UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended June 30, 2005
or
Commission File Number: 0-16471
First Citizens BancShares, Inc
(Exact name of Registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification Number)
(919) 716-7000
(Registrant’s telephone number, including area code)
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 twelve 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 ninety days. Yes x No ¨
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act) Yes x No ¨
Class A Common Stock—$1 Par Value—8,756,778 shares
Class B Common Stock—$1 Par Value—1,677,675 shares
(Number of shares outstanding, by class, as of August 4, 2005)
INDEX
Consolidated Statements of Income for the three-and six-month periods ended June 30, 2005, and June 30, 2004
Consolidated Statements of Changes in Shareholders’ Equity for the six-month periods ended June 30, 2005, and June 30, 2004
Consolidated Statements of Cash Flows for the six-month periods ended June 30, 2005, and June 30, 2004
PART I
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets
First Citizens BancShares, Inc. and Subsidiaries
(thousands, except share data)
June 30*
2005
December 31#
2004
Assets
Cash and due from banks
Overnight investments
Investment securities held to maturity
Investment securities available for sale
Loans and leases
Less allowance for loan and lease losses
Net loans and leases
Premises and equipment
Income earned not collected
Other assets
Total assets
Liabilities
Deposits:
Noninterest-bearing
Interest-bearing
Total deposits
Short-term borrowings
Long-term obligations
Other liabilities
Total liabilities
Shareholders’ Equity
Common stock:
Class A - $1 par value (8,756,778 shares issued, respectively, for all periods)
Class B - $1 par value (1,677,675 shares issued, respectively, for all periods)
Surplus
Retained earnings
Accumulated other comprehensive income
Total shareholders’ equity
Total liabilities and shareholders’ equity
See accompanying Notes to Consolidated Financial Statements.
3
Consolidated Statements of Income
(thousands, except share and per share data; unaudited)
Interest income
Loans
Investment securities:
U. S. Government
State, county and municipal
Dividends
Total investment securities interest and dividend income
Total interest income
Interest expense
Deposits
Total interest expense
Net interest income
Provision for credit losses
Net interest income after provision for credit losses
Noninterest income
Service charges on deposit accounts
Cardholder and merchant services income
Trust income
Fees from processing services
Commission income
ATM income
Mortgage income
Other service charges and fees
Securities gains (losses)
Other
Total noninterest income
Noninterest expense
Salaries and wages
Employee benefits
Occupancy expense
Equipment expense
Total noninterest expense
Income before income taxes
Income taxes
Net income
Other comprehensive income (loss) net of taxes
Unrealized securities gains (losses) arising during period
Less: reclassified adjustment for gains (losses) included in net income
Comprehensive income
Average shares outstanding
Net income per share
4
Consolidated Statements of Changes in Shareholders’ Equity
(thousands, except share data, unaudited)
Class A
Common
Stock
Class B
Retained
Earnings
Accumulated
Comprehensive
Income
Total
Shareholders’
Equity
Balance at December 31, 2003
Redemption of 1,892 shares of Class A common stock
Cash dividends
Unrealized securities losses, net of deferred taxes
Balance at June 30, 2004
Balance at December 31, 2004
Balance at June 30, 2005
5
Consolidated Statements of Cash Flows
OPERATING ACTIVITIES
Adjustments to reconcile net income to cash provided by operating activities:
Amortization of intangibles
Deferred tax (benefit) expense
Change in current taxes payable
Depreciation
Change in accrued interest payable
Change in income earned not collected
Securities losses (gains)
Origination of loans held for sale
Proceeds from sale of loans
Gain on sale of loans
Net amortization of premiums and discounts
Net change in other assets
Net change in other liabilities
Net cash provided by operating activities
INVESTING ACTIVITIES
Net change in loans outstanding
Purchases of investment securities held to maturity
Purchases of investment securities available for sale
Proceeds from maturities of investment securities held to maturity
Proceeds from maturities of investment securities available for sale
Net change in overnight investments
Dispositions of premises and equipment
Additions to premises and equipment
Purchase of branches, net of cash transferred
Net cash used in investing activities
FINANCING ACTIVITIES
Net change in time deposits
Net change in demand and other interest-bearing deposits
Net change in short-term borrowings
Repayments of long-term obligations
Originations of long-term obligations
Repurchases of common stock
Cash dividends paid
Net cash provided by financing activities
Change in cash and due from banks
Cash and due from banks at beginning of period
Cash and due from banks at end of period
CASH PAYMENTS FOR:
Interest
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
Unrealized securities gains (losses)
6
Notes to Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
Note A
Accounting Policies
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements.
In the opinion of management, the consolidated financial statements contain all material adjustments necessary to present fairly the financial position of First Citizens BancShares, Inc. as of and for each of the periods presented, and all such adjustments are of a normal recurring nature. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates.
These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the 2004 First Citizens BancShares, Inc. Annual Report, which is incorporated by reference on Form 10-K. Certain amounts for prior periods have been reclassified to conform with statement presentations for 2005. However, the reclassifications have no effect on shareholders’ equity or net income as previously reported.
Note B
Operating Segments
BancShares conducts its banking operations through its two wholly-owned subsidiaries, First-Citizens Bank & Trust Company (FCB) and IronStone Bank (ISB). Although FCB and ISB offer similar products and services to customers, each entity operates in distinct geographic markets and each entity operates under a separate charter. Additionally, the financial results and trends of ISB reflect the de novo nature of its growth.
FCB is a mature banking institution that operates from a single state bank charter from its branch network in North Carolina, Virginia and West Virginia. FCB has announced plans to expand its branch network into Maryland and Tennessee. ISB began operations in 1997 and currently operates in Georgia, Florida, Texas, Arizona, California, New Mexico, Colorado, Oregon and Washington under a federal thrift charter.
In the aggregate, FCB and its consolidated subsidiaries, which are integral to its branch operation, and ISB account for more than 90 percent of consolidated assets, revenues and net income. Other includes activities of the parent company, Neuse, Incorporated, a subsidiary that owns real property used in the banking operation and American Guaranty Insurance Corporation, a property insurance company.
The adjustments in the accompanying tables represent the elimination of the impact of certain inter-company transactions. The adjustments to interest income and interest expense neutralize the earnings and cost of inter-company borrowings. The adjustments to noninterest income and noninterest expense reflect the elimination of management fees and other services fees paid by one company to another within BancShares’ consolidated group.
7
Income (loss) before income taxes
Net income (loss)
Gross loans
Allowance for loan and lease losses
8
Note C
Employee Benefits
BancShares recognized pension expense totaling $7,470 and $6,005, respectively, in the six-month periods ended June 30, 2005 and 2004. Pension expense is included as a component of employee benefits expense.
Components of Net Periodic Benefit Cost
Service cost
Interest cost
Expected return on plan assets
Amortization of prior service cost
Recognized net actuarial loss
Net periodic benefit cost
The expected long-term rate of return on plan assets for 2005 is 8.50 percent.
Note D
Asset Securitization and Sale
During the second quarter of 2005, BancShares completed the securitization and sale of $256,232 of its home equity lines of credit. The transaction generated a pre-tax gain of $2,874, which is included in other noninterest income. BancShares will continue to service the assets that were sold.
The securitization and sale transaction was accounted for under the provisions of Statement of Financial Accounting Standards No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (Statement 140). The transaction was completed using a Qualified Special Purpose Entity (QPSE) which, in accordance with Statement 140, is a legally isolated, bankruptcy remote entity beyond the control of the seller. The QPSE is therefore not included within the consolidated financial statements.
BancShares received cash totaling $240,399 from the sale, net of $7,816 of loans retained by the trust as overcollateralization and $8,017 for cash collections and transaction costs.
BancShares retained a residual interest in the securitized assets in the form of an interest-only strip, which is included within investment securities available for sale and is carried at its estimated fair value. Since quoted market prices are not readily available for retained residual interests, the fair value was estimated based on various factors that may have an impact on the fair value of the retained interests. The assumed discount rate was 11 percent; the assumed rate of annual credit losses was 10 basis points; the estimated weighted average loan life was 3.3 years. Based on the assumptions used, the estimated fair value of the retained residual interest was $11,586 at the date of the securitization and at June 30, 2005.
BancShares established a servicing asset of $1,401, which represents the estimated fair value of the right to service the loans that were securitized and sold. The estimated fair value was determined based on various assumptions, including a 10 percent discount rate.
9
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
INTRODUCTION
Management’s discussion and analysis of earnings and related financial data are presented to assist in understanding the financial condition and results of operations of First Citizens BancShares, Inc. and Subsidiaries (BancShares). BancShares is a financial holding company with two wholly-owned banking subsidiaries: First-Citizens Bank & Trust Company (FCB), a North Carolina-chartered bank, and IronStone Bank (ISB), a federally-chartered thrift institution. FCB operates branches in North Carolina, Virginia and West Virginia. ISB operates offices in Georgia, Florida, Texas, New Mexico, Arizona, California, Oregon, Washington and Colorado. FCB is in the process of establishing offices in Tennessee and Maryland.
This discussion and analysis should be read in conjunction with the unaudited Consolidated Financial Statements and related notes presented within this report. Intercompany accounts and transactions have been eliminated. Although certain amounts for prior years have been reclassified to conform to statement presentations for 2005, the reclassifications have no effect on shareholders’ equity or net income as previously reported.
SUMMARY
BancShares’ earnings and cash flows are derived primarily from the commercial banking activities conducted by its banking subsidiaries, which include commercial and consumer lending, deposit and cash management products, cardholder and merchant services, wealth management services as well as various other products and services typically associated with commercial banking. FCB and ISB gather interest-bearing and noninterest-bearing deposits from retail and commercial customers. BancShares and its subsidiaries also provide supplemental short-term and long-term funding through various non-deposit sources. The liquidity generated from these funding sources is primarily invested in interest-earning assets consisting of various types of loans and leases, investment securities and overnight investments. In addition, funds are invested in bank premises as well as furniture and equipment used in the subsidiaries’ commercial banking business.
Various external factors influence customer demand for our deposit and loan products. As economic conditions improved in early 2004, loan demand was strong throughout our market areas. However, in late 2004 and during the first six months of 2005, FCB’s loan growth rates weakened causing consolidated loan growth to slow. Additionally, as short-term interest rates have continued to rise in connection with actions by the Federal Reserve, variable loan rates and yields on our investment securities have repriced towards higher market rates allowing improvement in the net interest margin. The increasing level of interest rates also has affected the composition of our deposit base, as customers rotate liquidity from low cost demand deposit and money market accounts to higher cost time deposits.
The general strength of the economy and higher interest rates also influence the quality and collectibility of the loan portfolio, as consumer bankruptcy rates and debt service levels tend to reflect the general economic cycle. Utilizing various asset–liability management and asset quality tools, we strive to minimize the potentially adverse financial impact of unforeseen and unfavorable economic trends and to take advantage of favorable economic conditions where appropriate.
Financial institutions frequently focus their strategic and operating emphasis on maximizing profitability, and therefore measure their relative success by reference to profitability measures such as return on average assets or return on average shareholders’ equity. BancShares’ return on average assets and return on average equity have historically compared unfavorably to the returns of similarly sized financial holding companies. BancShares has historically placed greater emphasis upon asset quality, balance sheet liquidity and capital conservation, even when those priorities may be detrimental to current earnings.
Our organization’s strengths and the competitive position of BancShares within the financial services industry suggest that continued opportunities for significant growth and expansion exist. We operate in diverse and growing geographic markets. We believe that through superior customer service, opportunities exist to increase earnings by attracting customers of larger competitors and customers of banks that have focused on growth through merger
10
transactions. We seek opportunities to increase fee income in areas such as merchant processing, client bank services, factoring, insurance, cash management, wealth management and private banking services. In recent years, we have focused our efforts on customers who own their own businesses, medical and other professionals and individuals who are financially active.
We focus substantial attention on the risks that can endanger our profitability and growth prospects. Such risks generally include those that are internal, and thus substantially controllable by management, and those risks that are external to BancShares. External risks fall into categories of economic, industry systemic, competitive and regulatory. Due to the inability to control the outcome of external risks, management believes that the identification of appropriate strategic initiatives in response to such external risks provides reasonable safeguards to minimize their potential adverse impact.
Detailed information regarding the components of net income and other key financial data over the most recent five quarters is provided in Table 1. Tables 4 and 5 provide information on net interest income. Table 6 provides information related to asset quality.
Net income. BancShares realized a significant increase in earnings during the second quarter of 2005 compared to the second quarter of 2004. Consolidated net income during the second quarter of 2005 was $30.1 million, compared to $15.9 million earned during the corresponding period of 2004, a $14.2 million or 89.5 percent increase. The improvement in net income during 2005 resulted from higher net interest income and noninterest income combined with a reduction in the provision for credit losses. Net income per share during the second quarter of 2005 totaled $2.88, compared to $1.52 during the second quarter of 2004. The annualized returns on average assets and equity were 0.89 percent and 10.79 percent for the second quarter of 2005 respectively as compared to 0.50 percent and 6.11 percent for the corresponding period in 2004.
For the first six months of 2005, BancShares recorded net income of $55.1 million, compared to $33.2 million earned during the first six months of 2004. The $21.9 million or 65.9 percent increase was attributable to significantly higher levels of net interest income, improved noninterest income and lower provision for loan losses. Net income per share for the first six months of 2005 was $5.28, compared to $3.18 during the same period of 2004. On an annualized basis, BancShares returned 0.82 percent on average assets during the first six months of 2005 compared to 0.53 percent during the corresponding period of 2004. Annualized return on average equity for the first six months of 2005 was 10.04 percent compared to 6.42 percent during the same period of 2004.
ISB reported net losses of $676,000 and $1.9 million during the second quarter and first six months of 2005, respectively, compared to net losses of $1.6 million reported during the comparable periods of 2004. Continuing losses by ISB result from higher provision for loan losses as well as costs associated with both planned and actual new branch openings. Since its inception, ISB has generated net losses of $28.2 million. Based on the magnitude of recent and planned branch growth, ISB’s net losses will likely extend into the foreseeable future.
Shareholders’ Equity. BancShares continues to exceed minimum regulatory capital standards, and the banking subsidiaries remain well-capitalized. In recent years, the de novo growth of ISB has required the infusion of significant amounts of capital by BancShares to support its rapidly expanding balance sheet. BancShares infused $10.0 million into ISB during the first six months of 2005. Since ISB was chartered in 1997, BancShares has provided $240.0 million in capital. BancShares’ prospective capacity to provide capital to support the growth and expansion of ISB is highly dependent upon FCB’s ability to return capital through dividends to BancShares.
11
Six Months Ended
June 30
(thousands, except per share data and ratios)
Second
Quarter
First
Fourth
Third
Summary of Operations
Net interest income-taxable equivalent
Selected Quarterly Averages
Investment securities
Interest-earning assets
Interest-bearing liabilities
Shareholders’ equity
Shares outstanding
Selected Quarter-End Balances
Profitability Ratios (averages)
Rate of return (annualized) on:
Dividend payout ratio
Liquidity and Capital Ratios (averages)
Loans to deposits
Shareholders’ equity to total assets
Time certificates of $100,000 or more to total deposits
Per Share of Stock
Book value at period end
Tangible book value at period end
12
INTEREST-EARNING ASSETS
Interest-earning assets include loans and leases, investment securities and overnight investments, all of which reflect varying interest rates based on the risk level and maturity of the underlying asset. Accordingly, riskier investments typically carry a higher interest rate, but expose the investor to potentially higher levels of default. We have historically focused on maintaining high asset quality, which results in a loan portfolio subjected to strenuous underwriting and monitoring procedures. Our investment securities portfolio includes high-quality assets, primarily United States Treasury and government agency securities. Generally, the investment securities portfolio grows and shrinks based on loan and deposit trends. When deposit growth exceeds loan demand, we invest excess funds in the securities portfolio. Conversely, when loan demand exceeds deposit growth, we use proceeds from maturing securities to fund loan demand. Overnight investments are selectively made with other financial institutions that are within our risk tolerance.
Interest-earning assets for the second quarter of 2005 averaged $12.26 billion, an increase of $878.8 million or 7.7 percent from the second quarter of 2004. For the six months ended June 30, 2005, interest-earning assets averaged $12.09 billion, an increase of $835.5 million or 7.4 percent over the same period of 2004. These increases resulted primarily from growth in the loan portfolio.
Loans. At June 30, 2005 and 2004, gross loans totaled $9.30 billion and $8.99 billion, respectively. The $312.9 million growth in loans from June 30, 2004 to June 30, 2005 represents a 3.5 percent annual growth rate. During the second quarter of 2005, FCB completed the securitization and sale of $256.2 million in revolving mortgage loans. Table 2 details outstanding loans by type for the past five quarters.
During the twelve-month period from June 30, 2004 to June 30, 2005, FCB’s overall loan growth has remained modest while ISB’s commercial loans have displayed significant increases. On a consolidated basis, total loans secured by real estate grew from $6.35 billion at June 30, 2004 to $6.67 billion at June 30, 2005, an increase of $321.5 million or 5.1 percent. Commercial mortgage loans displayed strong growth, increasing from $2.95 billion at June 30, 2004 to $3.43 billion at June 30, 2005, a $482.0 million or 16.4 percent growth rate. Construction and land development real estate loans increased $105.6 million or 18.1 percent from June 30, 2004 to June 30, 2005. Revolving mortgage loans decreased $290.6 million or 17.2 percent from June 30, 2004 to June 30, 2005, primarily due to the previously discussed securitization and sale.
At $2.63 billion as of June 30, 2005, total non-real estate-secured loans declined slightly from June 30, 2004. However, demand for our lease financing products have been strong, prompting a $29.9 million or 17.0 percent increase in outstanding leases over the twelve-month period to $205.1 million as of June 30, 2005.
We continue to focus on customer development within the medical community. At June 30, 2005, 14.5 percent of our loan portfolio represented loans for office facilities, medical and dental equipment and other needs incidental to the respective area of practice. We do not believe that the focus on medical and dental lending presents an inappropriate risk to our portfolio.
Our recent growth through ISB has allowed us to mitigate our historic exposure to geographic concentration in North Carolina and Virginia. Although these markets have endured economic instability in the past, we are pleased with the diversification that we are beginning to realize by the growth of ISB. We are aware that, in the absence of rigorous centralized underwriting and monitoring controls, rapid loan growth in new markets may present incremental lending risks. During the expansion of ISB into new markets, we have endeavored to ensure that such controls are functioning effectively and will continue to place emphasis upon maintaining strong lending standards in new markets.
13
(thousands)
Real estate:
Construction and land development
Mortgage:
1-4 family residential
Commercial
Revolving
Total real estate
Commercial and industrial
Consumer
Lease financing
Total loans and leases
Investment securities. At June 30, 2005 and 2004, the investment portfolio totaled $2.64 billion and $2.04 billion, respectively. The material $606.1 million or 29.7 percent increase in the investment portfolio since June 30, 2004 resulted from additional balance sheet liquidity provided by deposit growth, proceeds from the sale of the securitized revolving mortgage loans and proceeds arising from the issuance of $125 million in subordinated debt. Table 3 presents detailed information relating to the investment securities portfolio.
Investment securities held to maturity totaled $802.2 million at June 30, 2005, compared to $935.2 million at June 30, 2004. The average maturity of the held-to-maturity portfolio has extended from 9 months at June 30, 2004 to 14 months at June 30, 2005. Securities that are classified as held-to-maturity reflect BancShares’ ability and positive intent to hold those investments until maturity.
Investment securities available for sale totaled $1.84 billion at June 30, 2005, compared to $1.10 billion at June 30, 2004. The general shift in investment securities away from the held to maturity classification toward available for sale results from our decision to increase balance sheet liquidity and flexibility. Available-for-sale securities are reported at their aggregate fair value.
Overnight investments. Overnight investments totaled $634.0 million at June 30, 2005, compared to $400.0 million at June 30, 2004. Overnight investments averaged $586.4 million during the second quarter of 2005, an increase of $180.6 million or 44.5 percent from the second quarter of 2004. For the six-month periods ended June 30, overnight investments averaged $543.1 million and $374.6 million, respectively, for 2005 and 2004. The increased levels of overnight investments resulted from liquidity management decisions.
14
Fair
Value
Average
Maturity
(Yrs./Mos.)
Taxable
EquivalentYield
Equivalent
Yield
Investment securities held to maturity:
U. S. Government:
Within one year
One to five years
Five to ten years
Ten to twenty years
Over twenty years
State, county and municipal:
Total investment securities held to maturity
Investment securities available for sale:
Equity securities
Total investment securitiesavailable for sale
Total investment securities
Average maturity assumes callable securities mature on their earliest call date; yields are based on amortized cost; yields related to securities that are exempt from federal and/or state income taxes are stated on a taxable-equivalent basis assuming statutory rates of 35% for federal income tax purposes and 6.9% for state income taxes for all periods.
15
Income on Interest-Earning Assets. Interest income amounted to $160.2 million during the second quarter of 2005, a $35.5 million or 28.5 percent increase from the second quarter of 2004. This growth was the result of both higher yields and growth in interest-earning assets. For the second quarter, the taxable-equivalent yield on average interest-earning assets increased 83 basis points from 4.42 percent in 2004 to 5.25 percent in 2005.
Loan interest income for the second quarter of 2005 was $139.4 million, an increase of $27.6 million or 24.7 percent from the second quarter of 2004, due to higher loan yields and growth in the loan portfolio. The taxable-equivalent yield on loans increased 90 basis points from 5.11 percent to 6.01 percent from the second quarter of 2004 to the second quarter of 2005 due to new loans originated at current market rates and favorable repricing of existing variable rate loans due to increases in the prime interest rate prompted by Federal Reserve actions. Loan interest income in subsequent periods will be affected by the volume reduction resulting from the securitization and sale of revolving mortgage loans.
Within the investment securities portfolio, interest income was $16.6 million during the second quarter of 2005 compared to $11.9 million during the second quarter of 2004, an increase of $4.6 million or 38.7 percent. This increase in interest income was the result of higher yields on investments securities and growth within investment securities. The short average maturity of the investment securities portfolio caused the taxable-equivalent yield to increase by 59 basis points from 2.24 percent in 2004 to 2.83 percent in 2005.
Overnight investments generated interest income of $4.2 million during the second quarter of 2005, compared to $954,000 during the same period of 2004. This significant change is the combined result of higher average investments and a 196 basis points yield increase. Overnight investments returned 2.91 percent during the second quarter of 2005 compared to 0.95 percent during the same period of 2004.
Interest income amounted to $308.5 million during the first six months of 2005, a $60.1 million or 24.2 percent increase from the same period of 2004, the result of higher yields and growth in interest-earning assets. The taxable-equivalent yield on interest-earning assets increased 70 basis points from 4.44 percent for the first six months of 2004 to 5.14 percent during the same period of 2005. Higher market interest rates during 2005 caused the favorable rate variance.
For the six months ended June 30, 2005, loan interest income was $271.7 million, an increase of $50.4 million or 22.8 percent from the same period of 2004. The improvement in interest income reflects the effect of a 71 basis point increase in loan yields as well as growth in the loan portfolio.
For the six months ended June 30, 2005, income earned on the investment securities portfolio amounted to $29.5 million, compared to $25.2 million during the same period of 2004, an increase of $4.3 million or 16.9 percent. This increase was the result of a 41 basis point increase in the taxable-equivalent yield caused by the reinvestment yield on maturing securities exceeding that of the maturing instruments.
Interest earned on overnight investments totaled $7.2 million during the first six months of 2005 compared to $1.8 million during the same period of 2004, a $5.5 million or 304.4 percent increase. This strong growth was the combined result of higher average overnight investments and a 173 basis point yield increase.
INTEREST-BEARING LIABILITIES
Interest-bearing liabilities include our interest-bearing deposits as well as short-term borrowings and long-term obligations. Deposits are our primary funding source, although we also utilize non-deposit borrowings to fulfill commercial customer requirements for cash management services and to stabilize our liquidity base. Certain of our long-term borrowings also provide capital strength under existing guidelines established by the Federal Reserve and other banking regulators.
At June 30, 2005 and 2004, interest-bearing liabilities totaled $10.16 billion and $9.27 billion, respectively. During the second quarter of 2005, interest-bearing liabilities averaged $9.87 billion, an increase of $632.4 million or 6.8 percent from the second quarter of 2004. This increase resulted from growth in interest-bearing deposits and long-term and short-term obligations.
16
Balance
Income/
Expense
Yield/
Rate
Change
Total interest-earning assets
Checking With Interest
Savings
Money market accounts
Time deposits
Total interest-bearing deposits
Federal funds purchased
Repurchase agreements
Master notes
Other short-term borrowings
Total interest-bearing liabilities
Interest rate spread
Net interest income and net yield on interest-earning assets
Average loan balances include nonaccrual loans and leases. Yields related to loans and leases and securities exempt from both federal and state income taxes, federal income taxes only, or state income taxes only are stated on a taxable-equivalent basis assuming a statutory federal income tax rate of 35% and a state income tax rate of 6.90% for each period. The taxable-equivalent adjustment was $368 and $310 for 2005 and 2004, respectively.
Deposits. At June 30, 2005, total deposits were $11.76 billion, an increase of $796.0 million or 7.3 percent over June 30, 2004. Interest-bearing deposits averaged $9.04 billion during the second quarter of 2005 compared to $8.51 billion during the second quarter of 2004, an increase of $525.0 million or 6.2 percent. In the second quarter, average time deposits increased $373.2 million or 10.0 percent from 2005 to 2004 as customers shifted liquidity out of money market and other transaction accounts into higher-yielding time deposit instruments. Average money market and Checking With Interest balances increased only 3.3 percent and 3.9 percent respectively from the second quarter of 2004 to the second quarter of 2005.
For the first six months of 2005, interest-bearing deposits averaged $8.97 billion compared to $8.50 billion during the same period of 2004. This $474.7 million or 5.6 percent increase results from continued growth in all deposit categories, especially time deposits and Checking With Interest.
17
Short-term borrowings. At June 30, 2005, short-term borrowings totaled $621.7 million compared to $437.4 million at June 30, 2004. For the quarters ended June 30, 2005 and 2004, short-term borrowings averaged $522.7 million and $436.2 million, respectively. The $86.5 million or 19.8 percent increase in short-term borrowings resulted from master note growth, as customer interest in commercial cash management products has improved due to higher interest rates on those products.
For the six-month periods ended June 30, 2005 and 2004, short-term borrowings averaged $485.0 million and $435.9 million, respectively, an increase of 11.3 percent also caused by improved master note demand.
Average loan balances include nonaccrual loans and leases. Yields related to loans and leases and securities exempt from both federal and state income taxes, federal income taxes only, or state income taxes only are stated on a taxable-equivalent basis assuming a statutory federal income tax rate of 35% and a state income tax rate of 6.90% for each period. The taxable-equivalent adjustment was $715 and $635 for 2005 and 2004, respectively.
Long-term obligations. At June 30, 2005 and 2004, long-term obligations totaled $410.0 million and $286.7 million, respectively. The increase reflects the impact of $125 million in 5.125 percent ten-year fixed rate subordinated debt issued during the second quarter of 2005.
18
Expense on Interest-Bearing Liabilities. BancShares’ interest expense amounted to $49.5 million during the second quarter of 2005, an $18.4 million or 59.2 percent increase from the second quarter of 2004. The higher interest expense was the result of increasing market interest rates. The rate on interest-bearing liabilities was 2.01 percent during the second quarter of 2005 compared to 1.36 percent during the same period of 2004.
For the year-to-date, interest expense was $92.1 million, compared to $62.3 million for the same period of 2004. The $29.8 million or 47.7 percent increase results primarily from higher interest rates and growth in average time deposits. The rate on interest-bearing liabilities increased from 1.36 percent during the first six months of 2004 to 1.90 percent for the same period of 2005, a 54 basis point difference. The rate on money market accounts increased 95 basis points to 1.62 percent while the rate on time deposits increased 49 basis points from 2.16 percent to 2.65 percent. For the first six months, average interest-bearing liabilities increased $532.6 million or 5.8 percent from $9.22 billion to $9.76 billion. Average time deposits increased $328.2 million to $4.05 billion.
NET INTEREST INCOME
Net interest income totaled $110.7 million during the second quarter of 2005, an increase of $17.1 million or 18.3 percent from the $93.5 million recorded during the second quarter of 2004. The taxable-equivalent net yield on interest-earning assets was 3.63 percent for the second quarter of 2005, an increase of 31 basis points from the 3.32 percent reported for the second quarter of 2004. The growth in net interest income resulted primarily from higher interest rates and the asset-sensitive position of our balance sheet.
Net interest income was $216.3 million and $186.0 million for the six-month periods ended June 30, 2005 and 2004, respectively. This represents an increase of $30.3 million or 16.3 percent. Year-to-date net interest income benefited from both favorable rate and volume variances. Net interest income for ISB increased $7.4 million or 34.1 percent during the first six months of 2005 due to strong loan growth and a favorable rate variance.
Our asset/liability management strategy continues to focus on maintaining high levels of balance sheet liquidity and managing our interest rate risk. We maintain portfolios of interest-earning assets and interest-bearing liabilities with maturities or repricing characteristics that will protect against wide interest rate fluctuations, thereby limiting, to the extent possible, the ultimate interest rate exposure. We do not use interest rate swaps, floors, collars or other derivative financial instruments to attempt to hedge our interest rate sensitivity and interest rate risk. Management believes that due to the current interest sensitivity position of the balance sheet, future interest rate hikes will benefit net interest income. However, the favorable impact of rising interest rates could be offset by a flattened or inverted yield curve. We also recognize that downward movements in market interest rates may have an adverse impact on net interest income.
ASSET QUALITY
The maintenance of excellent asset quality is one of our primary areas of focus. Historically, we have dedicated significant resources to ensuring we are prudent in our lending practices. Accordingly, we have focused on asset quality as a key performance measure.
Nonperforming assets. At June 30, 2005, BancShares’ total nonperforming assets, consisting of nonaccrual loans and other real estate, amounted to $18.4 million or 0.20 percent of gross loans plus foreclosed properties, compared to $23.9 million at June 30, 2004. Nonaccrual loans totaled $13.4 million at June 30, 2005, compared to $17.3 million at June 30, 2004. We closely monitor nonperforming assets, taking necessary actions to minimize potential exposure.
Allowance for loan and lease losses. We continuously analyze the growth and risk characteristics of the total loan and lease portfolio under current economic conditions in order to evaluate the adequacy of the allowance for loan and lease losses. Such factors as the financial condition of the borrower, fair market value of collateral and other considerations are recognized in estimating probable credit losses. The allowance for credit losses includes the allowance for loan and lease losses and the liability for unfunded credit commitments. At June 30, 2005, the allowance for credit losses amounted to $133.2 million or 1.43 percent of total loans and leases outstanding. This compares to $125.4 million or 1.39 percent at June 30, 2004. The allowance for loan and lease losses was $126.2 million at June 30, 2005, compared to $118.9 million one year earlier.
The provision for credit losses charged to operations during the second quarter of 2005 was $7.0 million, compared to $9.9 million during the second quarter of 2004. For the six-month periods ended June 30, total provision for credit losses was $12.3 million for 2005 and $17.8 million for 2004. The $5.4 million decrease results from reduced levels of net charge offs and more modest loan growth during 2005.
19
(thousands, except ratios)
Allowance for credit losses at beginning of period
Adjustment for sale of loans
Net charge-offs:
Charge-offs
Recoveries
Net charge-offs
Allowance for credit losses at end of period
Allowance for credit losses includes:
Liability for unfunded credit commitments
Historical Statistics
Average loans and leases
Loans and leases at period-end
Risk Elements
Nonaccrual loans and leases
Other real estate
Total nonperforming assets
Accruing loans and leases 90 days or more past due
Ratios
Net charge-offs (annualized) to average total loans and leases
Percent of total loans and leases at period-end:
Allowance for credit losses
Nonperforming assets to total loans and leases plus other real estate
Net charge-offs for the three months ended June 30, 2005 totaled $4.9 million, compared to $6.5 million during the same period of 2004, the combined result of lower charge offs and higher recoveries. On an annualized basis, net charge-offs represent 0.21 percent and 0.30 percent of average loans outstanding during the respective periods. Net charge-offs for the six-month period ended June 30, 2005 totaled $8.4 million, compared to $11.8 million during the same period of 2004. As a percentage of average loans and leases outstanding, these losses represent 0.18 percent for 2005 and 0.27 percent for 2004 on an annualized basis. We consider the established allowance adequate to absorb losses that relate to loans and leases outstanding at June 30, 2005. While we use available information to establish the allowance, future additions may be necessary based on changes in economic conditions or other factors. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance. Such agencies may require the recognition of adjustments to the allowance based on their judgments of information available to them at the time of their examination.
20
NONINTEREST INCOME
The growth of noninterest income is essential to our ability to sustain adequate levels of profitability. The primary sources of noninterest income are service charges on deposit accounts, cardholder and merchant services income, various types of commission-based income including the sale of investments by our broker-dealer subsidiaries, fees from processing services for client banks, mortgage income and various types of revenues derived from wealth management services. Noninterest income also includes gains and losses resulting from securities transactions as well as gains recognized from the securitization and sale of loans.
During the first six months of 2005, total noninterest income equaled $129.8 million, compared to $124.4 million during the same period of 2004. The $5.3 million or 4.3 percent increase was primarily due to growth in cardholder and merchant services income and gain recognized on the securitization and sale of revolving mortgage loans. These increases were partially offset by reductions in securities gains and service charge income.
Service charges on deposit accounts decreased $1.6 million or 3.9 percent during the first six months of 2005. Lower commercial service charges contributed to this unfavorable variance, the result of higher earnings credit rates used to offset fees assessed for accounts on commercial analysis. Bad check and overdraft charges continued to improve. Cardholder and merchant services income increased $4.0 million or 13.1 percent for the first six months of 2005 when compared to the same period in 2004. Much of the increase results from higher transaction volume with our debit card product and continued growth in merchant discount.
The securitization and sale of revolving mortgage loans resulted in a gain of $2.9 million during the second quarter of 2005, which is included in other noninterest income. There were no securitization and sale transactions in prior periods. Securities transactions generated net gains of $1.9 million during the first six months of 2004, compared to net losses of $22,000 during the same period of 2005.
Other service charges and fees increased $1.4 million or 20.3 percent during the first six months of 2005, primarily due to fees we began collecting in late 2004. Among other components of noninterest income, fees from processing services increased $721,000 or 6.1 percent during the first six months of 2005. Much of this increase is due to higher transaction volume for client banks. Trust income contributed an additional $670,000 during the first six months of 2005 compared to the same period of 2004. This increase represents a 7.8 percent increase over the same period of 2004 due to improved investment returns. Mortgage income declined $669,000 or 14.9 percent during the first six months of 2005 due to lower origination activity.
During the second quarter of 2005, total noninterest income equaled $68.6 million, an increase of $5.7 million or 9.0 percent, compared to the $62.9 million earned during the second quarter of 2004. The trends noted during the second quarter were similar to those noted for the year-to-date, including higher cardholder and merchant services income and the gain recognized on the securitization and sale of the revolving mortgage loans.
NONINTEREST EXPENSE
The primary components of noninterest expense are salaries and related employee benefit costs, occupancy costs for branch offices and support facilities, and equipment costs related to branch offices and technology.
Total noninterest expense equaled $245.3 million for the first six months of 2005, a 2.1 percent increase over the $240.2 million recorded during the same period of 2004. The $5.1 million increase in noninterest expense results from higher personnel and general operating costs. Noninterest expense for ISB increased $6.8 million or 27.7 percent during the first six months of 2005.
Salary expense increased $1.8 million during 2005 when compared to the same period of 2004. This 1.7 percent increase is primarily due to the growth in employee population required to staff new branch offices of ISB. Total salary expense for ISB increased $2.5 million or 23.8 percent during the first six months of 2005. Employee benefits expense increased $295,000 or 1.2 percent during the first six months of 2005, compared to the corresponding period of 2004 due to higher pension expense, partially offset by lower health insurance costs.
Occupancy costs increased $609,000 or 2.7 percent during the first six months of 2005, the result of higher building depreciation and rent expense associated with the expansion of ISB. Other expenses increased $2.5 million or 3.9 percent during 2005 due to higher card processing costs and the absence of a gain recorded during 2004 on the sale of property.
For the second quarter of 2005, noninterest expense totaled $124.0 million, a $2.6 million or 2.1 percent increase over the same period of 2004. Salary expense equaled $52.5 million during the second quarter of 2005, an increase of $1.1 million or 2.2 percent due primarily to new associates hired to support the continued ISB expansion. Employee benefits expense increased $350,000 due to higher pension costs.
21
INCOME TAXES
Income tax expense was $33.4 million during the first six months of 2005, compared to $19.2 million during the same period of 2004, a 73.8 percent increase primarily due to higher pre-tax earnings. The effective tax rates for these periods were 37.8 percent and 36.7 percent, respectively. For the second quarters of 2005 and 2004, income tax expense was $18.2 million and $9.3 million, respectively. The effective tax rates were 37.7 percent and 37.0 percent for the respective periods.
LIQUIDITY
BancShares has historically maintained a strong focus on liquidity, and our deposit base represents our primary liquidity source. Through our deposit pricing strategies, we have the ability to stimulate or curtail deposit growth. BancShares also maintains additional sources for borrowed funds through federal funds lines of credit and other borrowing facilities. At June 30, 2005, BancShares had access to $450.0 million in unfunded borrowings through its correspondent bank network.
Once we have satisfied our loan demand, residual liquidity is invested in overnight and longer-term investment products. Investment securities available for sale provide immediate liquidity as needed. In addition, investment securities held to maturity provide an ongoing liquidity source based on the scheduled maturity dates of the securities.
SHAREHOLDERS’ EQUITY AND CAPITAL ADEQUACY
BancShares continues to exceed all minimum regulatory capital requirements, and the banking subsidiaries remain well-capitalized. At June 30, 2005 and 2004, the leverage capital ratio of BancShares was 9.38 percent and 9.37 percent, respectively, surpassing the minimum level of 3 percent. As a percentage of risk-adjusted assets, BancShares’ Tier 1 capital ratio was 12.45 percent at June 30, 2005, and 12.25 percent as of June 30, 2004. The minimum ratio allowed is 4 percent of risk-adjusted assets. The total risk-adjusted capital ratio was 15.01 percent at June 30, 2005 and 13.59 percent as of June 30, 2004. The minimum total capital ratio is 8 percent.
The subordinated debt issued during the second quarter of 2005 qualifies as Tier 2 capital under current regulatory guidelines. As a result, BancShares’ total capital ratio has been further strengthened by that transaction.
SEGMENT REPORTING
BancShares conducts its banking operations through its two banking subsidiaries, FCB and ISB. Although FCB and ISB offer similar products and services to customers, each entity operates in distinct geographic markets and has separate management groups. We monitor growth and financial results in these institutions separately and, within each institution, by geographic segregation.
Although FCB has grown through acquisition in certain of its markets, throughout its history much of its expansion has been accomplished on a de novo basis. However, because of FCB’s size, market share and maturity as well as the current modest expansion of its branch network, the costs associated with de novo branching are not material to FCB’s financial performance. Since it first opened in 1997, ISB has followed a similar business model for growth and expansion. Yet, due to the large number of branch offices that have yet to attain sufficient size for profitability, the financial results and trends of ISB are significantly affected by its current and continuing growth. Each new market ISB enters creates additional operating costs that are typically not fully offset by operating revenues until the third year after initial opening. ISB’s rapid growth in new markets in recent years has continued to adversely impact its financial performance.
IronStone Bank. ISB’s total assets increased from $1.33 billion at June 30, 2004 to $1.72 billion at June 30, 2005, an increase of $394.5 million or 29.8 percent. This growth resulted from significantly higher levels of loans, funded by a growing deposit base generated through the expanding branch network.
ISB recorded a net loss of $1.9 million during the first six months of 2005 compared to a net loss of $1.6 million during the same period of 2004. This represents an unfavorable variance of $243,000, the result of ISB’s higher provision for loan losses and noninterest expenses which are partially attributable to the presence in 2004 of a $2.1 million gain recognized on the sale of property, offset by higher levels of net interest income and noninterest income.
22
ISB’s net interest income increased $7.4 million or 34.1 percent during the first six months of 2005, when compared to the same period of 2004, the result of higher interest rates and balance sheet growth. Provision for credit losses increased $1.5 million or 76.2 percent due to higher net charge offs and growth in the loan portfolio.
ISB’s noninterest income increased $678,000 or 25.9 percent during the first six months of 2005, primarily the result of cardholder and merchant income and factoring commissions. Noninterest expense increased $6.8 million or 27.7 percent during 2005. Higher personnel, occupancy and equipment costs reflect the impact of the expanded branch network, much of which relates to the expansion of ISB into new markets.
ISB continues to evaluate both existing and new markets for expansion. As such growth occurs, ISB will continue to incur incremental operating costs, particularly in the areas of personnel, occupancy and equipment. As a result of the de novo status of much of the ISB franchise and plans for continued expansion, ISB’s net losses will likely extend into the foreseeable future.
First Citizens Bank. FCB’s total assets increased from $11.41 billion at June 30, 2004 to $12.17 billion at June 30, 2005, an increase of $754.4 million or 6.6 percent. FCB recorded net income of $63.4 million during the first six months of 2005 compared to $40.2 million during the same period of 2004. This represents a $23.2 million or 57.6 percent increase in net income, the result of significantly higher levels of net interest income and lower provision for credit losses.
FCB’s net interest income increased $22.6 million or 13.0 percent during the first six months of 2005, the result of strong loan growth and an improved net yield on interest-earning assets. Provision for credit losses decreased $6.9 million or 43.9 percent during 2005 due to lower net charge-offs and slower loan growth.
FCB’s noninterest income increased $7.3 million or 6.0 percent during the first six months of 2005, the result of the $2.9 million gain on the securitization and sale of revolving mortgage loans and higher cardholder and merchant service income, partially offset by reduced securities gains and lower levels of service charge and mortgage income.
Noninterest expense decreased $1.1 million or 0.5 percent during the first six months of 2005, primarily due to lower personnel expense, partially offset by higher credit card processing expense.
CURRENT ACCOUNTING AND REGULATORY ISSUES
During March 2004, the SEC issued Staff Accounting Bulletin 105, Application of Accounting Principles to Loan Commitments (SAB 105). SAB 105 addresses the accounting for loan commitments and provides that the required fair value measurement include only differences between the guaranteed interest rate in the loan commitment and a market interest rate excluding any expected future cash flows related to the customer relationship or loan servicing. SAB 105 applies to mortgage loan commitments accounted for as derivatives and entered into after March 31, 2004. Substantially all of our mortgage loan commitments are based on rates provided by third party correspondents, who have agreed to purchase resulting loans at those rates. As a result, we are protected from interest rate risk, and the adoption of SAB 105 did not have a material impact on our consolidated financial statements.
In December 2003, the American Institute of Certificate Public Accountants (AICPA) issued Statement of Position 03-3, Accounting for Loans or Certain Debt Securities Acquired in a Transfer (SOP 03-3). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investment in loans or debt securities acquired in a transfer if these differences relate to a deterioration of credit quality. SOP 03-3 also prohibits companies from carrying over or creating a valuation allowance in the initial accounting for loans acquired. SOP 03-3 is effective for loans acquired in years beginning after December 15, 2004. The adoption of SOP 03-3 did not expected to have a material impact on our consolidated financial statements.
Management is not aware of any current recommendations by regulatory authorities that, if implemented, would have or would be reasonably likely to have a material effect on liquidity, capital ratios or results of operations.
FORWARD-LOOKING STATEMENTS
Statements in this Report and exhibits relating to plans, strategies, economic performance and trends, projections of results of specific activities or investments, expectations or beliefs about future events or results, and other statements that are not descriptions of historical facts, may be forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
23
Forward-looking information is inherently subject to risks and uncertainties, and actual results could differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in our Annual Report on Form 10-K and in other documents filed by us with the Securities and Exchange Commission from time to time.
Forward-looking statements may be identified by terms such as “may,” “will,” “should,” “could,” “expects,” “plans,” “intends,” “anticipates,” “believes,” “estimates,” “predicts,” “forecasts,” “projects,” “potential” or “continue,” or similar terms or the negative of these terms, or other statements concerning opinions or judgments of BancShares’ management about future events.
Factors that could influence the accuracy of those forward-looking statements include, but are not limited to, the financial success or changing strategies of our customers, customer acceptance of our services, products and fee structure, the competitive nature of the financial services industry, our ability to compete effectively against other financial institutions in our banking markets, actions of government regulators, the level of market interest rates and our ability to manage our interest rate risk, changes in general economic conditions particularly changes that affect our loan portfolio, the abilities of our borrowers to repay their loans, and the values of loan collateral, and other developments or changes in our business that we do not expect.
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. We have no obligation to update these forward-looking statements.
24
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk is the potential economic loss resulting from changes in market prices and interest rates. This risk can either result in diminished current fair values of financial instruments or reduced net interest income in future periods. As of June 30, 2005, BancShares’ market risk profile has not changed significantly from December 31, 2004.
Item 4. Controls and Procedures
BancShares’ management, with the participation of its Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of BancShares’ disclosure controls and procedures in accordance with Rule 13a-15 of the Securities Exchange Act of 1934 (Exchange Act). Based on their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, BancShares’ disclosure controls and procedures were effective in enabling it to record, process, summarize and report in a timely manner the information required to be disclosed in reports it files under the Exchange Act.
No change in BancShares’ internal control over financial reporting occurred during the second quarter of 2005 that had materially affected, or is reasonably likely to materially affect, BancShares’ internal control over financial reporting.
PART II
Item 4. Submission of Matters to a Vote of Security Holders
On April 25, 2005, at the Annual Meeting of Shareholders of Registrant, the shareholders considered the election of directors. The shareholder vote regarding the election of the nominees for Board of Directors was:
Nominee
J.M. Alexander, Jr.
C.H. Ames
V.E. Bell, III
G.H. Broadrick
H.M. Craig, III
H.L. Durham, Jr.
L.M. Fetterman
F.B. Holding
F.B. Holding, Jr.
L.R. Holding
C.B.C. Holt
J.B. Hyler, Jr.
G.D. Johnson
F.R. Jones
L.S. Jones
J.T. Maloney, Jr.
R.T. Newcomb
L.T. Nunnellee, II
R.C. Scheeler
R.K. Shelton
R.C. Soles, Jr.
D.L. Ward, Jr.
4.1
4.2
31.1
31.2
32
25
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.
/s/ Kenneth A. Black
26