1 FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 (Mark one) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2001 -------------- OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------- ------------- Commission file number 000-4491 -------- FIRST TENNESSEE NATIONAL CORPORATION ----------------------------------------- (Exact name of registrant as specified in its charter) Tennessee 62-0803242 - ----------------------------------- -------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 165 Madison Avenue, Memphis, Tennessee 38103 - --------------------------------------- --------- (Address of principal executive offices) (Zip Code) (901) 523-4444 ---------------------------------------------------- (Registrant's telephone number, including area code) None ---------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common Stock, $.625 par value 127,228,403 - ----------------------------- ---------------------------- Class Outstanding on July 31, 2001
2 FIRST TENNESSEE NATIONAL CORPORATION INDEX Part I. Financial Information Part II. Other Information Signatures Exhibit Index
3 PART I. FINANCIAL INFORMATION Item 1. Financial Statements. - ------------------------------ The Consolidated Statements of Condition The Consolidated Statements of Income The Consolidated Statements of Shareholders' Equity The Consolidated Statements of Cash Flows The Notes to Consolidated Financial Statements This financial information reflects all adjustments which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the interim periods presented.
4 <TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF CONDITION First Tennessee National Corporation - ----------------------------------------------------------------------------------------------------------------------------------- June 30 December 31 --------------------------------- ------------- (Dollars in thousands)(Unaudited) 2001 2000 2000 - --------------------------------------------------------------------------------------------------------------- ------------- <S> <C> <C> <C> ASSETS: Cash and due from banks $ 741,436 $ 844,741 $ 838,148 Federal funds sold and securities purchased under agreements to resell 92,388 250,891 122,251 - --------------------------------------------------------------------------------------------------------------- ------------- Total cash and cash equivalents 833,824 1,095,632 960,399 - --------------------------------------------------------------------------------------------------------------- ------------- Investment in bank time deposits 1,098 1,096 3,629 Trading securities 589,852 374,211 253,796 Loans held for sale 2,465,810 2,950,272 1,735,070 Securities available for sale 1,977,007 2,069,712 2,200,741 Securities held to maturity (market value of $546,950 at June 30, 2001; $652,941 at June 30, 2000; and $619,728 at December 31, 2000) 559,975 702,144 638,315 Loans, net of unearned income 9,959,561 9,877,149 10,239,450 Less: Allowance for loan losses 148,658 142,722 143,696 - --------------------------------------------------------------------------------------------------------------- ------------- Total net loans 9,810,903 9,734,427 10,095,754 - --------------------------------------------------------------------------------------------------------------- ------------- Premises and equipment, net 269,029 293,219 286,107 Real estate acquired by foreclosure 15,525 17,877 16,290 Mortgage servicing rights, net 743,185 844,317 743,714 Intangible assets, net 130,417 126,662 121,624 Capital markets receivables and other assets 1,399,551 1,595,047 1,499,647 - --------------------------------------------------------------------------------------------------------------- ------------- TOTAL ASSETS $ 18,796,176 $ 19,804,616 $ 18,555,086 =============================================================================================================== ============= LIABILITIES AND SHAREHOLDERS' EQUITY: Deposits: Interest-bearing $ 8,806,085 $ 9,576,327 $ 9,341,603 Noninterest-bearing 3,465,020 2,979,094 2,847,088 - --------------------------------------------------------------------------------------------------------------- ------------- Total deposits 12,271,105 12,555,421 12,188,691 - --------------------------------------------------------------------------------------------------------------- ------------- Federal funds purchased and securities sold under agreements to repurchase 2,771,149 3,217,788 2,981,026 Commercial paper and other short-term borrowings 395,512 1,149,036 456,535 Capital markets payables and other liabilities 1,355,778 1,120,789 996,574 Term borrowings (Note 6) 479,579 359,830 409,676 - --------------------------------------------------------------------------------------------------------------- ------------- Total liabilities 17,273,123 18,402,864 17,032,502 - --------------------------------------------------------------------------------------------------------------- ------------- Guaranteed preferred beneficial interests in First Tennessee's junior subordinated debentures 100,000 100,000 100,000 Preferred stock of subsidiary 44,137 -- 38,428 - --------------------------------------------------------------------------------------------------------------- ------------- SHAREHOLDERS' EQUITY: Preferred stock - no par value (5,000,000 shares authorized, but unissued) -- -- -- Common stock - $.625 par value (shares authorized - 400,000,000; shares issued - 126,336,782 at June 30, 2001; 130,232,828 at June 30, 2000; and 128,744,573 at December 31, 2000) 78,960 81,396 80,465 Capital surplus 97,342 140,854 115,775 Undivided profits 1,177,967 1,091,374 1,172,548 Accumulated other comprehensive income 21,584 (10,712) 14,598 Deferred compensation on restricted stock incentive plans (3,199) (4,884) (4,183) Deferred compensation obligation 6,262 3,724 4,953 - --------------------------------------------------------------------------------------------------------------- ------------- Total shareholders' equity 1,378,916 1,301,752 1,384,156 - --------------------------------------------------------------------------------------------------------------- ------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 18,796,176 $ 19,804,616 $ 18,555,086 =============================================================================================================== ============= <FN> See accompanying notes to consolidated financial statements. </FN> </TABLE>
5 <TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF INCOME First Tennessee National Corporation - ----------------------------------------------------------------------------------------------------------------------------------- Three Months Ended Six Months Ended June 30 June 30 -------------------------------- -------------------------------- (Dollars in thousands except per share data)(Unaudited) 2001 2000 2001 2000 - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> INTEREST INCOME: Interest and fees on loans $ 205,296 $ 225,531 $ 431,480 $ 434,902 Interest on investment securities: Taxable 42,400 47,977 86,658 101,453 Tax-exempt 399 493 839 998 Interest on mortgage loans held for sale 45,287 57,869 79,938 103,237 Interest on trading securities 11,824 6,790 24,926 12,732 Interest on other earning assets 1,900 5,459 4,418 10,096 - ----------------------------------------------------------------------------------------------------------------------------------- Total interest income 307,106 344,119 628,259 663,418 - ----------------------------------------------------------------------------------------------------------------------------------- INTEREST EXPENSE: Interest on deposits: Savings 1,080 1,428 2,327 2,849 Checking interest and money market account 24,433 28,452 52,612 55,985 Certificates of deposit under $100,000 and other time 29,941 31,284 62,821 61,647 Certificates of deposit $100,000 and more 37,125 57,650 82,407 102,945 Interest on short-term borrowings 40,009 67,746 94,519 130,804 Interest on term borrowings 7,650 5,703 15,388 11,838 - ----------------------------------------------------------------------------------------------------------------------------------- Total interest expense 140,238 192,263 310,074 366,068 - ----------------------------------------------------------------------------------------------------------------------------------- NET INTEREST INCOME 166,868 151,856 318,185 297,350 Provision for loan losses 17,436 17,077 36,425 32,574 - ----------------------------------------------------------------------------------------------------------------------------------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 149,432 134,779 281,760 264,776 - ----------------------------------------------------------------------------------------------------------------------------------- NONINTEREST INCOME: Mortgage banking 160,068 93,275 291,751 193,147 Divestitures 70,033 40,921 81,467 40,921 Capital markets 65,740 18,973 144,550 43,337 Deposit transactions and cash management 31,674 29,731 59,434 56,144 Trust services and investment management 14,409 16,058 29,605 32,052 Merchant processing 11,330 12,310 22,960 23,340 Cardholder fees 5,264 6,942 9,580 13,975 Equity securities gains/(losses) (3,250) -- (3,303) 475 Debt securities gains/(losses) (140) 84 (237) 1,210 All other income and commissions 30,873 32,532 66,636 68,622 - ----------------------------------------------------------------------------------------------------------------------------------- Total noninterest income 386,001 250,826 702,443 473,223 - ----------------------------------------------------------------------------------------------------------------------------------- ADJUSTED GROSS INCOME AFTER PROVISION FOR LOAN LOSSES 535,433 385,605 984,203 737,999 - ----------------------------------------------------------------------------------------------------------------------------------- NONINTEREST EXPENSE: Employee compensation, incentives and benefits 190,400 146,201 369,054 286,195 Amortization of mortgage servicing rights 26,773 17,954 53,214 36,383 Occupancy 18,310 21,721 35,562 40,108 Operations services 16,691 17,170 31,514 34,531 Equipment rentals, depreciation and maintenance 22,741 17,283 40,542 32,761 Communications and courier 11,785 12,277 23,096 24,296 Amortization of intangible assets 2,877 2,666 5,757 5,337 All other expense 108,192 66,381 193,043 134,921 - ----------------------------------------------------------------------------------------------------------------------------------- Total noninterest expense 397,769 301,653 751,782 594,532 - ----------------------------------------------------------------------------------------------------------------------------------- PRETAX INCOME 137,664 83,952 232,421 143,467 Applicable income taxes 48,650 28,529 81,035 48,521 - ----------------------------------------------------------------------------------------------------------------------------------- Income before debt restructurings and cumulative effect of changes in accounting principles 89,014 55,423 151,386 94,946 Debt restructurings and cumulative effect of changes in accounting principles (3,225) -- (11,393) -- - ----------------------------------------------------------------------------------------------------------------------------------- NET INCOME $ 85,789 $ 55,423 $ 139,993 $ 94,946 =================================================================================================================================== EARNINGS PER COMMON SHARE BEFORE DEBT RESTRUCTURINGS AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES (Note 3) $ .70 $ .42 $ 1.18 $ .73 EARNINGS PER COMMON SHARE (Note 3) .67 .42 1.09 .73 - ----------------------------------------------------------------------------------------------------------------------------------- DILUTED EARNINGS PER COMMON SHARE BEFORE DEBT RESTRUCTURINGS AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES (Note 3) $ .68 $ .42 $ 1.14 $ .72 DILUTED EARNINGS PER COMMON SHARE (Note 3) .65 .42 1.06 .72 - ----------------------------------------------------------------------------------------------------------------------------------- WEIGHTED AVERAGE SHARES OUTSTANDING 127,889,957 130,612,102 128,593,538 130,503,240 - ----------------------------------------------------------------------------------------------------------------------------------- <FN> See accompanying notes to consolidated financial statements. </FN> </TABLE>
6 <TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY First Tennessee National Corporation - ----------------------------------------------------------------------------------------------------------------------------------- (Dollars in thousands)(Unaudited) 2001 2000 - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> BALANCE, JANUARY 1 $ 1,384,156 $ 1,241,467 Net income 139,993 94,946 Other comprehensive income: Cumulative effect of change in accounting principle 1,449 -- Unrealized market adjustments, net of tax and reclassification adjustment 5,537 11,040 - ----------------------------------------------------------------------------------------------------------------------------------- Comprehensive income 146,979 105,986 - ----------------------------------------------------------------------------------------------------------------------------------- Cash dividends declared (56,084) (57,294) Common stock issued for exercise of stock options 49,135 4,822 Elliot Ames, Inc. acquisition -- 1,385 Tax benefit from non-qualified stock options 19,055 -- Common stock repurchased (171,369) (5,474) Amortization on restricted stock incentive plans 984 1,019 Other 6,060 9,841 - ----------------------------------------------------------------------------------------------------------------------------------- BALANCE, JUNE 30 $ 1,378,916 $ 1,301,752 =================================================================================================================================== <FN> See accompanying notes to consolidated financial statements. </FN> </TABLE>
7 <TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF CASH FLOWS First Tennessee National Corporation - ----------------------------------------------------------------------------------------------------------------------------------- Six Months Ended June 30 -------------------------------- (Dollars in thousands)(Unaudited) 2001 2000 - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> OPERATING ACTIVITIES: Net income $ 139,993 $ 94,946 Adjustments to reconcile net income to net cash provided/(used) by operating activities: Provision for loan losses 36,425 32,574 Provision for deferred income tax 13,244 7,039 Depreciation and amortization of premises and equipment 28,411 29,187 Amortization and impairment of mortgage servicing rights 95,801 36,383 Amortization of intangible assets 5,757 5,337 Net other amortization and accretion 7,581 21,994 Net increase in net derivative product assets 106,617 -- Market value adjustment on foreclosed property 4,478 2,983 Loss on sale of securitized loans -- 1,315 Equity securities (gains)/losses 3,303 (475) Debt securities (gains)/losses 237 (1,210) Net losses on disposal of fixed assets 7,324 140 Gains on divestitures (81,467) (40,921) Net (increase)/decrease in: Trading Securities (181,332) (227,170) Mortgage loans held for sale (730,740) (800,919) Capital markets receivables (74,231) (227,336) Interest receivable 12,896 (3,515) Other assets (33,696) (121,608) Net increase/(decrease)in: Capital markets payables 152,585 233,229 Interest payable (9,316) (11,005) Other liabilities 180,960 (18,564) - ----------------------------------------------------------------------------------------------------------------------------------- Total adjustments (455,163) (1,082,542) - ----------------------------------------------------------------------------------------------------------------------------------- Net cash (used)/provided by operating activities (315,170) (987,596) - ----------------------------------------------------------------------------------------------------------------------------------- INVESTING ACTIVITIES: Held to maturity securities: Maturities 77,398 67,596 Purchases -- (500) Available for sale securities: Sales 95,031 279,536 Maturities 357,792 282,099 Purchases (384,090) (362,611) Premises and equipment: Sales 65 4,171 Purchases (15,559) (23,909) Proceeds from loan securitizations -- 184,379 Net increase in loans (247,034) (733,511) Net increase in investment in bank time deposits 2,531 2,167 Proceeds from divestitures 453,279 57,565 Acquisitions, net of cash and cash equivalents acquired (1,925) -- - ----------------------------------------------------------------------------------------------------------------------------------- Net cash used by investing activities 337,488 (243,018) - ----------------------------------------------------------------------------------------------------------------------------------- FINANCING ACTIVITIES: Common stock: Exercise of stock options 50,027 4,961 Cash dividends (56,472) (57,142) Repurchase of shares (171,368) (5,486) Term borrowings: Issuance 209,958 51,200 Payments (190,209) (50,185) Net increase/(decrease) in: Deposits 230,071 1,186,971 Short-term borrowings (220,900) (39,687) - ----------------------------------------------------------------------------------------------------------------------------------- Net cash provided by financing activities (148,893) 1,090,632 - ----------------------------------------------------------------------------------------------------------------------------------- Net decrease in cash and cash equivalents (126,575) (139,982) - ----------------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at beginning of period 960,399 1,235,614 - ----------------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 833,824 $ 1,095,632 =================================================================================================================================== Total interest paid $ 318,991 $ 376,812 Total income taxes paid 89,663 82,239 - ----------------------------------------------------------------------------------------------------------------------------------- <FN> See accompanying notes to consolidated financial statements. </FN> </TABLE>
8 NOTE 1 - FINANCIAL INFORMATION The unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles. In the opinion of management, all necessary adjustments have been made for a fair presentation of financial position and results of operations for the periods presented. The operating results for the three-month and six-month periods ended June 30, 2001, are not necessarily indicative of the results that may be expected going forward. For further information, refer to the audited consolidated financial statements and footnotes included in the financial appendix to the 2001 Proxy Statement. On June 30, 2001, the Financial Accounting Standards Board finalized Statement of Financial Accounting Standards No. 141, Business Combinations, and SFAS No. 142 Goodwill and Other Intangible Assets. Under SFAS No. 141 all business combinations initiated after June 30, 2001, must be accounted for using the purchase method. With the adoption of SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life. Rather, goodwill will be subject to an assessment for impairment using a fair-value-based test at least annually. Goodwill associated with equity-method investments is also no longer amortized, but impairment analysis is governed by existing impairment guidance for equity-method investments and not the new impairment rules. Also under the new rules, acquired intangible assets should be separately recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold or otherwise transferred, regardless of the acquirer's intent to do so. These new rules are expected to result in more intangible assets being separated from goodwill than generally occurs today. The resulting assets will be amortized over their useful lives. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001, which for First Tennessee will mean January 1, 2002. First Tennessee estimates the impact of adopting these new standards will be to reduce noninterest expense annually by approximately $7 million pre-tax without regard to any new acquisitions or future impairment that may occur, the effect of which cannot be predicted at this time. On January 1, 2001, First Tennessee adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" and EITF Issue 99-20: Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets. SFAS No. 133 establishes accounting standards requiring that every derivative instrument (including certain instruments embedded in other contracts) be recorded on the balance sheet as either an asset or liability measured at its fair value. It requires that changes in the instrument's fair value be recognized currently in earnings (or other comprehensive income). If certain criteria are met, changes in the fair value of the asset or liability being hedged are also recognized currently in earnings. Upon adoption of SFAS No. 133 all derivative instruments were measured at fair value with differences between the previous book value and fair value reported as part of a cumulative effect adjustment, except to the extent that they related to hedges of the variable cash flow exposure of forecasted transactions. To the extent the adoption adjustment related to hedges of the variable cash flow exposure of a forecasted transaction, the remainder of the accounting adjustment, a $1.4 million gain (after-tax) was reported as a cumulative effect adjustment of comprehensive income in first quarter 2001. Offsetting gains and losses on hedged assets and liabilities were recognized as adjustments of their respective book values at the adoption date as part of this cumulative effect adjustment. Additionally, EITF Issue 99-20, which provides impairment and interest income recognition and measurement guidance for interests retained in a securitization transaction accounted for as a sale, was adopted. The initial impact of adopting SFAS No. 133 and EITF Issue 99-20 was an $8.2 million loss (after-tax) net transition adjustment that was recognized as the cumulative effect of a change in accounting principle in first quarter 2001.
9 Fair value is determined on the last business day of a reporting period. This point in time measurement of derivative fair values and the related hedged item fair values may be well suited to the measurement of hedge effectiveness, as well as reported earnings, when hedge time horizons are short. The same measurement however may not consistently reflect the effectiveness of longer-term hedges and, in First Tennessee's view, can distort short-term measures of reported earnings. First Tennessee uses a combination of derivative financial instruments to hedge certain components of the interest rate risk associated with its portfolio of capitalized mortgage servicing rights, which currently have an average life of approximately seven years. Over this long-term time horizon this combination of derivatives can be effective in significantly mitigating the effects of interest rate changes on the value of the servicing portfolio. However, these derivative financial instruments can and do demonstrate significant price volatility depending upon prevailing conditions in the financial markets. If a reporting period ends during a period of volatile financial market conditions, the effect of such point in time conditions on reported earnings does not reflect the underlying economics of the transactions or the true value of the hedges to First Tennessee over their estimated lives. The fact that the fair value of a particular derivative is unusually low or high on the last day of the reporting period is meaningful in evaluating performance during the period only if First Tennessee sells the derivative within the period of time before fair value changes and does not replace the hedge coverage with another derivative. First Tennessee believes the effect of such volatility on short-term measures of earnings ($3.6 million pre-tax gain for the six-month period ending June 30, 2001) is not indicative of the expected long-term performance of this hedging practice. Certain provisions of SFAS No. 133 continue to undergo significant discussion and debate by the FASB. One such potential issue involves the determination of the components of value of mortgage banking interest rate lock commitments, which have tentatively been determined to be a derivative instrument by FASB. Under First Tennessee's interpretation of the components of value of an interest rate lock commitment a portion of the gain or loss from the sale of the related mortgage loan is recognized in mortgage banking noninterest income at the time the commitment is made ($16.2 million gain for the six months ending June 30, 2001). Under pre-SFAS No. 133 rules all of the gain or loss was recognized at the time the loan was sold into the secondary market. As the FASB continues to deliberate potential changes to the new rules the potential exists for a conflict between First Tennessee's interpretation and that of the FASB, the effects of which cannot presently be anticipated. Adoption of SFAS No. 133 was not retroactive, therefore, the manner in which derivatives historically have been accounted for was not affected, but significant changes have been made in accounting policies related to derivatives and hedges in 2001. Included below are certain accounting policies that were impacted by the adoption of SFAS No. 133. First Tennessee's mortgage lenders originate first-lien mortgage loans primarily for the purpose of selling them in the secondary market. Mortgage loans held for sale (the warehouse), are recorded at the lower of aggregate cost or market value. Gains and losses realized from the sale of these assets and adjustments to market value are included in noninterest income. In certain cases, mortgage banking continues to service securitized mortgage loans and has also retained interest-only strips. The interest-only strips are financial assets that represent rights to receive earnings from serviced assets that exceed contractually specified servicing fees and are recognized on the balance sheet at fair value in trading securities.
10 Mortgage banking has also completed proprietary securitizations of loans from the warehouse with prime quality jumbo fixed rate loans. The resulting securities are sold as senior and subordinate bonds, while servicing rights and a principal cashflow tranche are retained. The retained principal-only strip (PO strip) is initially valued by allocating the total cost between the assets sold, the servicing right and the PO strip based on their relative fair values. The PO strip is recognized on the balance sheet at fair value in trading securities. Servicing rights related to the mortgages sold have historically been mostly retained. Currently, only limited amounts of servicing rights are being retained as mortgage banking intends to curtail growth in the servicing portfolio. Accounting standards require the recognition of mortgage servicing rights (MSRs) as separate assets by allocating the total cost between the loan and the servicing right based on their relative fair values. First Tennessee uses a cash flow valuation model to determine the fair value of the servicing rights created. These valuations are tested for reasonableness against prices obtained from flow and bulk sales of servicing and are validated through an independent market valuation. Model assumptions are periodically reviewed and may be revised from time to time to more accurately reflect current assumptions such as prepayment speeds. For purposes of impairment evaluation and measurement, the MSRs are stratified based on the predominant risk characteristics of the underlying loans. These strata currently include adjustable and fixed rate loans. The fixed rate loans are further stratified by 150 basis-point interest rate bands. Previously the strata included adjustable rate conventional and government and fixed rate conventional and government by interest rate band. The MSRs are amortized as noninterest expense over the period of and in proportion to the estimated net servicing revenues. A quarterly value impairment analysis is performed using a discounted cash flow methodology that is disaggregated by predominant risk characteristics. Impairment, if any, is generally recognized through a valuation allowance for individual strata. Forward contracts used by mortgage banking operations to hedge against interest rate risk in the warehouse are reviewed periodically for correlation with expected changes in value. Interest rate derivative contracts used to hedge against interest rate risk in the servicing portfolio are designated to specific risk tranches of servicing. Derivative contracts utilized in trading activities by capital markets are measured at fair value, with changes in fair value recognized currently in capital markets noninterest income. Related assets are recorded on the balance sheet as capital markets securities inventory or receivables and any liabilities are recognized as capital markets payables. Any contracts that fail to qualify for hedge accounting are measured at fair value with any gains or losses included in current earnings in noninterest income. In September 2000, the FASB issued SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." This Statement replaces SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No. 140 revises the standards for accounting for securitizations and other transfers of
11 financial assets and collateral and requires substantial disclosures, but carries over most of SFAS No. 125's provisions without reconsideration. This Statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishment of liabilities. Those standards are based on consistent application of a financial-components approach that focuses on control. Under that approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. This Statement provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. The disclosure provisions of the statement were effective immediately and have been adopted by First Tennessee. Other provisions became effective for transactions occurring after March 31, 2001. Adoption of the new provisions of SFAS No. 140 was not material to First Tennessee's consolidated financial position or results of operations. On January 1, 1999, First Tennessee adopted SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained after Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise." This Statement amends SFAS No. 65, which required that retained securities be classified as trading securities. SFAS No. 134 allows these securities to be classified as trading, held to maturity or available for sale based on the intent and ability of the enterprise. On January 1, 1999, First Tennessee adopted Statement of Position 98-5, "Reporting on the Costs of Start-up Activities." This Statement requires that the costs of start-up activities, including organization costs, be expensed as incurred. The impact of adopting this standard was immaterial to First Tennessee.
12 NOTE 2 - DIVESTITURES/ACQUISITIONS On June 6, 2001, First Tennessee Bank National Association (FTBNA), the primary banking subsidiary of First Tennessee, along with its partner, International Business Machines Corporation (IBM) completed the sale of its interests in Check Solutions Company to Carreker Corporation of Dallas, Texas. First Tennessee recognized a divestiture gain of $44.9 million. On April 27, 2001, First Tennessee completed the sale of its wholly owned subsidiary, Peoples and Union Bank, of Lewisburg, Tennessee to First Farmers & Merchants National Bank, of Columbia, Tennessee. First Tennessee recognized a divestiture gain of $13.1 million. On April 2, 2001, FTBNA sold its existing portfolio of education loans totaling $342.1 million to Educational Funding of the South, Inc. The transaction resulted in a divestiture gain of $11.8 million. On January 17, 2001, FTBNA completed the sale of $31.4 million of its affinity, co-branded, and certain single relationship credit card accounts and assets, to MBNA Corporation for $37.9 million. The transaction resulted in a divestiture gain of $5.9 million. On October 18, 2000, FTBNA sold its corporate and municipal trust business to The Chase Manhattan Bank. This transaction resulted in an additional divestiture gain of $4.5 million due to an earn-out received in first quarter 2001. On November 15, 2000, First Tennessee Securities Corporation (FTSC), a wholly owned subsidiary of FTBNA, signed a definitive purchase agreement to acquire certain assets of Midwest Research-Maxus Group Limited, a Cleveland-based institutional equity research firm. This transaction was completed for approximately $13.7 million on January 2, 2001.
13 NOTE 3 - EARNINGS PER SHARE The following table shows a reconciliation of earnings per share to diluted earnings per share. <TABLE> <CAPTION> Three Months Ended Six Months Ended June 30 June 30 ----------------------------- ------------------------------ (Dollars in thousands, except per share data) 2001 2000 2001 2000 - ------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> Income before debt restructurings and cumulative effect of changes in accounting principles $ 89,014 $ 55,423 $ 151,386 $ 94,946 Debt restructurings and cumulative effect of changes in accounting principles (3,225) -- (11,393) -- - ------------------------------------------------------------------------------------------------------------------------ Net income $ 85,789 $ 55,423 $ 139,993 $ 94,946 ======================================================================================================================== Weighted average shares outstanding 127,180,282 130,091,044 127,903,890 130,003,997 Shares attributable to deferred compensation 709,675 521,058 689,648 499,243 - ------------------------------------------------------------------------------------------------------------------------ Total weighted average shares 127,889,957 130,612,102 128,593,538 130,503,240 ======================================================================================================================== EARNINGS PER COMMON SHARE: Income before debt restructurings and cumulative effect of changes in accounting principles $ .70 $ .42 $ 1.18 $ .73 Debt restructurings and cumulative effect of changes in accounting principles (.03) -- (.09) -- - ------------------------------------------------------------------------------------------------------------------------ Net income $ .67 $ .42 $ 1.09 $ .73 ======================================================================================================================== Weighted average shares outstanding 127,889,957 130,612,102 128,593,538 130,503,240 Dilutive effect due to stock options 3,978,163 1,232,741 3,794,194 1,691,628 - ------------------------------------------------------------------------------------------------------------------------ Total weighted average shares, as adjusted 131,868,120 131,844,843 132,387,732 132,194,868 ======================================================================================================================== DILUTED EARNINGS PER SHARE COMPUTATION: Income before debt restructurings and cumulative effect of changes in accounting principles $ .68 $ .42 $ 1.14 $ .72 Debt restructurings and cumulative effect of changes in accounting principles (.03) -- (.08) -- - ------------------------------------------------------------------------------------------------------------------------ Net income $ .65 $ .42 $ 1.06 $ .72 ======================================================================================================================== </TABLE>
14 NOTE 4 - LOANS The composition of the loan portfolio at June 30 is detailed below: <TABLE> <CAPTION> (Dollars in thousands) 2001 2000 - -------------------------------------------------------------------------------- <S> <C> <C> Commercial: Commercial, financial and industrial $4,064,002 $3,765,682 Real estate commercial 946,233 893,415 Real estate construction 427,737 398,914 Retail: Real estate residential 3,574,439 3,284,204 Real estate construction 182,780 151,923 Consumer 487,602 829,756 Credit card receivables 276,768 553,255 - -------------------------------------------------------------------------------- Loans, net of unearned income $9,959,561 $9,877,149 Allowance for loan losses 148,658 142,722 - -------------------------------------------------------------------------------- Total net loans $9,810,903 $9,734,427 ================================================================================ </TABLE> The following table presents information concerning nonperforming loans at June 30: <TABLE> <CAPTION> (Dollars in thousands) 2001 2000 - -------------------------------------------------------------------------------- <S> <C> <C> Impaired loans $ 54,258 $ 6,337 Other nonaccrual loans 24,676 20,225 - -------------------------------------------------------------------------------- Total nonperforming loans $ 78,934 $ 26,562 ================================================================================ </TABLE> Nonperforming loans consist of impaired loans, other nonaccrual loans and certain restructured loans. An impaired loan is a loan that management believes the contractual amount due probably will not be collected. Impaired loans are generally carried on a nonaccrual status. Nonaccrual loans are loans on which interest accruals have been discontinued due to the borrower's financial difficulties. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral is sufficient to recover the principal balance and accrued interest. Generally, interest payments received on impaired loans are applied to principal. Once all principal has been received, additional payments are recognized as interest income on a cash basis. The following table presents information concerning impaired loans: <TABLE> <CAPTION> Three Months Ended Six Months Ended June 30 June 30 ------------------- ------------------- (Dollars in thousands) 2001 2000 2001 2000 - -------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Total interest on impaired loans $ 113 $ 99 $ 192 $ 194 Average balance of impaired loans 59,809 7,686 54,268 7,612 - -------------------------------------------------------------------------------- </TABLE> An allowance for loan losses is maintained for all impaired loans. Activity in the allowance for loan losses related to non-impaired loans, impaired loans, and for the total allowance for the six months ended June 30, 2001 and 2000, is summarized as follows: <TABLE> <CAPTION> (Dollars in thousands) Non-impaired Impaired Total - ------------------------------------------------------------------------------ <S> <C> <C> <C> Balance on December 31, 1999 $ 136,978 $ 2,625 $ 139,603 Provision for loan losses 30,770 1,804 32,574 Securitization adjustment (2,173) -- (2,173) Charge-offs 28,323 3,086 31,409 Less loan recoveries 3,321 806 4,127 - ------------------------------------------------------------------------------ Net charge-offs 25,002 2,280 27,282 - ------------------------------------------------------------------------------ Balance on June 30, 2000 $ 140,573 $ 2,149 $ 142,722 ============================================================================== Balance on December 31, 2000 $ 128,339 $ 15,357 $ 143,696 Provision for loan losses 24,861 11,564 36,425 Divestiture (1,337) -- (1,337) Charge-offs 27,034 8,167 35,201 Less loan recoveries 3,717 1,358 5,075 - ------------------------------------------------------------------------------ Net charge-offs 23,317 6,809 30,126 - ------------------------------------------------------------------------------ BALANCE ON JUNE 30, 2001 $ 128,546 $ 20,112 $ 148,658 ============================================================================== </TABLE>
15 NOTE 5 - BUSINESS SEGMENT INFORMATION First Tennessee provides traditional retail/commercial banking and other financial services to its customers. These products and services are categorized into two broad groups: a regional banking group and national lines of business. The regional banking group provides a comprehensive package of financial services including traditional banking, trust services, investments, asset management, insurance, and credit card services to its customers. The national lines of business include mortgage banking, capital markets and transaction processing. The Other segment is used to isolate corporate items such as debt restructurings and the cumulative effect of changes in accounting principles SFAS No. 133 and EITF 99-20 which were adopted on January 1, 2001. The Other segment also includes expense related to guaranteed preferred beneficial interests in First Tennessee's junior subordinated debentures and securities gains or losses which include any venture capital gains or losses and related incentive costs. Total revenue, expense and asset levels reflect those which are specifically identifiable or which are allocated based on an internal allocation method. Because the allocations are based on internally developed assignments and allocations, they are to an extent subjective. This assignment and allocation has been consistently applied for all periods presented. The following table reflects the approximate amounts of consolidated revenue, expense, tax, and assets for the quarterly and year to date periods ending June 30, 2001 and 2000. <TABLE> <CAPTION> Regional Banking Mortgage Capital Transaction (Dollars in thousands) Group Banking Markets Processing Other Consolidated - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> 2Q01 Interest income $ 228,071 $ 65,219 $ 9,748 $ 4,068 $ -- $ 307,106 Interest expense 92,720 38,814 8,160 544 -- 140,238 - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income 135,351 26,405 1,588 3,524 -- 166,868 Other revenues 135,288 165,214 65,895 22,994 (3,390) 386,001 Other expenses* 166,183 172,174 46,689 28,036 2,123 415,205 - ------------------------------------------------------------------------------------------------------------------------------------ Pre-tax income 104,456 19,445 20,794 (1,518) (5,513) 137,664 Income taxes 36,418 7,039 7,865 (577) (2,095) 48,650 - ------------------------------------------------------------------------------------------------------------------------------------ Income before debt restructurings 68,038 12,406 12,929 (941) (3,418) 89,014 Debt restructurings -- -- -- -- (3,225) (3,225) - ------------------------------------------------------------------------------------------------------------------------------------ Net income $ 68,038 $ 12,406 $ 12,929 $ (941) $ (6,643) $ 85,789 ==================================================================================================================================== Average assets $12,751,454 $ 4,954,253 $923,577 $ 541,848 $ -- $ 19,171,132 - ------------------------------------------------------------------------------------------------------------------------------------ 2Q00 Interest income $ 253,779 $ 77,042 $ 9,124 $ 4,174 $ -- $ 344,119 Interest expense 118,180 64,968 8,614 501 -- 192,263 - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income 135,599 12,074 510 3,673 -- 151,856 Other revenues 64,640 137,367 19,727 29,008 84 250,826 Other expenses* 131,985 141,496 17,178 25,948 2,123 318,730 - ------------------------------------------------------------------------------------------------------------------------------------ Pre-tax income 68,254 7,945 3,059 6,733 (2,039) 83,952 Income taxes 22,715 2,927 1,104 2,558 (775) 28,529 - ------------------------------------------------------------------------------------------------------------------------------------ Net income $ 45,539 $ 5,018 $ 1,955 $ 4,175 $ (1,264) $ 55,423 ==================================================================================================================================== Average assets $12,960,731 $ 5,415,659 $637,580 $ 557,135 $ -- $ 19,571,105 - ------------------------------------------------------------------------------------------------------------------------------------ YEAR TO DATE 2001 Interest income $ 478,234 $ 121,113 $ 21,012 $ 7,900 $ -- $ 628,259 Interest expense 209,405 80,145 19,329 1,195 -- 310,074 - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income 268,829 40,968 1,683 6,705 -- 318,185 Other revenues 214,018 300,700 144,830 46,435 (3,540) 702,443 Other expenses* 319,694 312,128 100,687 51,452 4,246 788,207 - ------------------------------------------------------------------------------------------------------------------------------------ Pre-tax income 163,153 29,540 45,826 1,688 (7,786) 232,421 Income taxes 55,142 10,858 17,353 641 (2,959) 81,035 - ------------------------------------------------------------------------------------------------------------------------------------ Income before debt restructurings and cumulative effect of changes in accounting principles 108,011 18,682 28,473 1,047 (4,827) 151,386 Debt restructurings and cumulative effect of changes in accounting principles -- -- -- -- (11,393) (11,393) - ------------------------------------------------------------------------------------------------------------------------------------ Net income $ 108,011 $ 18,682 $ 28,473 $ 1,047 $(16,220) $ 139,993 ==================================================================================================================================== Average assets $12,991,747 $ 4,595,249 $933,834 $ 550,635 $ -- $ 19,071,465 - ------------------------------------------------------------------------------------------------------------------------------------ Year to Date 2000 Interest income $ 492,945 $ 144,842 $ 17,631 $ 8,000 $ -- $ 663,418 Interest expense 225,225 123,336 16,521 986 -- 366,068 - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income 267,720 21,506 1,110 7,014 -- 297,350 Other revenues 130,656 240,425 44,176 56,281 1,685 473,223 Other expenses* 265,162 270,487 37,081 50,130 4,246 627,106 - ------------------------------------------------------------------------------------------------------------------------------------ Pre-tax income 133,214 (8,556) 8,205 13,165 (2,561) 143,467 Income taxes 44,679 (3,199) 3,013 5,001 (973) 48,521 - ------------------------------------------------------------------------------------------------------------------------------------ Net income $ 88,535 $ (5,357) $ 5,192 $ 8,164 $ (1,588) $ 94,946 ==================================================================================================================================== Average assets $12,792,939 $ 5,265,614 $642,498 $ 569,608 $ -- $ 19,270,659 - ------------------------------------------------------------------------------------------------------------------------------------ <FN> * Includes loan loss provision. </FN> </TABLE>
16 NOTE 6 - TERM BORROWINGS The following table presents information pertaining to term borrowings (debt with original maturities greater than one year) for First Tennessee and its subsidiaries. This table reflects the debt restructuring that occurred during second quarter 2001 which resulted in a $5.1 million pre-tax loss ($3.2 million after-tax loss) reported as an extraordinary item on the Consolidated Statements of Income. <TABLE> <CAPTION> June 30 December 31 ------------------------------ ----------- (Dollars in thousands) 2001 2000 2000 - --------------------------------------------------------------------------------------------- ----------- <S> <C> <C> <C> FIRST TENNESSEE NATIONAL CORPORATION: Subordinated capital notes: Matures on November 15, 2005 -- 6 3/4% $ 74,642 $ 74,561 $ 74,601 FIRST TENNESSEE BANK NATIONAL ASSOCIATION: Notes payable to Federal Home Loan Bank: Matures on June 27, 2005 -- 4.14% 50,000 -- -- Matures through November 1, 2009 -- 8.10% 1,683 1,883 1,783 Matures through January 1, 2028 -- 4.00% 39 40 40 Matures through May 1, 2028 -- 4.00% 38 39 38 Matures through June 1, 2029 -- 4.00% 42 43 43 Maturity September 16, 2002 -- 5.42% -- 50,000 -- Maturity January 12, 2005 -- 6.125% -- -- 50,000 Maturity September 05, 2003 -- 6.67% -- -- 50,000 Bank notes: Payable to CS First Boston - matures May 23, 2003 -- 4.205% 69,960 -- -- Payable to the United Nations - matures April 2, 2004 -- 5.315% 50,000 -- -- Subordinated bank notes: Matures on April 1, 2008 -- 6.40% 89,525 89,454 89,490 Matures on December 1, 2008 -- 5.75% 140,502 140,350 140,426 FT REAL ESTATE SECURITIES COMPANY, INC.: Preferred stock minority interest -- 99 -- FIRST NATIONAL BANK OF SPRINGDALE: Notes payable to Federal Home Loan Bank: Matures through April 1, 2009 -- 5.885% 893 964 929 Matures through June 2, 2009 -- 5.885% 550 590 570 Matures through May 1, 2009 -- 5.698% 563 618 590 Matures through April 1, 2005 -- 7.345% 1,142 1,189 1,166 - --------------------------------------------------------------------------------------------- ----------- Total $479,579 $359,830 $409,676 ============================================================================================= =========== </TABLE>
17 NOTE 7 - CONTINGENCIES In May 1996, FTBNA was named as a defendant in a purported nationwide class action lawsuit filed in federal court in Alabama in which plaintiffs assert that FTBNA and another defendant engaged in unfair and deceptive practices in connection with the financing of satellite dish television systems (satellite systems). The complaint alleges violations of the Truth in Lending Act (TILA) and the federal RICO statute, and fraud by suppression with respect to Alabama residents. In addition to these theories, plaintiffs proceed against FTBNA on an agency theory. This case has been certified as a nationwide class action on the TILA statutory damages claim which has a cap of $500,000 plus attorney fees. In addition to the Alabama lawsuit, in September 1997, a conditionally certified multi-state class action was filed in state court in Tennessee relating to the same satellite systems financing program. The complaint asserts that material facts were withheld from the purchasers in connection with the financing and that purchasers were misled as to the true nature and conditions of the program. The complaint also alleges unjust enrichment, violations of the Tennessee Consumer Protection Act, negligent training, supervision, and monitoring of persons presenting the terms of financing, as well as civil conspiracy and fraudulent concealment of the causes of action. Plaintiffs seek an accounting of monies received by FTBNA, unspecified compensatory damages, including treble damages as well as punitive damages, injunctive relief, attorney fees, costs, and expenses. The case is presently certified as a class action and FTBNA and First Tennessee have filed a request for an interlocutory appeal on this issue. A third case originally filed in state court in Mississippi has been transferred to bankruptcy court in the Middle District of Tennessee where it is now pending. Plaintiffs allege violations of a Mississippi statute, Mississippi common law, and seek rescission and cancellation of the contracts. The complaint seeks $45 million in actual damages and $900 million in punitive damages. In 2000, two additional satellite dish cases were filed in the Choctaw Tribal Court. Plaintiffs allege false and negligent misrepresentations, fraudulent disclosure, fraud, negligent and wonton hiring, training, and supervision, and mental and emotional distress. Each complaint seeks rescission of the contract, the return of all monies paid, unquantified actual and punitive damages, attorney fees and injunctive relief. In 2001, another satellite dish case was filed by multiple plaintiffs in state court in Mississippi. The complaint alleges breach of fiduciary duty, intentional and/or reckless fraud, and fraud by suppression and/or concealment and seeks compensatory and punitive damages, interest, and attorney fees. FTBNA and First Tennessee deny liability, deny that any co-defendant is their agent, and intend to defend these actions vigorously. In 2001, the Tennessee Supreme Court affirmed the Court of Appeals judgment affirming an award of compensatory damages of $209,156 against FTBNA (as the successor by merger to Community Bank of Germantown) as well as a $60,000 award in favor of FTBNA against plaintiff, reversed the Court of Appeals' reversal of the award of punitive damages against FTBNA, vacated the trial court's award of punitive damages and remanded the case to the trial court to consider the record, take such additional evidence as necessary, and apply the factors outlined in a prior Tennessee Supreme Court opinion to arrive at an award of punitive damages. The punitive damages hearing has been set for November 5, 2001.
18 In addition to these cases, various other claims and lawsuits are pending against First Tennessee and its subsidiaries. Although First Tennessee cannot predict the outcome of the foregoing actions, after consulting with counsel, it is management's opinion that when resolved, the amount, if any, will not have a material adverse effect on the consolidated financial statements of First Tennessee and its subsidiaries. Numerous banks and other mortgage lenders, including a First Tennessee subsidiary, have been sued in actions seeking class certification in various courts by mortgage borrowers on the theory that yield spread premiums paid to mortgage brokers constitute referral fees in violation of the Real Estate Settlement Practices Act ("RESPA"). Under RESPA, the liability for an impermissible referral fee is three times the amount of the fees, and, accordingly, the amount of potential damages is substantial. The determination and the statements of the Eleventh Circuit referred to hereafter are inconsistent with holdings by other federal courts. On June 15, 2001, the Court of Appeals for the Eleventh Circuit issued an opinion against a lender unaffiliated with First Tennessee upholding class certification by the district court. Although the court's decision is procedural and does not contain a direct finding on liability, certain statements in the decision could be interpreted to suggest a liability standard which would be favorable to the plaintiff borrowers. A petition for reconsideration of the Eleventh Circuit opinion and/or for rehearing of that appeal en banc has been filed. First Tennessee believes that its subsidiary's yield spread premium payments, which are consistent with industry practice, are lawful, and intends to defend vigorously the lawsuits against it. Because, however, the suits against the First Tennessee subsidiary are in an early stage of litigation, and the law in this area is not clearly established, First Tennessee cannot at this time evaluate with any degree of precision either the likelihood of an unfavorable outcome or the dollar amount of any potential loss exposure.
19 ITEM 2. FIRST TENNESSEE NATIONAL CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION GENERAL INFORMATION - ------------------- First Tennessee National Corporation (First Tennessee) is headquartered in Memphis, Tennessee, and is a nationwide, diversified financial services institution which provides banking and other financial services to its customers through various regional and national business lines. The Regional Banking Group includes the retail/commercial bank, the credit card division, and the trust division. The National Lines of Business include First Horizon Home Loan Corporation (also referred to as First Horizon Home Loans and mortgage banking), First Tennessee Capital Markets (also referred to as capital markets), and transaction processing (credit card merchant processing, payment processing operation, and check clearing). Based on management's best estimates, certain revenue and expenses are allocated and equity is assigned to the various business lines to reflect the inherent risk in each business line. These allocations are periodically reviewed and may be revised from time to time to more accurately reflect current business conditions and risks; the previous history is restated to ensure comparability. For the purpose of this management discussion and analysis (MD&A), noninterest income (also called fee income) and total revenue exclude securities gains and losses. Net interest income has been adjusted to a fully taxable equivalent (FTE) basis for certain tax-exempt loans and investments included in earning assets. Earning assets, including loans, have been expressed as averages, net of unearned income. First Tennessee Bank National Association, the primary bank subsidiary, is also referred to as FTBNA in this discussion. The following is a discussion and analysis of the financial condition and results of operations of First Tennessee for the three-month and six-month periods ended June 30, 2001, compared to the three-month and six-month periods ended June 30, 2000. To assist the reader in obtaining a better understanding of First Tennessee and its performance, this discussion should be read in conjunction with First Tennessee's unaudited consolidated financial statements and accompanying notes appearing in this report. Additional information including the 2000 financial statements, notes, and management's discussion and analysis is provided in the 2000 Annual Financial Disclosures and 2001 Proxy Statement. FORWARD-LOOKING STATEMENTS - -------------------------- Management's discussion and analysis may contain forward-looking statements with respect to First Tennessee's beliefs, plans, goals, expectations, and estimates. These statements are contained in certain sections that follow such as Noninterest Income, Net Interest Income and Other. Forward-looking statements are statements that are not based on historical information but rather are related to future operations, strategies, financial results or other developments. The words "believe", "expect", "anticipate", "intend", "estimate", "should", "is likely", "going forward", and other expressions which indicate future events and trends identify forward-looking statements. Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond a company's control, and many of which, with respect to future business decisions and actions (such as acquisitions and divestitures), are subject to change. Examples of uncertainties and contingencies include, among other important factors, general and local economic and business conditions; expectations of and actual timing and amount of interest rate movements (which can have a significant impact on a financial services institution); market and monetary fluctuations; inflation; competition within and outside the financial services industry; technology; and new products and services in the industries in which First Tennessee operates. Other factors are those inherent in originating and servicing loans, including prepayment risks and fluctuation of collateral values and changes in customer profiles. Additionally, the policies of the Office of the Comptroller of the Currency (OCC) and the Board of Governors of the Federal Reserve System,
20 unanticipated regulatory and judicial proceedings, and changes in laws and regulations applicable to First Tennessee and First Tennessee's success in executing its business plans and strategies and managing the risks involved in the foregoing, could cause actual results to differ. First Tennessee assumes no obligation to update any forward-looking statements that are made from time to time. FINANCIAL SUMMARY (COMPARISON OF SECOND QUARTER 2001 TO SECOND QUARTER 2000) Earnings for second quarter 2001 were $89.0 million before the effect of debt restructurings, or $.68 per diluted common share. After the effect of debt restructurings, earnings were $85.8 million for second quarter 2001, an increase of 55 percent from last year's second quarter earnings of $55.4 million. Diluted earnings per common share after debt restructurings were $.65 in 2001, an increase of 55 percent from the $.42 earned in 2000. Before the effect of debt restructurings, earnings per common share were $.70 for second quarter 2001. Earnings per common share after debt restructurings were $.67, an increase of 60 percent from $.42 for second quarter 2000. Return on average shareholders' equity was 25.1 percent and return on average assets was 1.79 percent for second quarter 2001. For the same period in 2000, return on average shareholders' equity was 17.4 percent and return on average assets was 1.14 percent. The growth in earnings was influenced by nonoperating gains, primarily from divestitures, which totaled $70.2 million (pre-tax) in second quarter 2001. Certain nonoperating expenses and losses, such as costs related to efficiency and revenue enhancement programs and divestitures, which totaled $38.3 million in second quarter 2001, reduced the impact of these gains. On June 30, 2001, First Tennessee was ranked as one of the top 50 bank holding companies nationally in market capitalization ($4.4 billion) and total assets ($18.8 billion). On June 30, 2000, market capitalization was $2.2 billion and total assets were $19.8 billion. Total revenue increased 38 percent from second quarter 2000, with a 55 percent increase in fee income (noninterest income excluding securities gains and losses) and a 10 percent increase in net interest income. NONINTEREST INCOME - ------------------ Fee income provides the majority of First Tennessee's revenue. In second quarter 2001, fee income contributed 70 percent to total revenues compared with 62 percent for the same period in 2000. Second quarter 2001 fee income increased 55 percent to $389.4 million, from $250.7 million for 2000. Fee income in capital markets and mortgage banking increased 246 percent and 72 percent, respectively, over the levels achieved in second quarter 2000. A more detailed discussion follows. MORTGAGE BANKING First Horizon Home Loans, a subsidiary of FTBNA, originates and services residential mortgage loans. Following origination, the mortgage loans, primarily first-lien, are sold to investors in the secondary market while a majority (approximately 55 percent in second quarter 2001) of the rights to service such loans are sold under flow servicing sales agreements (in prior years a majority of the rights were retained). Various hedging strategies are used to mitigate changes in the market value of the loan during the time period beginning with a price commitment to the customer and ending when the loan is delivered to the investor. Closed loans held during this time period are referred to as the mortgage warehouse. Origination fees and gains or losses from the sale of loans are recognized at the time a mortgage loan is sold into the secondary market. Subsequent to the 2001 adoption of new accounting standards related to derivatives (Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133) and EITF 99-20), a portion of the gain or loss formerly recognized with the sale of a mortgage loan is now recognized at the time an interest rate lock commitment is made (see also Other - Further Interpretations of SFAS No. 133). Secondary marketing activities include gains or losses from mortgage warehouse hedging activities, product pricing decisions, and gains or losses from the sale of loans into the secondary market including the capitalized net present value of mortgage servicing rights. Servicing rights permit the collection of fees for gathering and processing monthly mortgage payments for the owner of the
21 mortgage loans. First Horizon Home Loans employs hedging strategies intended to counter a change in the value of its mortgage servicing rights through changing interest rate environments. Miscellaneous income includes servicing rights net value changes (see also Other - Accounting for Derivative Instruments and Hedging Activities), income from the foreclosure repurchase program and other miscellaneous items including net gains or losses related to rebalancing hedges of mortgage servicing rights in 2000. Mortgage banking fee income increased 72 percent to $160.0 million from $93.3 million for second quarter 2000 as shown in Table 1. TABLE 1 - MORTGAGE BANKING <TABLE> <CAPTION> Second Quarter Six Months ------------------------- Growth ------------------------ Growth (Dollars in millions) 2001 2000 Rate (%) 2001 2000 Rate (%) - ------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> NONINTEREST INCOME: Loan origination fees $ 53.2 $ 34.8 53.2 $ 87.2 $ 60.5 44.3 Secondary marketing activities 66.8 28.7 132.5 122.4 45.3 170.2 - ------------------------------------------------------------------------------------------------------------------------------- Mortgage origination function 120.0 63.5 89.0 209.6 105.8 98.2 - ------------------------------------------------------------------------------------------------------------------------------- Servicing fees 38.1 38.6 (1.2) 79.0 77.8 1.6 Gains/(losses) from trading securities (4.8) -- N/A (7.1) -- N/A Bulk sales of mortgage servicing rights -- (.2) N/A -- 13.7 N/A Miscellaneous 6.7 (8.6) 176.7 10.2 (4.1) 344.9 - ------------------------------------------------------------------------------------------------------------------------------- Total noninterest income $ 160.0 $ 93.3 71.6 $ 291.7 $ 193.2 51.1 =============================================================================================================================== Refinance originations $ 3,812.9 $ 656.5 480.8 $ 6,823.7 $ 1,312.9 419.8 Home purchase-related originations 2,884.9 3,630.1 (20.5) 5,100.8 6,482.1 (21.3) - ------------------------------------------------------------------------------------------------------------------------------- Mortgage loan originations $ 6,697.8 $ 4,286.6 56.3 $11,924.5 $ 7,795.0 53.0 =============================================================================================================================== Servicing portfolio $44,967.1 $45,774.3 (1.8) $44,967.1 $45,774.3 (1.8) - ------------------------------------------------------------------------------------------------------------------------------- </TABLE> Origination activity increased 56 percent due to the impact that lower interest rates had on refinance activity, which increased $3.2 billion. Total origination volume, consisting of home purchase-related mortgages and refinances, was $6.7 billion in second quarter 2001 compared with $4.3 billion in the previous year. Home purchase-related mortgage originations decreased $.7 billion due to the closing of less profitable production offices and the divestiture of HomeBanc in 2000. Fees from the mortgage origination process (loan origination fees, profits from the sale of loans, flow sales of mortgage servicing rights, and other secondary marketing activities) increased 89 percent to $120.0 million from $63.5 in second quarter 2000. This increase was primarily the result of more loans sold into the secondary market due to increased production, a return to more normal margins, and improvement in the results in hedging and other loan sale activities as well as the recognition this year of the value of interest rate lock commitments. Going forward, the percentage of originations from refinanced mortgages is expected to decline as a result of the recent stabilization of mortgage interest rates. Home purchase-related mortgage originations should be reflective of the relative strength of the economy. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion. The mortgage servicing portfolio (which includes servicing for ourselves and others) totaled $45.0 billion on June 30, 2001, compared to $45.8 billion on June 30, 2000. Mortgage servicing fees for second quarter 2001 were $38.1 million compared with $38.6 million for the same period in 2000. In second quarter 2001, there were no bulk purchases or sales of mortgage servicing rights. For second quarter 2001 a net loss of $4.8 million related to market value adjustments on interest only strips that were classified as trading securities in first quarter 2001 was recognized in mortgage banking income. Miscellaneous mortgage income totaled $6.7 million for second quarter 2001 compared to a net loss of $8.6 million in 2000, which included $13.9 million of losses on hedge instruments associated with the mortgage servicing rights portfolio.
22 CAPITAL MARKETS First Tennessee Capital Markets generates fee income primarily from the purchase and sale of securities as both principal and agent. Inventory positions are limited to the procurement of securities solely for distribution to customers by the sales staff. Inventory is hedged to protect against movements in interest rates. For second quarter 2001, capital markets fee income increased 246 percent to $65.7 million from $18.9 million in 2000. Total underwritings during second quarter 2001 were $14.5 billion compared to $4.1 billion for the same period in 2000. Total securities bought and sold were $359.1 billion for second quarter 2001, up from $188.2 billion in the same period in 2000. This increased activity reflects continued growth and penetration into our targeted institutional customer base. Additionally, fee income was favorably impacted during second quarter 2001 by revenues from new products and services that capital markets began offering in the middle of 2000 ($4.5 million) and the acquisition of Midwest Research, an equity research and sales division, in first quarter 2001 ($5.7 million). Going forward, market conditions are likely to stabilize, but new products and services will continue to impact revenues favorably. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A. OTHER FEE INCOME For second quarter 2001, gains from divestitures were $70.1 million due to gains from the sale of a portfolio of student loans ($12 million), the sale of Peoples and Union Bank ($13 million) and the sale of First Tennessee's partnership interest in Check Solutions Company ($45 million). There were divestiture gains of $40.9 million in second quarter 2000 from the sale of the HomeBanc Mortgage division. Fee income from deposit transactions and cash management for second quarter 2001 increased 7 percent to $31.6 million from $29.7 million in 2000. Trust services and investment management fees decreased 10 percent to $14.4 million from $16.1 million in 2000, primarily due to the divestiture of corporate and municipal trust in fourth quarter 2000 and a decline in market values of managed portfolios which fell 6 percent to $9.2 billion on June 30, 2001, from $9.8 billion on June 30, 2000. Second quarter 2001 fee income from merchant processing decreased 8 percent to $11.4 million from $12.3 million in 2000 primarily due to a slowdown in the hospitality industry. Cardholder fees decreased 24 percent to $5.3 million from $7.0 million in second quarter 2000 primarily due to the sales of the credit card accounts in fourth quarter 2000 and first quarter 2001. All other income and commissions decreased 5 percent to $30.8 million from $32.5 million in second quarter 2000 primarily due to the sale of MONEY BELT in fourth quarter 2000. SECURITY GAINS/LOSSES - --------------------- Second quarter 2001 net security losses of $3.4 million were primarily related to First Tennessee's venture capital subsidiaries. For the second quarter 2000 net security gains were $.1 million. NET INTEREST INCOME - ------------------- Net interest income increased 10 percent to $167.5 million from $152.5 million in second quarter 2000, primarily due to lower funding costs. Earning assets remained relatively flat with an average of $16.2 billion in second quarter 2001 compared to $16.3 billion for the same period in 2000. The consolidated net interest margin (margin) increased to 4.15 percent for second quarter 2001 compared with 3.74 percent in 2000. The margin was positively impacted by improvement in the negative impact from mortgage banking due to a steeper yield curve. For second quarter 2001, the regional banking group's margin increased to 4.94 percent from 4.91 percent primarily due to the lower funding costs. Table 2 details the computation of the net interest margin for the regional banking group and the impact that the other business lines had on the consolidated margin for the second quarters of 2001 and 2000.
23 TABLE 2 - NET INTEREST MARGIN <TABLE> <CAPTION> Second Quarter --------------------------------- 2001 2000 - -------------------------------------------------------------------------------- <S> <C> <C> REGIONAL BANKING GROUP: Yields on earning assets 7.70% 8.46% Rates paid on interest-bearing liabilities 3.80 4.60 - -------------------------------------------------------------------------------- Net interest spread 3.90 3.86 - -------------------------------------------------------------------------------- Effect of interest-free sources .88 .88 Loan fees .16 .17 FRB interest and penalties -- -- - -------------------------------------------------------------------------------- Net interest margin - Regional banking group 4.94% 4.91% MORTGAGE BANKING (.61) (1.03) CAPITAL MARKETS (.18) (.15) TRANSACTION PROCESSING -- .01 - -------------------------------------------------------------------------------- Net interest margin 4.15% 3.74% ================================================================================ </TABLE> As shown in Table 2, the margin is affected by the activity levels and related funding for First Tennessee's national lines of business as these nonbank business lines typically produce different margins than traditional banking activities. Mortgage banking can affect the overall margin based on a number of factors, including the size of the mortgage warehouse, the time it takes to deliver loans into the secondary market, the amount of custodial balances, and the level of mortgage servicing rights. Capital markets tends to compress the margin because of its strategy to reduce market risk by hedging its inventory in the cash markets which effectively eliminates net interest income on these positions. As a result, First Tennessee's consolidated margin cannot be readily compared to that of other bank holding companies. Going forward, if short-term rates remain at current levels or continue to decline and the slope of the yield curve does not flatten, the margin is likely to remain stable or increase. However, the consolidated margin will continue to be influenced by the activity levels in the nonbanking lines of business, especially from mortgage banking. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion. NONINTEREST EXPENSE - ------------------- Total noninterest expense for second quarter 2001 increased 32 percent to $397.8 million from $301.7 million in 2000. The type and level of activity in mortgage banking and capital markets effect changes in personnel and total noninterest expense. Excluding mortgage banking, capital markets, and the second quarter 2001 nonoperating expenses, total noninterest expense increased 6 percent. Going forward, capital markets, mortgage banking and investments in efficiency and revenue enhancement programs will influence the level of noninterest expense. Employee compensation, incentives and benefits (personnel expense), the largest component of noninterest expense, increased 30 percent from the previous year primarily due to higher activity levels in mortgage banking and capital markets in second quarter 2001. Personnel expense in second quarter 2001 included $4.2 million in nonoperating expenses related to early retirement, severance and commissions associated with marketing campaign initiatives. Excluding mortgage banking, capital markets and the second quarter 2001 nonoperating expenses, personnel expense increased 4 percent. Additional business line information related to expenses is provided in Table 3 and the discussion that follows.
24 TABLE 3 - NONINTEREST EXPENSE COMPOSITION <TABLE> <CAPTION> Second Quarter Six Months -------------------- Growth ------------------- Growth (Dollars in millions) 2001 2000 Rate(%) 2001 2000 Rate(%) - -------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Mortgage banking $ 170.6 $ 141.5 20.6 $ 309.3 $ 270.5 14.3 Regional banking group 150.3 114.9 30.8 286.1 232.6 23.0 Capital markets 46.7 17.2 171.8 100.7 37.1 171.5 Transaction processing 28.1 26.0 8.0 51.5 50.2 2.6 Other 2.1 2.1 -- 4.2 4.2 -- - -------------------------------------------------------------------------------------------------------- Total operating expense $ 397.8 $ 301.7 31.9 $ 751.8 $ 594.6 26.4 ======================================================================================================== </TABLE> Mortgage banking expenses increased 21 percent from the previous year. Expense growth for this business line varies with the volume and type of activity. The increase was primarily due to a $25.5 million write-down of the book value of mortgage servicing rights due primarily to the increase in actual mortgage prepayments over the projected level as a result of the decrease in mortgage interest rates since third quarter 2000. Also impacting this growth rate was higher amortization in mortgage servicing rights which increased 49 percent to $26.8 million in second quarter 2001 from $18.0 million in 2000 primarily due to faster projected prepayment speeds associated with lower mortgage interest rates. The increase was also impacted by growth in personnel expense, due to the higher activity levels in second quarter 2001. Partially offsetting these increases was a decrease of $11.3 million in the amount of hedge expense reflected in noninterest expense due to the repositioning of the mortgage servicing hedge portfolio in 2000 and the adoption of SFAS No. 133 in 2001. Expenses for the regional banking group increased 31 percent from second quarter 2000. This growth was impacted by $25.9 million in nonoperating expenses related in part to the previously mentioned personnel costs as well as expenses associated with asset write-offs, lease abandonment, branch closures, major marketing campaigns to attract new retail customers, litigation losses and consulting fees. Excluding the nonoperating expenses in second quarter 2001, regional banking expense growth would have been 8 percent. Capital markets expenses grew 172 percent from second quarter 2000 primarily due to higher commissions and incentives recognized in second quarter 2001 which caused total personnel expense for this segment to increase 214 percent, or $26.0 million from 2000. Transaction processing expenses for second quarter 2001 increased 8 percent from the previous year. The increase in expense for this segment was due to $2.3 million of nonoperating expenses related to asset write-offs. PROVISION FOR LOAN LOSSES / ASSET QUALITY - ----------------------------------------- The provision for loan losses increased slightly for second quarter 2001 to $17.4 million from $17.1 million for second quarter 2000 even after the sale of the single relationship credit card portfolio in fourth quarter 2000 and first quarter 2001. The provision for loan losses is the charge to operating earnings that management determines to be necessary to maintain the allowance for loan losses at an adequate level reflecting management's estimate of the risk of loss inherent in the loan portfolio. Additional asset quality information is provided in Table 4 - Asset Quality Information and Table 5 - Charge-off Ratios.
25 TABLE 4 - ASSET QUALITY INFORMATION <TABLE> <CAPTION> June 30 ---------------------------- (Dollars in thousands) 2001 2000 - ------------------------------------------------------------------------------- <S> <C> <C> Nonperforming loans $ 52,668 $ 5,973 Foreclosed real estate 5,029 4,108 Other assets 155 90 - ------------------------------------------------------------------------------- Total Regional Banking Group 57,852 10,171 - ------------------------------------------------------------------------------- Nonperforming loans 26,266 20,589 Foreclosed real estate 10,496 13,769 - ------------------------------------------------------------------------------- Total Mortgage Banking 36,762 34,358 - ------------------------------------------------------------------------------- Total nonperforming assets $ 94,614 $ 44,529 =============================================================================== Loans and leases 30 to 89 days past due $ 83,085 $ 94,004 Loans and leases 90 days past due $ 33,814 $ 38,013 Potential problem assets* $ 111,302 $ 83,872 Second Quarter ---------------------------- 2001 2000 ---------------------------- <S> <C> <C> ALLOWANCE FOR LOAN LOSSES: Beginning balance at March 31 $ 146,949 $ 140,736 Provision for loan losses 17,436 17,077 Securitization adjustments -- (2,173) Divestiture (1,337) -- Charge-offs (16,974) (14,922) Loan recoveries 2,584 2,004 - ------------------------------------------------------------------------------- Ending balance at June 30 $ 148,658 $ 142,722 =============================================================================== June 30 --------------------- 2001 2000 --------------------- <S> <C> <C> Allowance to total loans 1.49% 1.44% Allowance to nonperforming assets 157 321 Nonperforming assets to total loans, foreclosed real estate and other assets (Regional Banking Group only) .63 .11 Nonperforming assets to unpaid principal balance of servicing portfolio (Mortgage Banking only) .08 .08 - ------------------------------------------------------------------------------- <FN> * Includes loans and leases 90 days past due. </FN> </TABLE> An analytical model based on historical loss experience, current trends, and reasonably foreseeable events is used to determine the amount of provision to be recognized and to test the adequacy of the loan loss allowance. The ratio of allowance for loan losses to total loans, net of unearned income, was 1.49 percent on June 30, 2001, and was 1.44 percent on June 30, 2000. The ratio of net charge-offs to average loans increased to .58 percent for second quarter 2001 from .52 percent for second quarter 2000. The credit card receivables charge-off ratio increased to 4.40 percent for second quarter 2001 from 4.05 percent for second quarter 2000, but was down from a high of 4.66 percent for fourth quarter 2000. Net charge-offs on credit card receivables remain elevated after the sale of a significant portion of the credit card portfolio due to delinquencies that were retained. As these delinquent credits are eliminated, they will cease to have a negative impact on the credit card charge-off ratio.
26 TABLE 5 - CHARGE-OFF RATIOS <TABLE> <CAPTION> Second Quarter ------------------------------- 2001 2000 - -------------------------------------------------------------------------------- <S> <C> <C> Commercial .32% .08% Consumer real estate .39 .31 Other consumer 2.66 1.48 Credit card receivables 4.40 4.05 Total net charge-offs .58 .52 - -------------------------------------------------------------------------------- </TABLE> As nonperforming loans grew to $78.9 million on June 30, 2001, the ratio of nonperforming loans to total loans increased to .79 percent. This compares to nonperforming loans of $26.6 million on June 30, 2000, and a nonperforming loans ratio of .27 percent. The growth in nonperforming loans occurred primarily in the regional banking group ($46.7 million) principally due to three large Tennessee domiciled commercial customers and related parties with total balances of approximately $36 million that were classified as nonperforming loans since the third quarter of 2000. The growth in mortgage banking nonperforming loans ($5.6 million) was primarily due to the classification as nonperforming of approximately $3.5 million in construction loans to two developers of single family residential properties. Nonperforming assets totaled $94.6 million on June 30, 2001, compared with $44.5 million on June 30, 2000. On June 30, 2001, First Tennessee had no concentrations of 10 percent or more of total loans in any single industry. Going forward, asset quality ratios will be affected by balance sheet strategies and shifts in loan mix to and from products with higher risk/return profiles. Asset quality indicators should be reflective of the relative strength of the economy. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion. DEBT RESTRUCTURINGS - ------------------- In second quarter 2001, there was a $5.1 million pre-tax ($3.2 million after-tax) loss related to debt restructurings. For financial statement presentation purposes this nonoperating loss is treated as an extraordinary item and therefore, net income and earnings per share are indicated before and after the after-tax loss (see also Note 6 - Term Borrowings). BALANCE SHEET REVIEW EARNING ASSETS - -------------- Earning assets primarily consist of loans, loans held for sale and investment securities. For second quarter 2001, earning assets averaged $16.2 billion compared with $16.3 billion for second quarter 2000. On June 30, 2001, First Tennessee reported total assets of $18.8 billion compared with $19.8 billion on June 30, 2000. Average total assets decreased 2 percent to $19.2 billion from $19.6 billion in second quarter 2000. LOANS Average loans increased 1 percent for second quarter 2001 to $10.0 billion from $9.9 billion in 2000 with growth in commercial loans, which increased 9 percent, and a decrease in retail loans of 7 percent after the sale of Peoples and Union Bank, certain credit card accounts and student loans previously mentioned. Additional loan information is provided in Table 6.
27 TABLE 6 - AVERAGE LOANS <TABLE> <CAPTION> Three Months Ending June 30 ------------------------------------------------------ PERCENT GROWTH Percent (Dollars in thousands) 2001 OF TOTAL RATE 2000 of Total - -------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Commercial: Commercial, financial and industrial $4,090.4 41% 9.1% $3,750.5 38% Real estate commercial 955.8 9 9.7 871.4 9 Real estate construction 423.6 4 6.6 397.4 4 Retail: Real estate residential 3,572.1 36 13.3 3,153.1 32 Real estate construction 181.8 2 25.6 144.7 1 Other consumer 493.9 5 (50.9) 1,005.0 10 Credit card receivables 275.8 3 (50.1) 552.3 6 - ------------------------------------------------------------------------------------------------------------- Total loans, net of unearned $9,993.4 100% 1.2% $9,874.4 100% ============================================================================================================= </TABLE> During years prior to 2001 certain retail loans have been securitized. The majority of these securities are owned by subsidiaries of First Tennessee, including FTBNA, and are classified as investment securities. In addition, since second quarter 2000, First Tennessee has sold almost $300 million of its credit card receivables, approximately $340 million of student loans, and Peoples and Union Bank with total loans of approximately $110 million. If the impact of these transactions had been excluded from the growth rate calculation, retail loans would have increased approximately 6 percent and total loans would have increased approximately 7 percent since second quarter 2000. LOANS HELD FOR SALE / INVESTMENT SECURITIES Loans held for sale, consisting primarily of mortgage loans, decreased 10 percent to $2.6 billion from $2.9 billion due to the earlier delivery of loans out of the warehouse in 2001. Average investment securities decreased 6 percent in second quarter 2001 to $2.6 billion from $2.8 billion primarily due to certain securities available for sale being transferred to trading securities and declining balances of retained securitization interests, which are paying down without being replenished. DEPOSITS AND OTHER SOURCES OF FUNDS - ----------------------------------- Since the second quarter of 2000, average core deposits increased 4 percent to $9.4 billion from $9.0 billion. While interest-bearing core deposits remained relatively flat at $6.0 billion compared with $6.1 billion in 2000, noninterest-bearing deposits increased 15 percent to $3.4 billion from $2.9 billion due to expanded usage of a cash management investment product and growth in mortgage escrow accounts. Short-term purchased funds decreased 15 percent to $6.9 billion from $8.1 billion for the previous year. CAPITAL - ------- Total capital (shareholders' equity plus qualifying capital securities and subsidiary preferred stock) on June 30, 2001, was $1.5 billion, up 9 percent from $1.4 billion on June 30, 2000. Shareholders' equity (excluding the qualifying capital securities and subsidiary preferred stock) was $1.4 billion on June 30, 2001, an increase of 6 percent from $1.3 billion on June 30, 2000. The increase in total capital was primarily due to the retention of net income after dividends. The change in capital was reduced by share repurchases, primarily related to stock option exercises, which totaled $214.4 million, or 7.4 million shares, since June 30, 2000. Average shareholders' equity increased 7 percent since second quarter 2000 to $1.4 billion from $1.3 billion, reflecting internal capital generation. The average total equity to average assets ratio was 7.91 percent and the average shareholders' equity to average assets ratio was 7.16 percent for second quarter 2001. This compares with 7.06 percent and 6.55 percent, respectively, for second
28 quarter 2000. Unrealized market valuations had no material effect on the ratios during second quarter 2001. On June 30, 2001, the corporation's Tier 1 capital ratio was 8.69 percent, the total capital ratio was 11.96 percent and the leverage ratio was 6.86 percent. On June 30, 2001, First Tennessee's bank affiliates had sufficient capital to qualify as well-capitalized institutions. FINANCIAL SUMMARY (COMPARISON OF FIRST SIX MONTHS OF 2001 TO FIRST SIX MONTHS OF 2000) Earnings for 2001 were $151.4 million before debt restructurings and the cumulative effect of changes in accounting principles related to derivatives (SFAS No. 133 and EITF 99-00). Diluted earnings per common share before the cumulative effect of changes in accounting principles were $1.14 in 2001. Earnings for 2001 after debt restructurings and the cumulative effect of changes in accounting principles were $140.0 million or $1.06 diluted earnings per common share. Earnings in 2000 were $94.9 million or $.72 diluted earnings per common share. For the first six months of 2001, return on average shareholders' equity was 20.5 percent and return on average assets was 1.48 percent, while in 2000 these ratios were 15.2 percent and .99 percent, respectively. Total revenue increased 33 percent, with a 50 percent increase in fee income and a 7 percent increase in net interest income. Fee income contributed 69 percent to total revenue in 2001 compared with 61 percent in 2000. INCOME STATEMENT REVIEW - ----------------------- Noninterest income, excluding securities gains and losses, increased 50 percent for the first six months of 2001 to $705.9 million from $471.5 million for the same period last year. Mortgage banking fee income increased 51 percent to $291.7 million from $193.2 million. See Table 1 - Mortgage Banking for a breakout of noninterest income as well as mortgage banking origination volume and servicing portfolio levels. Fee income from capital markets increased 234 percent to $144.5 million from $43.3 million for 2000. For the first six months of 2001, fee income in deposit transactions and cash management grew 6 percent to $59.4 million from $56.1 million. Trust services and investment service fees decreased 8 percent to $29.6 million from $32.1 million and merchant processing fees decreased 2 percent to $23.0 million from $23.3 million. Cardholder fees decreased 31 percent to $9.6 million from $14.0 million. All other income and commissions decreased 3 percent to $66.6 million from $68.6 million. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed. Net interest income increased 7 percent to $319.3 million from $298.7 million for the first six months of 2000 while earning assets remained relatively flat at $16.0 billion. Year-to-date consolidated margin increased to 3.99 percent in 2001 from 3.74 percent in 2000. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed. In the regional banking group the year-to-date margin decreased to 4.82 percent from 4.92 percent primarily due to the sale of high-yielding credit card loans since second quarter 2000. Noninterest expense for the first six months of 2001 increased 26 percent to $751.8 million from $594.6 million. See Table 3 - Noninterest Expense Compensation for a breakdown of total expenses by business line. Mortgage banking expenses increased 14 percent to $309.3 million from $270.5 million. During this period, amortization of capitalized mortgage servicing rights increased 46 percent to $53.2 million from $36.4 million. Also included in this growth is the $42.6 million write-down in 2001 of the book value of mortgage servicing rights primarily due to the increase in actual mortgage prepayments over the projected level as a result of the decrease in mortgage interest rates since third quarter 2000. Capital markets expenses increased 172 percent over this same period to $100.7 million from $37.1 million. Expense growth for mortgage banking and capital markets varies with the volume and type of activity. Expenses in the regional banking group grew 23 percent from the previous year to $286.1 million from $232.6 million due primarily to the nonoperating expenses associated with asset write-offs, lease abandonment, branch closures, major marketing campaigns to attract new retail customers, litigation losses, consulting fees, and personnel costs related to early retirement and severance. Transaction processing expenses increased 3 percent for the six-month period due to nonoperating expenses associated with asset write-offs. The provision for loan losses increased 12 percent to $36.4 million from $32.6 million for the previous year. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed.
29 CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - ----------------------------------------------------- SFAS No. 133 and EITF 99-20 were adopted on January 1, 2001. At that date all freestanding derivative instruments were measured at fair value with differences between the previous book value and fair value reported as a one-time accounting adjustment. Likewise, offsetting gains and losses on hedged assets, liabilities and firm commitments were recognized as adjustments of their respective book values at the adoption date as part of this accounting adjustment, except to the extent that they related to hedges of the variable cash flow exposure of a forecasted transaction. To the extent the adoption adjustment related to hedges of the variable cash flow exposure of a forecasted transaction, the accounting adjustment, a $1.4 million after-tax gain, was reported as a cumulative effect adjustment of comprehensive income. Additionally, the new rules regarding the recognition of impairment and income of interest-only strips were adopted. The net one-time accounting adjustments reported on the income statement as the cumulative effect of changes in accounting principles were an $8.2 million after-tax loss. BALANCE SHEET REVIEW - -------------------- For the first six months of 2001, total assets averaged $19.1 billion compared with $19.3 billion in 2000. Average loans grew 5 percent to $10.2 billion from $9.7 billion for the first six months of 2000. Average commercial loans increased 11 percent to $5.5 billion from $4.9 billion. Retail loans remained relatively flat with an average of $4.7 billion in 2001 compared with $4.8 billion in 2000. Average investment securities decreased 10 percent to $2.7 billion from $2.9 billion for 2000. Loans held for sale, consisting primarily of mortgage loans, decreased 14 percent to $2.2 billion from $2.6 billion. For the first six months of 2001, average core deposits increased 3 percent to $9.2 billion from $9.0 billion. While interest-bearing core deposits decreased 2 percent to $6.0 billion from $6.1 billion, noninterest-bearing deposits increased 12 percent to $3.2 billion from $2.9 billion in 2000. Short-term purchased funds decreased 11 percent for the six-month period to $7.0 billion from $7.8 billion. OTHER ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES - ------------------------------------------------------------ SFAS No. 133, which was adopted on January 1, 2001, establishes accounting standards requiring that every derivative instrument be recorded on the balance sheet as either an asset or liability measured at its fair value. It requires that changes in the instrument's fair value be recognized currently in earnings (or other comprehensive income). If certain criteria are met, changes in the fair value of the asset or liability being hedged are also recognized currently in earnings. The initial impact of adopting SFAS No. 133 resulted in a net transition adjustment that was recognized as the cumulative effect of a change in accounting principle. Fair value is determined on the last business day of a reporting period. This point in time measurement of derivative fair values and the related hedged item fair values may be well suited to the measurement of hedge effectiveness, as well as reported earnings, when hedge time horizons are short. The same measurement however may not consistently reflect the effectiveness of longer-term hedges and, in First Tennessee's view, can distort short-term measures of reported earnings. First Tennessee uses a combination of derivative financial instruments to hedge certain components of the interest rate risk associated with its portfolio of capitalized mortgage servicing rights, which currently have an average life of approximately seven years. Over this long-term time horizon this combination of derivatives can be effective in significantly mitigating the effects of interest rate changes on the value of the servicing portfolio. However, these derivative financial instruments can and do demonstrate significant price volatility depending upon prevailing conditions in the financial markets. If a reporting period ends during a period of volatile financial market conditions, the effect of such point in time conditions on reported earnings does not reflect the underlying economics of the transactions or the true value of the hedges to First Tennessee over their estimated lives. The fact that the fair value of a particular derivative is unusually low or high on the last day of the reporting period is meaningful in evaluating performance during the period only if First Tennessee sells the derivative within the period of time before fair value changes and does not replace the hedge coverage with another derivative. First Tennessee believes the effect of such volatility on
30 short-term measures of earnings is not indicative of the expected long-term performance of this hedging practice. First Tennessee believes that difficulties in interpreting the effects of SFAS No. 133 are sufficiently great that it may be worthwhile to be able to identify and isolate these effects and to determine what net income would be excluding certain SFAS No. 133 adjustments related to mortgage banking capitalized servicing rights. Therefore, this analysis has been added as a recurring part of management's discussion of operating results. This new item, servicing rights net value changes under SFAS No. 133, represents the change in the fair value of hedged interest rate risk of capitalized mortgage servicing rights, net of changes in the fair value of derivative financial instruments designated to hedge such risks excluding the impact of cash settlements and interest accruals on derivatives with periodic cash flows and the time decay (economic amortization of cost) on option-based derivative instruments. For the first six months of 2001, a pre-tax gain of $3.6 million ($2.4 million after tax) was recognized as servicing right net value changes under SFAS No. 133. For the second quarter, a pre-tax gain of $.1 million was recognized. The impact on earnings from hedging of the mortgage servicing rights portfolio is included on the Statement of Income in noninterest income. First Tennessee believes a review of the trend, if any, of the servicing rights net value changes under SFAS No. 133 over a long period of time, preferably over an interest rate business cycle, is a more meaningful measure to determine the effectiveness of hedging strategies. For its internal evaluation of performance for each applicable period, First Tennessee subtracts SFAS No. 133 gains from reported net income and adds SFAS No. 133 losses to reported net income. The internal evaluation of long-term performance will include the long-term trend, if any, in SFAS No. 133 gains or losses. FURTHER INTERPRETATIONS OF SFAS NO. 133 - --------------------------------------- Certain provisions of SFAS No. 133 continue to undergo significant discussion and debate by the Financial Accounting Standards Board (FASB). One such potential issue involves the determination of the components of value of mortgage banking interest rate lock commitments (IRLCs), which have tentatively been determined to be a derivative instrument by FASB. Based upon First Tennessee's interpretation of the components of value of an IRLC, a portion of the gain or loss from the sale of the related mortgage loan is recognized at the time the commitment is made. Under this interpretation the value of IRLCs is limited to the market value of loan commitments sold by third-party loan brokers less estimated costs to complete. Prior to the implementation of SFAS No. 133 rules, all of the gain or loss was recognized at the time the loan was sold into the secondary market. As the FASB continues to deliberate potential changes to the new rules the potential exists for a conflict between First Tennessee's interpretation and that of the FASB, the effects of which cannot presently be anticipated. ACCOUNTING CHANGES On June 30, 2001, the FASB finalized SFAS No. 141, Business Combinations, and SFAS No. 142 Goodwill and Other Intangible Assets. Under SFAS No. 141 all business combinations initiated after June 30, 2001, must be accounted for using the purchase method. With the adoption of SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life. Rather, goodwill will be subject to an assessment for impairment using a fair-value-based test at least annually. Goodwill associated with equity-method investments is also no longer amortized, but impairment analysis is governed by existing impairment guidance for equity-method investments and not the new impairment rules. Also under the new rules, acquired intangible assets should be separately recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold or otherwise transferred, regardless of the acquirer's intent to do so. These new rules are expected to result in more intangible assets being separated from goodwill than generally occurs today. The resulting assets will be amortized over their useful lives. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001, which for First Tennessee will mean January 1, 2002. First Tennessee estimates the impact of adopting these new standards will be to reduce noninterest expense annually by approximately $7 million pre-tax without regard to any new acquisitions or future impairment that may occur, the effect of which cannot be predicted at this time.
31 Item 3. Quantitative and Qualitative Disclosures About Market Risk - ------------------------------------------------------------------------------ The information called for by this item is incorporated herein by reference to Management's Discussion and Analysis included as Item 2 of Part I of this report and to Notes 1 and 24 to the Consolidated Financial Statements and the "Risk Management-Interest Rate Risk Management" subsection of the Management's Discussion and Analysis section contained in the financial appendix to the Corporation's 2001 Proxy Statement.
32 Part II. OTHER INFORMATION Items 1, 2 and 3 - ---------------- As of the end of the second quarter, 2001, the answers to Items 1, 2 and 3 were either inapplicable or negative, and therefore, these items are omitted. Item 4 - Submission of Matters to a Vote of Security Holders. - ------------------------------------------------------------- (a) The Corporation's Annual Meeting of Shareholders was held April 17, 2001. (b) Proxies for the Annual Meeting were solicited pursuant to Regulation 14 under the Securities Exchange Act of 1934. There were no solicitations in opposition to management's nominees for election to Class II (Blattberg, Glass, Kelly and Rose). The Class II nominees were elected for a three-year term or until their respective successors are duly elected and qualified. Directors continuing in office are Messrs. Cantu, Cates, Haslam, Horn, Martin, Orgill and Sansom and Mrs. Palmer. (c) At the Annual Meeting, the shareholders also ratified the appointment of Arthur Andersen LLP as independent auditors for the year 2001. The shareholder vote was as follows: <TABLE> <CAPTION> Nominees Class II For Withheld - ------------------- ----------- ---------- <S> <C> <C> Robert C. Blattberg 108,630,501 593,006 J. Kenneth Glass 108,634,589 588,918 John C. Kelley, Jr. 108,671,831 551,676 Michael D. Rose 108,629,184 594,923 <CAPTION> For Withheld Abstained ----------- -------- --------- <S> <C> <C> <C> Ratification of Auditors 108,326,943 582,500 314,064 </TABLE> There were no "broker non-votes" with respect to any of the nominees or the ratification of auditors and no abstentions with respect to any of the nominees.
33 Item 5 - Other Information. - --------------------------- In connection with First Tennessee Bank National Association's $3 billion Bank Note Program, Chase Manhattan Trust Company, National Association, a national banking association with its principal office in Pittsburgh, Pennsylvania, is serving as the successor issuing and paying agent (in such capacity, the "Fiscal and Paying Agent") under the Fiscal and Paying Agency Agreement dated as of November 18, 1999.
34 Item 6 - Exhibits and Reports on Form 8-K. - ------------------------------------------ (a) Exhibits. Exhibit No. Description - ----------- ----------- 3(ii) Bylaws of the Corporation, as amended and restated. 4 Instruments defining the rights of security holders, including indentures.* **10(h) Directors and Executives Deferred Compensation Plan, as amended and restated. <FN> * The Corporation agrees to furnish copies of the instruments, including indentures, defining the rights of the holders of the long-term debt of the Corporation and its consolidated subsidiaries to the Securities and Exchange Commission upon request. ** This is a management contract or compensatory plan required to be filed as an exhibit. </FN> (b) Reports on Form 8-K. A report on Form 8-K was filed on May 22, 2001 (with a Date of Report of May 21, 2001) disclosing under Item 5 a development in Culbreath v. First Tennessee Bank National Association (previously described in Note 18 to the Corporation's 2000 audited financial statements).
35 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FIRST TENNESSEE NATIONAL CORPORATION ------------------------------------ (Registrant) DATE: 08/10/01 By: /s/ Elbert L. Thomas Jr. -------------------- ----------------------------------------- Elbert L. Thomas Jr. Executive Vice President and Chief Financial Controller (Duly Authorized Officer and Principal Financial Officer)
36 EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 3(ii) Bylaws of the Corporation, as amended and restated. 4 Instruments defining the rights of security holders, including indentures.* **10(h) Directors and Executives Deferred Compensation Plan, as amended and restated. <FN> * The Corporation agrees to furnish copies of the instruments, including indentures, defining the rights of the holders of the long-term debt of the Corporation and its consolidated subsidiaries to the Securities and Exchange Commission upon request. ** This is a management contract or compensatory plan required to be filed as an exhibit. </FN>