UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended June 30, 2006
or
Commission File Number: 0-16471
First Citizens BancShares, Inc
(Exact name of Registrant as specified in its charter)
(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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the Registrant in a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
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 7, 2006)
INDEX
PART I
Item 1. Financial Statements (Unaudited)
Consolidated Balance Sheets
First Citizens BancShares, Inc. and Subsidiaries
(thousands, except share data)
Assets
Cash and due from banks
Overnight investments
Investment securities available for sale
Investment securities held to maturity
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
Common stock:
Class A - $1 par value (8,756,778 shares issued for all periods)
Class B - $1 par value (1,677,675 shares issued 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 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
Service charges on deposit accounts
Cardholder and merchant services income
Trust and asset management fees
Fees from processing services
Commission income
ATM income
Mortgage income
Other service charges and fees
Securities gains (losses)
Other
Total noninterest income
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
Unrealized gain on interest rate swap 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)
Balance at December 31, 2004
Cash dividends
Unrealized securities losses, net of deferred taxes
Balance at June 30, 2005
Balance at December 31, 2005
Unrealized gain on interest rate swap, net of deferred taxes
Balance at June 30, 2006
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
Change in current taxes payable
Depreciation
Change in accrued interest payable
Change in income earned not collected
Securities losses
Origination of loans held for sale
Proceeds from sale of loans
Loss (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 and sale of branches, net of cash transferred
Net cash used by investing activities
FINANCING ACTIVITIES
Net change in time deposits
Net change in demand and other interest-bearing deposits
Net change in short-term borrowings
Originations of long-term obligations
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
Interest
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
Unrealized securities losses
Unrealized gain on interest rate swap
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 2005 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 2006. However, the reclassifications have no effect on shareholders’ equity or net income as previously reported.
Derivative Financial Instruments
During the second quarter of 2006, BancShares entered into an interest rate swap that synthetically converts the variable interest rate on trust preferred securities issued in 2006 to a fixed rate. The interest rate swap is a derivative financial instrument that qualifies as a cash flow hedge under Statement of Financial Accounting Standards No. 133 Accounting for Derivative Instruments and Hedging Activities (Statement 133). The initial assessment required under Statement 133 concluded that there was no ineffectiveness for this interest rate swap, and there was no fair value at the inception of the swap. Subject to periodic effectiveness testing over the five-year life of the swap, any change in fair value related to the effective portion of the swap will be recorded in other comprehensive income. Any change in fair value related to the ineffective portion of the swap will be reported in earnings.
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 charter from its branch network in North Carolina, Virginia, West Virginia, 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
Noninterest income
Noninterest expense
Income (loss) before income taxes
Net income (loss)
Period-end assets
Allowance for loan and lease losses
8
Note C
Employee Benefits
BancShares recognized pension expense totaling $6,898 and $7,470, respectively, in the six-month periods ended June 30, 2006 and 2005. Pension expense is included as a component of employee benefit 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 2006 is 8.50 percent.
9
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, Maryland, Tennessee and West Virginia. ISB operates offices in Georgia, Florida, Texas, New Mexico, Arizona, California, Oregon, Washington and Colorado.
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 2006, 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. These activities include commercial and consumer lending, deposit and cash management products, cardholder, merchant, wealth management services as well as various other products and services typically offered by commercial banks. FCB and ISB gather interest-bearing and noninterest-bearing deposits from retail and commercial customers. BancShares and its subsidiaries also secure supplemental short-term and long-term funding through various non-deposit sources. We invest the liquidity generated from these funding sources in various types of interest-earning assets such as loans and leases, investment securities and overnight investments. We also invest in bank premises, furniture and equipment used in the subsidiaries’ commercial banking business.
External factors influence customer demand for our loan, lease and deposit products. The general strength of the economy influences loan and lease demand as well as the quality and collectibility of our loan and lease portfolio. External economic indicators such as consumer bankruptcy rates and business debt service capacity closely follow trends in the economic cycle. In an effort to stimulate and control the rate of growth of economic activity, monetary actions by the Federal Reserve are significant to the interest rate environment in which we operate. At any point in time, both the existing level and anticipated movement of interest rates have a profound impact on customer demand for our products, our pricing of those products and on our profitability.
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’ profitability measures have historically compared unfavorably to the returns of similar-sized financial holding companies. We have historically placed significant emphasis upon asset quality, balance sheet liquidity and capital conservation, even when those priorities may be detrimental to short-term profitability.
Based on our organization’s strengths, competitive position and strategic focus within the financial services industry, we believe opportunities for significant growth and expansion exist. We operate in diverse and growing geographic markets and believe that through competitive products and superior customer service, we can increase our business volumes and profitability. 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 seek to increase fee income in areas such as merchant processing, working capital finance, insurance, cash management, wealth management and private banking services. We also focus on opportunities to generate income by providing processing services to other banks.
We attempt to mitigate certain of the risks that can endanger our profitability and growth prospects. These risks generally fall into categories of economic, industry systemic, competitive and regulatory. While we are attentive to all areas of risk, economic risk is especially problematic due to the lack of control and the likelihood of a material impact on our financial results. Specific economic risks include recession, rapid movements in interest rates and significant changes in inflation expectations. Compared to our larger competitors, our relatively small asset size and limited capital resources create a level of economic risk that requires constant and focused management attention.
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.
10
(thousands, except per share data and ratios)
First
Quarter
Third
Net interest income-taxable equivalent
Investment securities
Interest-earning assets
Interest-bearing liabilities
Shareholders’ equity
Shares outstanding
Rate of return (annualized) on:
Dividend payout ratio
Loans and leases to deposits
Shareholders’ equity to total assets
Time certificates of $100,000 or more to total deposits
Book value at period end
Tangible book value at period end
11
Net income. BancShares realized an increase in earnings during the second quarter of 2006 compared to the second quarter of 2005. Consolidated net income during the second quarter of 2006 was $31.7 million, compared to $30.1 million earned during the corresponding period of 2005, a $1.6 million or 5.4 percent increase. The improvement in net income during 2006 resulted from higher net interest income and a reduction in the provision for credit losses. Net income per share during the second quarter of 2006 totaled $3.04, compared to $2.88 during the second quarter of 2005. The annualized returns on average assets and equity were 0.84 percent and 10.46 percent for the second quarter of 2006 respectively compared to 0.89 percent and 10.79 percent for the corresponding period in 2005.
For the first six months of 2006, BancShares recorded net income of $60.4 million, compared to $55.1 million earned during the first six months of 2005. The $5.3 million or 9.6 percent increase was attributable to significantly higher levels of net interest income, improved noninterest income and lower provision for credit losses. Net income per share for the first six months of 2006 was $5.79, compared to $5.28 during the same period of 2005. On an annualized basis, BancShares returned 0.82 percent on average assets during the first six months of 2006, unchanged from the corresponding period of 2005. Annualized return on average equity for the first six months of 2006 was 10.11 percent, up slightly from 10.04 percent during the same period of 2005.
ISB reported net income of $78,000 during the first six months of 2006, respectively, compared to a net loss of $1.9 million reported during 2005. Improved earnings for ISB have resulted from the favorable impact of loan growth, higher working capital finance fees and merchant income as well as lower provision expense. However, due to added costs arising from anticipated franchise expansion and the adverse impact of the flat yield curve, ISB’s profitability will remain low.
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 $20.0 million into ISB during the first six months of 2006. Since ISB was chartered in 1997, BancShares has provided $270.0 million in capital. Losses incurred since ISB’s inception total $29.1 million. 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.
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 2006 averaged $13.52 billion, an increase of $1.27 billion or 10.3 percent from the second quarter of 2005. For the six months ended June 30, 2006, interest-earning assets averaged $13.33 billion, an increase of $1.23 million or 10.2 percent over the same period of 2005. These increases resulted from growth in the loan, lease and investment securities portfolios.
12
(thousands)
Real estate:
Construction and land development
Commercial mortgage
Residential mortgage
Revolving mortgage
Other mortgage
Total real estate loans
Commercial and industrial
Consumer
Lease financing
Total loans and leases
Loans and leases. At June 30, 2006 and 2005, loans and leases totaled $10.03 billion and $9.30 billion, respectively. The $728.1 million growth from June 30, 2005 to June 30, 2006 represents a 7.8 percent annual growth rate. Table 2 details outstanding loans and leases by type for the past five quarters.
During the twelve-month period from June 30, 2005 to June 30, 2006, we have continued to see modest loan growth. Total loans secured by real estate grew from $6.67 billion at June 30, 2005 to $6.96 billion at June 30, 2006, an increase of $295.3 million or 4.4 percent. Commercial mortgage loans increased from $3.43 billion at June 30, 2005 to $3.59 billion at June 30, 2006, a $161.7 million or 4.7 percent growth rate. Construction and land development real estate loans increased $132.3 million or 19.2 percent from June 30, 2005 to June 30, 2006 due to strong market demand for these loan types.
While real estate loan growth has been generally sluggish over the past year, commercial and industrial loans increased $409.4 million or 40.6 percent from June 30, 2005 to June 30, 2006. This growth has resulted from the ISB expansion as well as continued focus on commercial lending in new and existing FCB markets. In addition, we recorded $144.5 million in loans made in conjunction with the United States Department of Agriculture tobacco buyout program. Over this same 12-month period, lease financing increased $54.2 million or 26.4 percent as demand for our lease products remains robust particularly among medical customers.
We continue to focus on customer development within the medical community. At June 30, 2006, 13.8 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 continuing growth in new markets has allowed us to mitigate our historic exposure to geographic concentration in North Carolina and Virginia. We are aware that rapid loan growth in new markets may present incremental lending risks. During the expansion and growth in new markets, we have and will continue to rely on a centralized underwriting process, and we have endeavored to ensure that credit monitoring controls are functioning effectively.
13
Investment securities available for sale:
U.S. Government:
Within one year
One to five years
Five to ten years
Ten to twenty years
Over twenty years
Total
State, county and municipal:
Equity securities
Total investment securities available for sale
Investment securities held to maturity:
Total investment securities held to maturity
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.
14
Investment securities. At June 30, 2006 and 2005, the investment portfolio totaled $3.02 billion and $2.64 billion, respectively. The $380.4 million or 14.4 percent increase in the investment portfolio since June 30, 2005 resulted from additional balance sheet liquidity provided by deposit and master note growth as well as proceeds arising from the issuance of $115.0 million in trust preferred securities. Table 3 presents detailed information relating to the investment securities portfolio.
Investment securities available for sale totaled $2.63 billion at June 30, 2006, compared to $1.84 billion at June 30, 2005. Available-for-sale securities are reported at their aggregate fair value.
Investment securities held to maturity totaled $398.7 million at June 30, 2006, compared to $802.2 million at June 30, 2005. Securities that are classified as held-to-maturity reflect BancShares’ ability and positive intent to hold those investments until maturity.
The growth in investment securities available for sale and the corresponding reduction in investment securities held to maturity results from our decision to increase balance sheet liquidity and flexibility.
Income on interest-earning assets. Interest income amounted to $202.5 million during the second quarter of 2006, a $42.3 million or 26.4 percent increase from the second quarter of 2005. 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 77 basis points from 5.25 percent in 2005 to 6.02 percent in 2006.
Loan and lease interest income for the second quarter of 2006 was $167.2 million, an increase of $27.8 million or 19.9 percent from the second quarter of 2005, due to higher yields and growth in the loan portfolio. The taxable-equivalent yield on loans and leases increased 76 basis points from 6.01 percent to 6.77 percent from 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. Average loans and leases increased $600.0 million or 6.4 percent during the second quarter of 2006.
Within the investment securities portfolio, interest income was $27.5 million during the second quarter of 2006 compared to $16.6 million during the second quarter of 2005, an increase of $11.0 million or 66.3 percent. This increase was the result of higher yields and growth in the investment securities portfolio. The short average maturity of the investment securities portfolio has allowed for rapid repricing of the investment securities portfolio as interest rates have increased. As a result, the taxable-equivalent yield on investment securities increased by 89 basis points from 2.83 percent during the second quarter of 2005 to 3.72 percent in 2006. Average investment securities increased $619.3 million or 26.4 percent during the second quarter of 2006 compared to the same period of 2005.
Overnight investments generated interest income of $7.8 million during the second quarter of 2006, compared to $4.2 million during the same period of 2005. The $3.5 million increase is the combined result of a 201 basis points yield increase and higher average balances. Overnight investments returned 4.92 percent during the second quarter of 2006 compared to 2.91 percent during the same period of 2005.
Interest income amounted to $392.5 million during the first six months of 2006, an $84.0 million or 27.2 percent increase from the same period of 2005, the result of higher yields and growth in interest-earning assets. The taxable-equivalent yield increased 80 basis points from 5.15 percent for the first six months of 2005 to 5.95 percent during the same period of 2006. Higher market interest rates during 2006 boosted the yield earned on all categories of interest-earning assets.
15
Consolidated Taxable Equivalent Rate/Volume Variance Analysis - Second Quarter
Table 4
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. Yields related to loans 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 $418 and $368 for 2006 and 2005, respectively.
For the six months ended June 30, 2006, loan and lease interest income equaled $326.4 million, an increase of $54.6 million or 20.1 percent from the same period of 2005. The improvement in interest income reflects the effect of an 85 basis point increase in loan and lease yields as well as a 5.1 percent increase in average balances.
For the six months ended June 30, 2006, income earned on the investment securities portfolio amounted to $52.6 million, compared to $29.5 million during the same period of 2005, an increase of $23.1 million or 78.5 percent. This increase was the result of portfolio growth and a 91 basis point increase in the taxable-equivalent yield resulting from the reinvestment of proceeds arising from maturing securities to current market rates.
Interest earned on overnight investments totaled $13.5 million during the first six months of 2006 compared to $7.2 million during the same period of 2005, a $6.3 million or 86.6 percent increase. This strong growth was the combined result of a 200 basis point yield increase.
16
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, 2006 and 2005, interest-bearing liabilities totaled $11.40 billion and $10.16 billion, respectively, a $1.24 billion or 12.2 percent increase. This increase resulted from growth in interest-bearing deposits, master notes and long-term obligations.
Deposits. At June 30, 2006, total deposits were $12.72 billion, an increase of $959.1 million or 8.2 percent over June 30, 2005.
Interest-bearing deposits averaged $9.78 billion during the second quarter of 2006 compared to $9.04 billion during the second quarter of 2005, an increase of $746.0 million or 8.3 percent. In the second quarter, average time deposits increased $810.6 million or 19.7 percent from 2006 to 2005 as customers shifted liquidity out of money market and other transaction accounts into higher-yielding time deposit instruments. From the second quarter of 2005 to the second quarter of 2006, average money market increased only $31.7 million or 1.2 percent, while average savings and average Checking With Interest decreased $86.1 million and $10.2 million, respectively.
For the first six months of 2006, interest-bearing deposits averaged $9.69 billion compared to $8.97 billion during the same period of 2005. This $718.9 million or 8.0 percent increase results from continued growth in time deposits and money market accounts.
Short-term borrowings. At June 30, 2006, short-term borrowings totaled $957.0 million compared to $621.7 million at June 30, 2005. For the quarters ended June 30, 2006 and 2005, short-term borrowings averaged $908.5 million and $522.7 million, respectively. The $385.8 million or 73.8 percent increase in short-term borrowings resulted from strong master note growth as customer interest in commercial cash management sweep products improved due to higher interest rates on those products.
For the six-month periods ended June 30, 2006 and 2005, short-term borrowings averaged $847.0 million and $485.0 million, respectively, an increase of 74.6 percent prompted by improved master note demand.
Long-term obligations. At June 30, 2006 and 2005, long-term obligations totaled $527.5 million and $410.0 million, respectively. The increase reflects the impact of $115 million in trust preferred capital securities issued during the second quarter of 2006.
In addition to the trust preferred securities issued during 2006, long-term obligations also include $150.0 million in trust preferred capital securities issued in 1998 and $100.0 million in trust preferred capital securities issued in 2001 (the 2001 Securities). The 2001 Securities mature in 2031, but may be redeemed in whole or in part at par on or after October 31, 2006. Although no definitive action has been taken, given current interest rates it is likely that the 2001 Securities will be redeemed during the fourth quarter of 2006.
Expense on interest-bearing liabilities. BancShares’ interest expense amounted to $83.6 million during the second quarter of 2006, a $34.0 million or 68.7 percent increase from the second quarter of 2005. The higher interest expense was the result of increasing market interest rates and higher average volume. The rate on interest-bearing liabilities was 3.00 percent during the second quarter of 2006 compared to 2.01 percent during the same period of 2005. During the second quarter of 2006, interest-bearing liabilities averaged $11.16 billion, an increase of $1.29 billion or 13.1 percent from the second quarter of 2005.
For the year-to-date, interest expense was $155.7 million, compared to $92.1 million for the same period of 2005. The $63.6 million or 69.1 percent increase results from higher interest rates and growth in average deposits. The rate on interest-bearing liabilities increased from 1.90 percent during the first six months of 2005 to 2.86 percent for the same period of 2006, a 96 basis point difference. The rate on time deposits increased 101 basis points from 2.65 percent to 3.66 percent while the rate on average money market savings increased 102 basis points from 1.62 percent to 2.64 percent. The rate on average master notes increased 201 basis points from 1.96 percent to 3.97 percent. For the first six months, average interest-bearing liabilities increased $1.22 billion or 12.5 percent from $9.76 billion to $10.98 billion. Average time deposits increased $751.1 million to $4.80 billion and average master notes increased $312.0 million from $250.9 million to $562.8 million.
17
Consolidated Taxable Equivalent Rate/Volume Variance Analysis - Six Months
Table 5
Average loan balances include nonaccrual loans. Yields related to loans 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.
NET INTEREST INCOME
Net interest income totaled $118.9 million during the second quarter of 2006, an increase of $8.3 million or 7.5 percent from the $110.7 million recorded during the second quarter of 2005. On a linked quarter basis, net interest income increased by only $1.1 million, or 0.9 percent. Due primarily to the unfavorable impact of the flat yield curve and the declining asset sensitivity of the balance sheet, the taxable-equivalent net yield on interest-earning assets declined 9 basis points from 3.63 percent during the second quarter of 2005 to 3.54 percent for the second quarter of 2006. The growth in net interest income resulted primarily from higher volume of interest-earning assets.
Net interest income totaled $236.8 million for the six-month period ended June 30, 2006, a $20.4 million or 9.4 percent increase over the same period of 2005. For the year-to-date, the taxable equivalent net yield on interest-earning assets fell from 3.62 percent in 2005 to 3.59 percent in 2006. Like the second quarter comparison, the impact of the flat yield curve over the six-month period offset the balance sheet growth, causing the net yield to decline by three basis points.
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.
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Due to customer preference for fixed-rate commercial loans, rate ceilings that are limiting the repricing of variable rate loans, and surges in shorter-term deposit balances, our interest-sensitivity position has shifted from an asset-sensitive position to a liability-sensitive position. Based upon recent trends, it appears that the liability-sensitivity position will continue to grow during the next quarter. Assuming no other changes, a liability sensitive position indicates that rising market interest rates will likely cause a contraction in the net yield on interest-earning assets and, thus, net interest income. Changes in the slope of the yield curve and shifts in the mix of interest-earning assets and interest-bearing liabilities may cause actual results to vary.
Historically, we have managed our interest rate risk through decisions regarding pricing and availability of our loan and deposit products and through selected balance sheet management activities such as sales of certain long-term fixed rate assets and revolving loans. We have not relied on interest rate floors, collars or other derivative financial instruments to hedge interest rate sensitivity and interest rate risk. However, during the second quarter of 2006, in conjunction with the issuance of $115.0 million in trust preferred securities, we entered into an interest rate swap to synthetically convert the variable rate coupon of the securities to a fixed rate of 7.125% for a period of five years.
ASSET QUALITY
The maintenance of excellent asset quality is one of our primary areas of focus. Historically, we have dedicated significant resources to ensuring prudent lending practices. Accordingly, we have focused on asset quality as a key performance measure.
Nonperforming assets. At June 30, 2006, BancShares’ total nonperforming assets, consisting of nonaccrual loans and other real estate, amounted to $24.0 million or 0.24 percent of loans and leases plus other real estate, compared to $18.4 million or 0.20 percent at June 30, 2005. The increase is primarily attributable to the transfer to other real estate of three parcels of land that were initially acquired for branch sites. The transfer resulted from the subsequent decision to abandon plans for branch offices at those locations. Nonaccrual loans totaled $15.6 million at June 30, 2006, compared to $13.4 million at June 30, 2005. We closely monitor nonperforming assets, taking necessary actions to minimize potential exposure.
Allowance for credit losses. We continuously analyze the growth and risk characteristics of the loan and lease portfolio under current economic conditions in order to evaluate the adequacy of the allowance for credit 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, 2006, the allowance for credit losses amounted to $137.1 million or 1.37 percent of total loans and leases outstanding. This compares to $135.8 million or 1.41 percent at December 31, 2005, and $133.2 million or 1.43 percent at June 30, 2005.
The provision for credit losses charged to operations during the second quarter of 2006 was $3.0 million, compared to $7.0 million during the second quarter of 2005. For the six-month periods ended June 30, total provision for credit losses was $9.7 million for 2006 and $12.3 million for 2005. The $2.6 million decrease results from enhancements to the allowance methodology that were implemented during the second quarter of 2006.
Net charge-offs for the three months ended June 30, 2006 totaled $3.0 million, compared to $4.9 million during the same period of 2005, the combined result of lower charge offs and higher recoveries. On an annualized basis, net charge-offs represent 0.12 percent and 0.21 percent of average loans and leases outstanding during the respective periods. Net charge-offs for the six-month period ended June 30, 2006 totaled $8.4 million, unchanged from the same period of 2005. As a percentage of average loans and leases outstanding, these losses represent 0.17 percent for 2006 and 0.18 percent for 2005 on an annualized basis.
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Summary of Loan and Lease Loss Experience and Risk Elements
(thousands, except ratios)
Allowance for credit losses at beginning of period
Adjustment
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
We consider the established allowance adequate to absorb losses that relate to loans and leases outstanding at June 30, 2006. 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.
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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 2006, total noninterest income equaled $135.4 million, compared to $129.8 million during the same period of 2005. The $5.6 million or 4.3 percent increase was primarily due to growth in cardholder and merchant services income and commission income. These increases were partially offset by reductions in service charges on deposit accounts. Additionally, during 2005, noninterest income included a $2.9 million gain on the securitization and sale of home equity loans. No such gain was recognized during 2006.
Cardholder and merchant services income increased $6.3 million or 18.5 percent for the first six months of 2006 when compared to the same period in 2005. Much of the increase results from continued strong growth in merchant discount and higher transaction volume with our credit and debit card products.
Commission income increased $3.4 million or 26.3 percent from $12.8 million during the first six months of 2005 compared to $16.2 million during the first six months of 2006. Much of the growth in commission income was attributed to brokerage fees generated by First Citizens Investor Services and IronStone Securities. Broker-dealer commissions increased $2.6 million during 2006 due to improved sales performance and market returns.
Among other components of noninterest income, fees from processing services increased $2.0 million or 15.7 percent during the first six months of 2006. Much of this increase is due to higher client bank transaction volume as a result of item processing services provided to new client banks. Trust and asset management fees contributed an additional $1.1 million during the first six months of 2006 compared to the same period of 2005. This increase represents an 11.5 percent increase over the same period of 2005 due to improved investment returns and favorable business development activity within our wealth management function.
Reducing the overall growth in noninterest income, service charges on deposit accounts decreased $1.9 million or 5.0 percent during the first six months of 2006. Service charges were generally lower for both personal and commercial customers. Bad check and overdraft charges declined modestly. Mortgage income declined $665,000 or 17.4 percent during the first six months of 2006 due to losses recognized on loans held for sale due to rising interest rates.
During the second quarter of 2006, total noninterest income equaled $69.6 million, an increase of $1.0 million or 1.5 percent, compared to the $68.6 million earned during the second quarter of 2005. The trends noted during the second quarter were similar to those noted for the year-to-date, including higher cardholder and merchant services income, commission income, processing fees as well as trust and asset management fees.
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 $266.9 million for the first six months of 2006, an 8.8 percent increase over the $245.3 million recorded during the same period of 2005. The $21.6 million increase in noninterest expense results from higher personnel and general operating costs.
Salary expense increased $9.4 million during 2006 when compared to the same period of 2005. This 9.0 percent increase is primarily due to higher incentive-based compensation for both wealth management sales and mortgage activity and labor costs resulting from new branch offices. Employee benefits expense increased $2.2 million or 8.5 percent during the first six months of 2006, compared to the corresponding period of 2005 due to higher health insurance costs and employer social security contributions. These increases were partially offset by lower pension expense.
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Occupancy costs increased $2.4 million or 10.4 percent during the first six months of 2006, the result of higher building depreciation and rent expense largely resulting from the expansion of the branch network. Other expenses increased $6.9 million or 10.3 percent during 2006. Much of this increase was due to cardholder and merchant processing costs, which increased $3.2 million. We also recognized higher costs related to cardholder rewards programs and external computer processing. Partially offsetting these increases were lower consulting expense.
For the second quarter of 2006, noninterest expense totaled $135.2 million, an $11.3 million or 9.1 percent increase over the same period of 2005. Salary expense equaled $57.1 million during the second quarter of 2006, an increase of $4.6 million or 8.8 percent due primarily to higher incentive compensation and new associates hired to staff new branch offices. Occupancy expense increased $941,000 or 8.2 percent due to the expansion of the branch network.
INCOME TAXES
Income tax expense was $35.1 million during the first six months of 2006, compared to $33.4 million during the same period of 2005, a 5.0 percent increase caused primarily by higher pre-tax earnings. The effective tax rates for these periods were 36.8 percent and 37.8 percent, respectively. For the second quarters of 2006 and 2005, income tax expense was $18.7 million and $18.2 million, respectively. The effective tax rates were 37.0 percent and 37.7 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, 2006, BancShares had access to $525.0 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, 2006 and 2005, the leverage capital ratio of BancShares was 9.92 percent and 9.38 percent, respectively, surpassing the minimum level of 3 percent. As a percentage of risk-adjusted assets, BancShares’ Tier 1 capital ratio was 13.56 percent at June 30, 2006, and 12.45 percent as of June 30, 2005. The minimum ratio allowed is 4 percent of risk-adjusted assets. The total risk-adjusted capital ratio was 16.05 percent at June 30, 2006 and 15.01 percent as of June 30, 2005. The minimum total capital ratio is 8 percent.
The trust preferred securities issued during the second quarter of 2006 qualify as Tier 1 capital under current regulatory guidelines. As a result, BancShares’ total capital ratio was further strengthened by that transaction. However, due to the likely redemption during the fourth quarter of 2006 of the $100.0 million in trust preferred securities issued during 2001, BancShares’ capital ratios may decline. BancShares, FCB and ISB will remain well-capitalized following the anticipated redemption of those securities.
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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 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 and maturity for adequate 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 has and will likely continue to adversely impact its financial performance.
IronStone Bank. ISB’s total assets increased from $1.72 billion at June 30, 2005 to $2.00 billion at June 30, 2006, an increase of $283.9 million or 16.5 percent. This growth resulted from significantly higher levels of loans, funded by a growing deposit base generated through the expanding branch network.
ISB recorded net income of $78,000 during the first six months of 2006 compared to a net loss of $1.9 million during the same period of 2005. This improvement, results from higher levels of net interest income, stronger noninterest income and lower provision for credit losses. Offsetting these improvements, noninterest expense was higher.
ISB’s net interest income increased $4.2 million or 14.4 percent during the first six months of 2006, when compared to the same period of 2005, the result of higher market interest rates and balance sheet growth. Provision for credit losses decreased $1.3 million or 38.4 percent due to lower net charge offs and slower growth in the allowance for loan and lease losses.
ISB’s noninterest income increased $2.0 million or 60.4 percent during the first six months of 2006, primarily the result of improved cardholder and merchant income and working capital finance commissions. Noninterest expense increased $4.4 million or 13.8 percent during 2006. Higher personnel, occupancy and equipment costs reflect the impact of the expanded branch network, much of which relates to the growth and expansion by 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 plans for continued expansion, ISB’s profitability will remain low.
First-Citizens Bank & Trust Company. FCB’s total assets increased from $12.17 billion at June 30, 2005 to $13.35 billion at June 30, 2006, an increase of $1.18 billion or 9.7 percent. FCB recorded net income of $67.3 million during the first six months of 2006 compared to $63.4 million during the same period of 2005. This represents a $3.9 million or 6.1 percent increase in net income, the result of higher levels of net interest and noninterest income and lower provision for credit losses.
FCB’s net interest income increased $17.1 million or 8.7 percent during the first six months of 2006, the result of strong growth among interest-earning assets. Provision for credit losses decreased $1.3 million or 14.5 percent during 2006 due to lower net charge-offs and modifications to the allowance methodology.
FCB’s noninterest income increased $4.0 million or 3.1 percent during the first six months of 2006, the result of the $5.0 million gain in cardholder and merchant service income and a $2.6 million increase in broker-dealer fees. Deposit service charges declined.
Noninterest expense increased $17.8 million or 8.2 percent during the first six months of 2006, primarily due to higher personnel, occupancy and credit card processing expenses.
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CURRENT ACCOUNTING AND REGULATORY ISSUES
In November 2003, the Emerging Issues Task Force (EITF) issued EITF Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03- 01). In September 2004, the Financial Accounting Standards Board (FASB) issued a FASB Staff Position (FSP EITF 03-1-b). In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1. Collectively, these documents consider when an investment is considered impaired, what disclosures are appropriate for impairment losses, and what disclosures are appropriate for unrealized losses that have not been recognized as other-than-temporary impairments. The new disclosure requirements are effective for reporting periods beginning after December 15. 2005.
In May 2005, the FASB issued Statement of Financial Accounting Standards No. 154 (SFAS 154), Accounting Changes and Error Corrections, which replaces prior accounting guidance related to accounting changes and error corrections. SFAS 154 changes the requirements for the accounting for and reporting of a change in an accounting principle. SFAS 154 requires retrospective application for voluntary changes in an accounting principle unless it is impracticable to do so. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. We adopted SFAS 154 on January 1, 2006. There will be no 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.
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 from time to time with the Securities and Exchange Commission.
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 and lease portfolio, the abilities of our borrowers to repay their loans and leases, and the values of 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.
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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, 2006, BancShares’ market risk profile has not changed significantly from December 31, 2005. Changes in fair value that result from movement in market rates cannot be predicted with any degree of certainty. Therefore, the impact that future changes in market rates will have on the fair values of financial instruments is uncertain.
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 2006 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 24, 2006, 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:
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Nominee
J.M. Alexander, Jr.
C.H. Ames
V.E. Bell, III
G.H. Broadrick
H.H. Connell
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.
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.
Item 6. Exhibits
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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
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