been reclassified as loan balances were $4.9 million and $4.7 million at December 31, 2005 and 2004, respectively. Overdraft charge-offs and recoveries are reflected in the allowance for loan losses.
NOTE 11-SHORT-TERM BORROWINGS
At December 31, short-term borrowings were as follows:
The following table sets forth various data on securities sold under repurchase agreements and federal funds purchased.
At December 31, 2005, the Corporation had $753 million in unused federal funds lines of credit. The weighted average rate on the variable rate Federal Home Loan Bank (“FHLB”) advances was 4.24% at December 31, 2005.
NOTE 12-LONG-TERM DEBT
Long-term debt at December 31 was as follows:
At December 31, 2005, investment securities and certain real estate loans with carrying values of $410.3 million and $744.8 million, respectively, collateralize the FHLB advances and term repurchase agreements. At December 31, 2005, the Corporation had $284 million in unused lines of credit at the FHLB.
The principal maturities of long-term debt at December 31, 2005 are presented below.
Since 1997, the Corporation has formed three wholly owned statutory business trusts in addition to acquiring three additional trusts in the Southern Financial merger. These trusts issued securities that were sold to third parties. The sole purpose of the trusts was to invest the proceeds in junior subordinated debentures of the Corporation that have terms identical to the trust securities.
The junior subordinated debentures, which are the sole assets of the trusts, are subordinate and junior in right of payment to all present and future senior and junior subordinated indebtedness and certain other financial obligations of the Corporation. The Corporation fully and unconditionally guarantees each trust’s securities obligations. The junior subordinated debentures are includable in tier 1 capital for regulatory capital purposes, subject to certain limitations.
Under the provisions of the junior subordinated debentures, the Corporation has the right to defer payment of interest on the junior subordinated debentures at any time, or from time to time, for periods not exceeding five years. If interest payments on the junior subordinated debentures are deferred, the distributions on the junior subordinated debentures are also deferred. Interest on the junior subordinated debentures is cumulative. The accrual of interest to be paid on the junior subordinated debentures held by the trusts is included in interest expense.
The securities are redeemable in whole or in part on or after their respective call dates. Any of the securities are redeemable at any time in whole, but not in part, from the date of issuance on the occurrence of certain events. On March 31, 2005, the Corporation redeemed $30.0 million in aggregate principal amount of 10% Junior Subordinated Debentures issued to Provident Trust II. The Junior Subordinated Debentures had a final stated maturity of March 31, 2030, but were callable at par beginning on March 31, 2005. On July 15, 2005, the Corporation redeemed $5.0 million in aggregate principal amount of 11% Junior Subordinated Debentures issued to Southern Financial Capital Trust I. The Junior Subordinated Debentures were callable beginning July 15, 2005 and had a final stated maturity date of July 15, 2030.
The amounts and terms of each respective issuance at December 31 were as follows:
NOTE 13-STOCKHOLDERS’ EQUITY
During 1998, the Corporation initiated a stock repurchase program for its outstanding stock. The Corporation monitors the program and approves certain amounts to be repurchased on an annual basis. These purchases may occur in the open market from time to time and on an ongoing basis, depending upon market conditions. The Corporation repurchased 684,962 and 116,900 shares of common stock at a cost of $22.6 million and $4.2 million during 2005 and 2004, respectively. At December 31, 2005, the Corporation had remaining authority to repurchase up to 1,237,865 shares under its current authorization.
The Corporation’s Option Plan covers a maximum of 12.5 million shares of common stock that has been reserved for issuance under the Option Plan. The Option Plan provides for the granting of non-qualified stock options and restricted stock to certain key employees and directors of the Corporation and the Bank, as designated by the Corporation’s board of directors. Options granted prior to 2004 have a maximum duration of ten years from the date of grant. Beginning in 2005, options have a duration of eight
years. Options granted typically have a vesting schedule from three to five years. Regardless of the vesting schedule, all options vest immediately upon a change in control. At December 31, 2005 all stock options are vested.
As part of director compensation, the Corporation grants shares of restricted stock to directors of the Corporation. During 2004, the Corporation granted 7,196 shares of fully vested restricted stock to the directors of the Corporation that had a market price at the grant date of $29.35 per share. The Corporation recognized $209 thousand in expense relating to these grants. In 2005, the Corporation granted 6,580 shares of fully vested and 214 shares of unvested restricted stock to the directors of the Corporation that had a market price at the grant date of $31.90 per share. The Corporation recognized $210 thousand in expense relating to these grants. Additionally during 2005, the Corporation granted 32,550 shares of unvested restricted stock to certain employees that had a market price at the grant date of $33.66. The Corporation will record compensation expense ratably over the four year vesting period. For the year ended December 31, 2005, the Corporation recognized $246 thousand in compensation expense related to the vesting of the restricted stock grants to employees.
The following table presents a summarization of the activity related to the options for the periods indicated:
The table below provides information on the stock options outstanding at December 31, 2005.
The weighted average fair value of all of the stock options granted during the periods 2003 through 2005 have been estimated using the Black-Scholes option-pricing model with the following assumptions.
NOTE 14-DERIVATIVE FINANCIAL INSTRUMENTS
Fair value hedges that meet the criteria for effectiveness have changes in the fair value of the derivative and the designated hedged item recognized in earnings. At and during all periods presented, the derivatives designated as fair value hedges were determined to be effective. Accordingly, the designated hedges and the associated hedged items were marked to fair value by an equal and offsetting amount of $657 thousand and $167 thousand for the years ended December 31, 2005 and 2004, respectively. Cash flow hedges have the effective portion of changes in the fair value of the derivative, net of taxes recorded in net accumulated other comprehensive loss. At December 31, 2005, the Corporation recorded an increase in fair value of derivatives of $1.3 million compared to an increase of $1.1 million in 2004, net of taxes, in net accumulated other comprehensive loss to reflect the effective portion of cash flow hedges. Amounts recorded in net accumulated other comprehensive loss are recognized into earnings concurrent with the impact of the hedged item on earnings. For the years ended December 31, 2005 and 2004, the Corporation had no ineffective hedges.
Non-designated derivatives are marked to market and the gains or losses are recorded in non-interest income at the end of each reporting period. These non-designated derivatives represent interest rate protection on the net interest income but do not meet hedge accounting treatment. For the year ended December 31, 2005, the Corporation recorded a pre-tax net loss of $4.4 million to reflect the decrease in value of the non-designated interest rate swaps. The Corporation recorded a pre-tax net gain of $2.4 million for the year ended December 31, 2004 to reflect the net increase in value of the non-designated interest rate swaps. The net cash settlements on the interest rate swaps are recorded in non-interest income. Net cash settlements on interest rate swaps were $3.5 million in 2005 and 2004, respectively.
The table below presents the Corporation’s open derivative positions as of the dates indicated:
The fair value of cash flow hedges reflected in net accumulated other comprehensive loss (“OCI”) is determined using the projected cash flows of the derivatives over their respective lives. This amount may or may not exceed the amount expected to be recognized into earnings out of OCI in the next twelve months, depending on the remaining time to maturity of the position. The
Corporation expects approximately $1.3 million before taxes to be recognized into expense out of OCI in the next twelve months. This amount represents amortization of $1.9 million for interest rate caps and corridors, net of $620 thousand recognized from interest rate swaps. The $620 thousand is projected based on the anticipated forward yield curve. The amount currently reflected in OCI represents the earnings impact over the life of the derivatives, or $1.5 million on interest rate caps and corridors, net of $849 thousand on the interest rate swaps.
At December 31, 2005, the Corporation had deferred gains of $1.4 million and deferred losses of $1.6 million related to terminated contracts which are being amortized as a yield adjustment in various amounts through 2020, based on the lives of the underlying assets or liabilities. At December 31, 2004, the Corporation had deferred gains of $1.6 million and deferred losses of $2.5 million.
NOTE 15-CONTINGENCIES AND OFF-BALANCE SHEET RISK
Commitments
Commitments to extend credit in the form of consumer, commercial real estate and business loans at December 31 were as follows:
Historically, many of the commitments expire without being fully drawn; therefore, the total commitment amounts do not necessarily represent future cash requirements.
Litigation
The Corporation is involved in various legal actions that arise in the ordinary course of its business. In April 2005, the Corporation became a party to litigation where a former employee alleges a breach by the Corporation of a previously executed employment contract. The former employee claims that, under the terms of the contract, he is due a so-called “imputed interest payment” valued at approximately $2 million. Further, under a theory of damages put forth, he asserts that he is owed a multiple of the imputed interest payment. The aggregate damage award sought against the Corporation in this action is approximately $6 million. The litigation is currently in the discovery phase and no trial date has been set. The Corporation believes it has meritorious defenses against this action and is vigorously and actively contesting the allegations against it.
All other active lawsuits entail amounts which management believes, in the aggregate, are immaterial to the financial condition and the results of operations of the Corporation.
Concentrations of Credit Risk
Commercial construction and mortgage loan receivables from real estate developers represent $890.9 million and $693.1 million of the total loan portfolio at December 31, 2005 and 2004, respectively. Substantially all such loans are collateralized by real property or other assets. These loans are expected to be repaid from the proceeds received by the borrowers from the retail sales or rentals of these properties to third parties. Consumer loan receivables include $1.4 billion and $1.4 billion in originated and acquired residential and home equity loans at December 31, 2005 and 2004, respectively. Additionally, the consumer portfolio contains marine loans originated through brokers of $405.0 million and $426.2 million at December 31, 2005 and 2004, respectively.
The Corporation’s investment portfolio contains mortgage-backed securities totaling $1.03 billion and $1.65 billion at December 31, 2005 and 2004, respectively. The underlying collateral for these securities is in the form of pools of mortgages on residential properties. U.S. Government agencies or corporations either directly or indirectly guarantee the majority of the securities. Management is of the opinion that credit risk is minimal.
NOTE 16-RELATED PARTY TRANSACTIONS
Loans to directors and members of executive management are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than normal risk of collectibility. The credit criteria used to evaluate each loan is the same as required of any Bank customer.
The schedule below presents information on these loans.
NOTE 17-NET GAINS (LOSSES), OTHER NON-INTEREST INCOME AND EXPENSE
The components of net gains (losses), other non-interest income and other non-interest expense for the three years ended December 31 were as follows:
In the normal course of business, the Corporation may extinguish debt prior to its maturity. During 2005, 2004 and 2003, the Corporation extinguished $36 million, $295 million and $140 million of debt, respectively.
NOTE 18-INCOME TAXES
The components of income tax expense and the sources of deferred income taxes for the three years ended December 31 are presented below.
The combined federal and state effective income tax rate for each year is different than the statutory federal income tax rate. The table below is a reconciliation of the statutory federal income tax expense and rate to the effective income tax expense and rate for the years indicated.
SFAS No. 109, “Accounting for Income Taxes” provides that a valuation allowance is established against deferred tax assets when, in the judgment of management, it is more likely than not that such tax assets will not become realizable. SFAS No. 109 further provides that upon the likelihood of realization, the valuation allowance associated with the deferred tax benefit would no longer be appropriate. Prior to 2003, the Corporation had a valuation allowance of $7.5 million associated with state income tax benefits. In 2003, a benefit of $6.0 million associated with the realization of accumulated state income tax benefits was included in tax expense as it became more likely than not that accumulated deferred benefits would be utilized in the foreseeable future. During 2004 and 2005, the creation of additional state net operating losses required increases in the valuation allowance. At December 31, 2005 the valuation allowance of $2.2 million relates to additional state net operating losses that are unlikely to be utilized in the foreseeable future. Management believes that, except for that portion which is covered by the valuation allowance, the Corporation’s deferred tax assets at December 31, 2005 are more likely than not to be realized through the generation of sufficient future taxable income.
The net tax benefit recorded directly to stockholders’ equity related to exercised stock options was $2.8 million, $2.6 million and $3.1 million for 2005, 2004 and 2003, respectively.
Tax expense associated with net realized investment securities gains was $0.4 million in 2005. Tax benefits associated with net realized investment securities losses were $1.1 million in 2004. A tax expense of $3.2 million associated with net realized investment securities gains was recorded in 2003.
The primary sources of temporary differences that give rise to significant portions of the deferred tax assets and liabilities, which are classified as other assets in the Consolidated Statements of Financial Condition at December 31, 2005 and 2004 are presented below.
During 2005, the Corporation recorded a reduction to deferred tax assets of $34 thousand related to purchase accounting adjustments from prior years.
At December 31, 2005, the Corporation had state net operating loss carryforwards of $267 million that begin to expire in 2009 if not utilized. In addition to the state net operating loss carryforwards at December 31, 2005, the Corporation also had federal net operating loss carryforwards of $4.5 million that will begin to expire in 2009 if not utilized. These net operating losses are subject to Section 382 limitations resulting in a limitation on net operating loss deductions of $1.4 million per year.
NOTE 19-EARNINGS PER SHARE
Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Basic earnings per share does not include the effect of any potentially dilutive transactions or conversions. Diluted earnings per share reflects the potential dilution of earnings per share which could occur under the treasury stock method if contracts to issue common stock, such as stock options, were exercised and shared in corporate earnings.
The following table presents a summary of per share data and amounts for the periods indicated:
NOTE 20-OTHER COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) is defined as net income plus transactions and other occurrences that are the result of non-owner changes in equity. For financial statements presented for the Corporation, non-owner equity changes are comprised of unrealized gains or losses on available for sale debt securities, unrealized gains or losses attributable to derivatives that will be accumulated with net income from operations, and any minimum pension liability adjustment. These do not have an impact on the Corporation’s results of operations. Below are the components of other comprehensive income (loss) and the related tax effects allocated to each component.
The following table presents net accumulated other comprehensive income (loss) for the periods indicated:
NOTE 21-EMPLOYEE BENEFIT PLANS
Qualified Pension Plan
The Corporation’s non-contributory defined benefit pension plan covers substantially all employees with the exception of on-call, peak time, temporary or summer employees with at least one year of service and provides an optional lump sum or monthly benefits upon retirement to participants based on average career earnings and length of service. The Corporation’s policy is to contribute amounts to the plan sufficient to meet the minimum funding requirements set forth in the Employee Retirement Income Security Act of 1974 (“ERISA”), as amended, plus such additional amounts as the Corporation deems appropriate. On March 31, 2005, the Corporation communicated to employees that the pension plan would be frozen for new entrants effective May 1, 2005. Participants in the plan prior to May 1, 2005 were not affected by this change.
Postretirement Benefits
Prior to March 31, 2005 the Corporation provided certain health care and life insurance benefits to retired employees. The under age 65 health care plan was a contributory plan, in which the retirees were responsible for all premiums. The cost of life insurance benefits provided to the retirees is borne by the Corporation. These plans are unfunded. On March 31, 2005, the Corporation communicated to retirees under the age of 65 currently receiving postretirement health benefits that these benefits would be eliminated and no longer offered effective January 1, 2006. Postretirement life insurance benefits continue to be provided to retirees. This action resulted in the reversal of the actuarially determined liability of $1.2 million at March 31, 2005 associated with health care benefits.
The following tables set forth the activity for each benefit plan’s projected benefit obligation, plan assets and funded status.
The weighted average assumptions used in determining the actuarial present value of the projected benefit obligation at December 31 are as follows:
Impact on Financial Condition
Amounts recognized in the Consolidated Statements of Condition consist of the following at December 31.
During 2004, the Corporation recorded an additional liability of $4.0 million for the non-qualified pension plan. This was required due to the size projected benefit obligation compared to the assets of the plan. This liability, net of $1.8 million of unrecognized prior service cost, resulted in $1.4 million, net of tax, being reflected as a component of net accumulated other comprehensive loss. At December 31, 2005 the additional liability increased to $4.9 million and was offset by $3.0 million in prior service cost and, accordingly, resulted in $1.2 million, net of tax, being reflected in net accumulated other comprehensive loss.
Components of Net Periodic Benefit Expense
The actuarially estimated net benefit cost for the years ended December 31 includes the following components.
Weighted average assumptions used in determining net periodic benefit cost for the three years ended December 31 are presented below:
The Corporation revises the rates applied in the determination of the actuarial present value of the projected benefit obligation to reflect the anticipated performance of the plan and changes in compensation levels.
Qualified Pension Plan Assets
The investment objective for the qualified pension plan assets is to increase the market value of the pension fund by achieving above average results over time, within acceptable risk parameters. Specific guidelines are to achieve a total return from investment income and capital appreciation that exceeds the annual rate of inflation by 3 to 5% over a five-year period while insuring adequate asset protection. This is to be achieved by focusing on all market sectors and managing the asset mix between certain categories, reflecting specific plan requirements and market conditions. The composition of the portfolio is covered by the following parameters-equities: 40-70%, fixed income: 15-60%, and cash and equivalents: 0-35%. No single equity or industry or group can constitute more than 20% of either portfolio. No single company or equity can constitute more than 5% of the total portfolio. No single equity may compose more than 10% of the equity portfolio. No single issue, with the exception of U.S. Government and Agency obligations, can constitute more than 5% of the total value of the cash and equivalents. Quarterly, the pension plan’s investment advisor reviews the asset mix and portfolio performance with management. Management periodically evaluates the long-term rate of return on the qualified pension plan assets by reviewing the actual returns on the assets for specific periods of time, in addition to averaging the actual returns over specific periods of time. Based on these reviews, the vast majority of the rates of return for the qualified plan assets were greater than or equal to 8.5% for 2005, 8.5% for 2004 and 8.5% for 2003.
The Corporation’s pension plan weighted-average asset allocations at December 31 by asset category were as follows:
Contributions
During 2005 and 2004, the Corporation contributed $6.6 million and $5.0 million, respectively, to the qualified pension plan. The minimum required contribution in 2006 for the qualified plan is estimated to be zero. The maximum contribution amount for the qualified plan is the maximum deductible contribution under the Internal Revenue Code, which is dependent on several factors including proposed legislation that will affect the interest rate used to determine the current liability. In addition, the decision to contribute the maximum amount is dependent on other factors including the actual investment performance of plan assets. Given these uncertainties, the Corporation is not able to reliably estimate the maximum deductible contribution or the amount that will be contributed in 2006 to the qualified plan. For the unfunded non-qualified pension and postretirement benefit plans, the Corporation will contribute the minimum required amount in 2006, which is equal to the benefits paid under the plans.
Benefit Payments
Presented below are the estimated future benefit payments, which as appropriate, reflect expected future service.
Retirement Savings Plan
The Retirement Savings Plan (the “Plan”) is a defined contribution plan that is qualified under Section 401(a) of the Internal Revenue Code of 1986. The Plan generally allows all employees who complete six months of employment and elect to participate, to receive matching funds from the Corporation for pre-tax retirement contributions made by the employee. The annual contribution to this Plan is at the discretion of, and determined by, the Board of Directors of the Corporation. Under provisions of the Plan, the maximum contribution is 75% of an employee’s contribution up to 4.5% of the individual’s salary. Contributions to this Plan amounted to $2.5 million, $1.8 million and $1.6 million for the years ended December 31, 2005, 2004 and 2003, respectively.
NOTE 22-REGULATORY CAPITAL
The Corporation and the Bank are subject to various capital adequacy guidelines imposed by federal and state regulatory agencies. Under these guidelines, the Corporation and the Bank must meet specific capital adequacy requirements that are quantitative measures of their respective assets, liabilities and certain off-balance sheet items calculated under regulatory accounting practices.
The Corporation’s and the Bank’s core (or tier 1) capital is equal to total stockholders’ equity less net accumulated OCI plus capital securities less intangible assets. Total regulatory capital consists of core capital plus the allowance for loan losses, subject to certain limitations. The trust preferred securities are considered capital securities, and accordingly, are includable as tier 1 capital of the Corporation subject to a 25% limitation. The leverage ratio represents core capital, as defined above, divided by average total assets. Risk-based capital ratios measure core and total regulatory capital against risk-weighted assets as prescribed by regulation. Risk-weighted assets are determined by applying a weighting to asset categories and certain off-balance sheet commitments based on the level of credit risk inherent in the assets.
The Corporation and the Bank exceeded all regulatory capital requirements as of December 31, 2005. The Corporation is a one-bank holding company that relies upon the Bank’s performance to generate capital growth through the Bank earnings. A portion of the Bank’s earnings is passed to the Corporation in the form of cash dividends.
As a commercial bank under the Maryland Financial Institution Law, the Bank may declare cash dividends from undivided profits or, with the prior approval of the Commissioner of Financial Regulation, out of additional paid-in capital in excess of 100% of its required capital stock, and after providing for due or accrued expenses, losses, interest and taxes.
The Corporation and the Bank, in declaring and paying dividends, are also limited insofar as minimum regulatory capital requirements must be maintained. The Corporation and the Bank comply with such capital requirements. If the Corporation or the Bank were unable to comply with the minimum capital requirements, it could result in regulatory actions that could have a material impact on the Corporation.
The actual regulatory capital ratios and required ratios for capital adequacy purposes under FIRREA and the ratios to be categorized as “well capitalized” under prompt corrective action regulations are summarized in the following table for the periods indicated:
NOTE 23-BUSINESS SEGMENT INFORMATION
The Corporation’s lines of business are structured according to the channels through which its products and services are delivered to its customers. For management purposes the lines are divided into the following segments: Consumer Banking, Commercial Banking, and Treasury and Administration.
The Corporation offers consumer and commercial banking products and services through its wholly owned subsidiary, Provident Bank. The Bank offers its services to customers in the key urban areas of Baltimore, Washington and Richmond through 91 traditional and 61 in-store banking offices in Maryland, Virginia and southern York County, Pennsylvania. Additionally, the Bank offers its customers 24-hour banking services through 251 ATMs, telephone banking and the Internet. Consumer banking services include a broad array of small business and consumer loan, deposit and investment products offered to retail and commercial customers through the retail branch network and direct channel sales center. Commercial Banking provides an array of commercial financial services including asset-based lending, equipment leasing, real estate financing, cash management and structured financing to middle market commercial customers. Treasury and Administration is comprised of balance sheet management activities that include managing the investment portfolio, discretionary funding, utilization of derivative financial instruments and optimizing the Corporation’s equity position.
The financial performance of each business segment is monitored using an internal profitability measurement system. This system utilizes policies that ensure the results reflect the economics for each segment compiled on a consistent basis. Line of business information is based on management accounting practices that support the current management structure and is not necessarily comparable with similar information for other financial institutions. This profitability measurement system uses internal management accounting policies that generally follow the policies described in Note 1. The Corporation’s funds transfer pricing system utilizes a matched maturity methodology that assigns a cost of funds to earning assets and a value to the liabilities of each business segment with an offset in the Treasury and Administration business segment. The provision for loan losses is charged to the consumer and commercial segments based on actual charge-offs with the balance to the Treasury and Administration segment. Operating expense is charged on a fully absorbed basis. Income tax expense is calculated based on the segment’s fully taxable equivalent income and the Corporation’s effective tax rate. Revenues from no individual customer exceeded 10% of consolidated total revenues.
The table below summarizes results by each business segment for the periods indicated.
The following table discloses the net carrying amount of goodwill at December 31, 2005, 2004 and 2003 respectively by segment.
NOTE 24-FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, “Disclosure about Fair Value of Financial Instruments” (“SFAS No. 107”) requires all entities to disclose the fair value of recognized and unrecognized financial instruments on a prospective basis, where feasible, in an effort to provide financial statement users with information in making rational investment and credit decisions. To estimate the fair value of each class of financial instrument the Corporation applied the following methods using the indicated assumptions:
Cash and Due from Banks and Short-Term Investments
The amounts reported in the balance sheet approximate the fair values of these assets.
Mortgage Loans Held for Sale
Fair values of mortgage loans held for sale are based on prices entered into between the Corporation and a third party.
Securities Available for Sale
Fair values of investment securities are based on quoted market prices.
Securities Held to Maturity
Fair values of investment securities are based on quoted market prices.
Loans
The fair value calculation of loans differentiates loans on their financial characteristics, such as product classification, loan category, pricing features and remaining maturity. Prepayment estimates are evaluated by product and loan rate. The fair value of commercial loans, commercial real estate loans and real estate construction loans is calculated by discounting contractual cash flows, using discount rates that are believed to reflect current credit quality and other related factors. Loans that have homogeneous characteristics, such as residential mortgages and installment loans, are valued using discounted cash flows.
Other Assets
Fair value of cash surrender value life insurance contracts are based upon cash values of the policies as provided by each insurance carrier.
Deposits
The fair value of demand deposits, savings accounts and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposits is estimated using a discounted cash flow calculation that applies interest rates and remaining maturities for currently offered certificates of deposit.
Borrowings
Fair values of the borrowings are based on quoted market prices of borrowings and debt with similar terms and remaining maturities.
Derivative Financial Instruments
Interest rate swaps and cap/corridor arrangements are valued at quoted market prices.
The estimated fair values of the Corporation’s financial instruments at December 31 are as follows:
The calculations represent estimates and do not represent the underlying value of the Corporation. These amounts are based on the relative economic environment at the respective year-ends; therefore, economic movements since year-end may have affected the valuations.
NOTE 25-PARENT COMPANY FINANCIAL INFORMATION
The statements of income, financial condition and cash flows for Provident Bankshares Corporation (parent only) are presented below.
Statements of Income
Statements of Condition
Statements of Cash Flows
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Corporation’s management, including the Corporation’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Corporation’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Corporation’s disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Corporation files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and communicated to the Corporation’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
Management’s Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting. The internal control process has been designed under our supervision to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Corporation’s financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.
Management conducted an assessment of the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2005, utilizing the framework established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management has determined that the Corporation’s internal control over financial reporting as of December 31, 2005 is effective.
Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that accurately and fairly reflect, in reasonable detail, transactions and dispositions of assets; and provide reasonable assurances that (i) transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States; (ii) receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Corporation; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Corporation’s assets that could have a material effect on the Corporation’s financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management’s assessment of the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2005 has been audited by KPMG LLP, an independent registered public accounting firm, as stated in their report. Accordingly, KPMG LLP has issued an attestation report on management’s assessment of the Corporation’s internal control over financial reporting. KPMG LLP’s report is included in “Item 8 Financial Statements and Supplementary Data”.
Changes in Internal Control over Financial Reporting
Changes in the Corporation’s internal control over financial reporting during the quarter ended December 31, 2005 that have materially affected, or are reasonably likely to materially affect the Corporation’s internal controls over financial reporting are described as follows:
In November 2005, management determined that the Corporation’s internal control over financial reporting as of December 31, 2004 was not effective because of the existence of the following material weakness in internal control over financial reporting: the Corporation’s policies and procedures did not provide for sufficient testing and verification of the criteria for the “short-cut” method to ensure proper application of the provisions of SFAS No. 133 at inception for certain derivative financial instruments and did not provide for periodic timely review of the proper accounting for certain derivative financial instruments for periods subsequent to inception. This material weakness resulted in the restatement of the Company’s unaudited condensed consolidated financial statements for the interim periods ended June 30, 2005 and March 31, 2005 and the consolidated financial statements for the year ended December 31, 2004 and for each of the interim periods during 2004.
As a result, the Corporation implemented several important changes in its internal control over financial reporting relating to its accounting for derivatives. These actions include:
•
Enhancing the Corporation’s policy and procedures related to hedge documentation at the inception of a hedge. In addition, enhancing the subsequent review, documentation and effectiveness measurements of the existing hedges for each reporting period;
•
Evaluating at each reporting period commencing with December 31, 2005, all the Corporation’s hedges that use the “short-cut” method to ensure this method meets current U.S. generally accepted accounting principles guidance;
•
Subscribing to the Derivative Implementation Notification Service to ensure prompt notification of newly posted guidance on the requirements of SFAS No. 133
All of the above changes to the Corporation’s internal control over financial reporting were implemented by December 31, 2005 and have improved the Corporation’s internal control over financial reporting. As a result, management believes that the material weakness was fully remediated at December 31, 2005.
Compliance with Laws and Regulations
Management is also responsible for compliance with the federal and state laws and regulations concerning dividend restrictions and federal laws and regulations concerning loans to insiders designated by the FDIC as safety and soundness laws and regulations.
Management assessed its compliance with the designated laws and regulations relating to safety and soundness. Based on this assessment, management believes that Provident Bank, the wholly owned subsidiary of Provident Bankshares Corporation complied, in all significant respects, with the designated laws and regulations related to safety and soundness for the year ended December 31, 2005.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information relating to the directors and officers of Provident Bankshares Corporation and information regarding compliance with Section 16(a) of the Exchange Act is incorporated herein by reference to the sections “Election of Directors” and “Other Information Relating to Directors and Executive Officers of Provident Bankshares” in the Corporation’s Proxy Statement for the 2006 Annual Meeting of Stockholders (the “Proxy Statement”).
A copy of the Corporation’s Code of Ethics is available, without charge, upon written request to Robert L. Davis, General Counsel and Corporate Secretary, 114 East Lexington Street, Baltimore, Maryland 21202.
Item 11.
Item 11. Executive Compensation
The information regarding executive compensation is incorporated herein by reference to the text and tables under “Directors’ Compensation” and “Executive Compensation” in the Corporation’s Proxy Statement.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information relating to security ownership of certain beneficial owners and management is incorporated herein by reference to the text and tables under “Stock Ownership” in the Corporation’s Proxy Statement. The Corporation is not aware of any arrangement, including any pledge by any person of securities of the Corporation, the operation of which may at a subsequent date result in a change of control of the Corporation.
Equity Compensation Plan Information
The following table sets forth information, as of December 31, 2005, about Corporation equity securities that may be issued under all of Provident Bankshares’ equity compensation plans. The Corporation’s stockholders approved each of the Corporation’s equity compensation plans.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information relating to certain relationships and related transactions is incorporated herein by reference to the sections “Compensation Committee Interlocks and Insider Participation” and “Transactions with Management” in the Corporation’s Proxy Statement.
Item 14.
Item 14. Principal Accountant Fees and Services
The information regarding principal accountant fees and services is incorporated herein by reference to “Ratification of Appointment of the Independent Registered Public Accounting Firm” in the Corporation’s Proxy Statement.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) The exhibits and financial statements filed as a part of this report are as follows:
(1) The Consolidated Financial Statements of Provident Bankshares Corporation and Subsidiaries are included in Item 8.
(2) All financial statement schedules are omitted as the required information either is not applicable or is contained in the financial statements or related notes.
(3) Exhibits
The following is an index of the exhibits included in this report:
(1) Incorporated by reference from Registrant’s Registration Statement on Form S-8 (File No. 33-58881) filed with the Commission on July 10, 1998.
(2) Incorporated by reference from Registrant’s 2004 Annual Report on Form 10-K (File No. 0-16421) filed with the Commission on March 16, 2005.
(3) Incorporated by reference from Registrant’s 2001 Annual Report on Form 10-K (File No. 0-16421) filed with the Commission on March 8, 2002.
(4) Incorporated by reference from Registrant’s definitive 2001 Proxy Statement for the Annual Meeting of Stockholders held on April 18, 2001 (File No. 0-16421) filed with the Commission on March 14, 2001.
(5) Incorporated by reference from Registrant’s 1995 Annual Report on Form 10-K (File No. 0-16421) filed with the Commission on March 18, 1996.
(6) Incorporated by reference from Registrant’s 1998 Annual Report on Form 10-K (File No. 0-16421) filed with the Commission on March 3, 1999.
(7) Incorporated by reference from Registrant’s 2002 Annual Report on Form 10-K (File No. 0-16421) filed with the Commission on March 7, 2003.
(8) Incorporated by reference from Registrant’s Registration Statement on Form S-4, as amended (File No. 333-112083) filed with the Commission on January 22, 2004.
(9) Incorporated herein by reference to Note 19 in the Notes to Consolidated Financial Statements.
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacity and on the dates indicated.
Principal Executive Officer:
March 16, 2006
By
/s/ GARY N. GEISEL
Gary N. Geisel
Chairman of the Board
and Chief Executive Officer
Principal Financial and Accounting Officer:
March 16, 2006
By
/s/ DENNIS A. STARLIPER
Dennis A. Starliper
Executive Vice President
and Chief Financial Officer
A Majority of the Board of Directors*
Melvin A. Bilal, Thomas S. Bozzuto, Kevin G. Byrnes, Ward B. Coe, III, Charles W. Cole, Jr., William J. Crowley, Jr., Pierce B. Dunn, Enos K. Fry, Gary N. Geisel, Mark K. Joseph, Bryan L. Logan, Barbara B. Lucas, Peter M. Martin, Pamela J. Mazza, Frederick W. Meier, Jr., Francis G. Riggs, Sheila K. Riggs, Donald E. Wilson
* Pursuant to the Power of Attorney incorporated by reference.
EXHIBIT INDEX
EXHIBIT
DESCRIPTION
21.0
Subsidiaries of Provident Bankshares Corporation
23.1
Consent of Independent Registered Public Accounting Firm
24.0
Power of Attorney
31.1
Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
31.2
Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
32.1
Section 1350 Certification of Chief Executive Officer
32.2
Section 1350 Certification of Chief Financial Officer