FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549 (Mark one) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 ------------------ OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------- ------------- Commission file number 000-4491 -------- FIRST TENNESSEE NATIONAL CORPORATION ----------------------------------------------------- (Exact name of registrant as specified in its charter) Tennessee 62-0803242 - ---------------------------------- ------------------ (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 165 Madison Avenue, Memphis, Tennessee 38103 - --------------------------------------- ---------- (Address of principal executive offices) (Zip Code) (901) 523-4444 -------------------------------------------------------- (Registrant's telephone number, including area code) None -------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ----- ----- APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Common Stock, $.625 par value 126,621,440 - ----------------------------- ------------------------------- Class Outstanding on October 31, 2001
FIRST TENNESSEE NATIONAL CORPORATION INDEX Part I. Financial Information Part II. Other Information Signatures Exhibit Index
PART I. FINANCIAL INFORMATION Item 1. Financial Statements. - ------------------------------ The Consolidated Statements of Condition The Consolidated Statements of Income The Consolidated Statements of Shareholders' Equity The Consolidated Statements of Cash Flows The Notes to Consolidated Financial Statements This financial information reflects all adjustments which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the interim periods presented.
<TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF CONDITION First Tennessee National Corporation - --------------------------------------------------------------------------------------------------------------------- September 30 December 31 -------------------------------- ------------- (Dollars in thousands)(Unaudited) 2001 2000 2000 - ------------------------------------------------------------------------------------------------- ------------- <S> <C> <C> <C> ASSETS: Cash and due from banks $ 898,133 $ 804,330 $ 838,148 Federal funds sold and securities purchased under agreements to resell 158,252 196,671 122,251 - -------------------------------------------------------------------------------------------------- ------------- Total cash and cash equivalents 1,056,385 1,001,001 960,399 - -------------------------------------------------------------------------------------------------- ------------- Investment in bank time deposits 5,570 4,430 3,629 Trading securities 600,168 582,226 253,796 Loans held for sale 2,194,390 2,137,079 1,735,070 Securities available for sale 2,035,628 2,104,990 2,200,741 Securities held to maturity (market value of $510,999 at September 30, 2001; $630,320 at September 30, 2000; and $619,728 at December 31, 2000) 513,496 667,291 638,315 Loans, net of unearned income 10,001,673 10,168,459 10,239,450 Less: Allowance for loan losses 151,180 145,923 143,696 - -------------------------------------------------------------------------------------------------- ------------- Total net loans 9,850,493 10,022,536 10,095,754 - -------------------------------------------------------------------------------------------------- ------------- Premises and equipment, net 259,587 289,574 286,107 Real estate acquired by foreclosure 18,818 15,669 16,290 Mortgage servicing rights, net 526,013 859,022 743,714 Intangible assets, net 127,740 125,156 121,624 Capital markets receivables and other assets 2,494,714 1,410,656 1,499,647 - -------------------------------------------------------------------------------------------------- ------------- TOTAL ASSETS $ 19,683,002 $ 19,219,630 $ 18,555,086 ================================================================================================== ============= LIABILITIES AND SHAREHOLDERS' EQUITY: Deposits: Interest-bearing $ 8,248,807 $ 10,259,580 $ 9,341,603 Noninterest-bearing 3,401,940 2,918,584 2,847,088 - -------------------------------------------------------------------------------------------------- ------------- Total deposits 11,650,747 13,178,164 12,188,691 - -------------------------------------------------------------------------------------------------- ------------- Federal funds purchased and securities sold under agreements to repurchase 3,179,848 2,730,729 2,981,026 Commercial paper and other short-term borrowings 471,279 494,003 456,535 Capital markets payables and other liabilities 2,206,528 996,828 996,574 Term borrowings 593,737 409,803 409,676 - -------------------------------------------------------------------------------------------------- ------------- Total liabilities 18,102,139 17,809,527 17,032,502 - -------------------------------------------------------------------------------------------------- ------------- Guaranteed preferred beneficial interests in First Tennessee's junior subordinated debentures 100,000 100,000 100,000 Preferred stock of subsidiary 44,162 -- 38,428 - -------------------------------------------------------------------------------------------------- ------------- SHAREHOLDERS' EQUITY: Preferred stock - no par value (5,000,000 shares authorized, but unissued) -- -- -- Common stock - $.625 par value (shares authorized - 400,000,000; shares issued - 125,874,856 at September 30, 2001; 128,081,182 at September 30, 2000; and 128,744,573 at December 31, 2000) 78,672 80,051 80,465 Capital surplus 103,765 104,868 115,775 Undivided profits 1,215,907 1,129,144 1,172,548 Accumulated other comprehensive income 33,722 (4,513) 14,598 Deferred compensation on restricted stock incentive plans (2,526) (4,400) (4,183) Deferred compensation obligation 7,161 4,953 4,953 - -------------------------------------------------------------------------------------------------- ------------- Total shareholders' equity 1,436,701 1,310,103 1,384,156 - -------------------------------------------------------------------------------------------------- ------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 19,683,002 $ 19,219,630 $ 18,555,086 ================================================================================================== ============= <FN> See accompanying notes to consolidated financial statements. </FN> </TABLE>
<TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF INCOME First Tennessee National Corporation - ---------------------------------------------------------------------------------------------------------------------------------- Three Months Ended Nine Months Ended September 30 September 30 ------------------------------- ------------------------------ (Dollars in thousands except per share data)(Unaudited) 2001 2000 2001 2000 - ---------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> INTEREST INCOME: Interest and fees on loans $ 195,088 $ 235,407 $ 626,568 $ 670,309 Interest on investment securities: Taxable 40,620 47,401 127,278 148,854 Tax-exempt 391 484 1,230 1,482 Interest on mortgage loans held for sale 37,918 54,541 117,856 157,778 Interest on trading securities 12,540 9,073 37,466 21,805 Interest on other earning assets 1,623 5,676 6,041 15,772 - ---------------------------------------------------------------------------------------------------------------------------------- Total interest income 288,180 352,582 916,439 1,016,000 - ---------------------------------------------------------------------------------------------------------------------------------- INTEREST EXPENSE: Interest on deposits: Savings 864 1,370 3,191 4,219 Checking interest and money market account 19,539 27,058 72,151 83,043 Certificates of deposit under $100,000 and other time 26,337 33,467 89,158 95,114 Certificates of deposit $100,000 and more 30,148 76,447 112,555 179,392 Interest on short-term borrowings 30,431 58,160 124,950 188,964 Interest on term borrowings 7,922 5,931 23,310 17,769 - ---------------------------------------------------------------------------------------------------------------------------------- Total interest expense 115,241 202,433 425,315 568,501 - ---------------------------------------------------------------------------------------------------------------------------------- NET INTEREST INCOME 172,939 150,149 491,124 447,499 Provision for loan losses 22,778 16,593 59,203 49,167 - ---------------------------------------------------------------------------------------------------------------------------------- NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 150,161 133,556 431,921 398,332 - ---------------------------------------------------------------------------------------------------------------------------------- NONINTEREST INCOME: Mortgage banking 189,644 116,406 481,395 309,553 Divestitures -- -- 81,467 40,921 Capital markets 90,268 37,598 234,818 80,935 Deposit transactions and cash management 35,258 30,631 94,692 86,775 Trust services and investment management 13,752 17,086 43,357 49,138 Merchant processing 11,780 12,958 34,740 36,298 Cardholder fees 5,402 7,683 14,982 21,658 Equity securities gains/(losses) 39 (269) (3,264) 206 Debt securities gains/(losses) (1) 35 (238) 1,245 All other income and commissions 30,185 39,074 96,821 107,696 - ---------------------------------------------------------------------------------------------------------------------------------- Total noninterest income 376,327 261,202 1,078,770 734,425 - ---------------------------------------------------------------------------------------------------------------------------------- ADJUSTED GROSS INCOME AFTER PROVISION FOR LOAN LOSSES 526,488 394,758 1,510,691 1,132,757 - ---------------------------------------------------------------------------------------------------------------------------------- NONINTEREST EXPENSE: Employee compensation, incentives and benefits 199,911 156,305 568,965 442,500 Amortization of mortgage servicing rights 29,524 21,366 82,738 57,749 Occupancy 17,898 17,947 53,460 58,055 Operations services 13,249 17,151 44,763 51,682 Equipment rentals, depreciation and maintenance 15,366 15,476 55,908 48,237 Communications and courier 12,296 11,875 35,392 36,171 Amortization of intangible assets 2,677 2,833 8,434 8,170 All other expense 104,318 67,283 297,361 202,204 - ---------------------------------------------------------------------------------------------------------------------------------- Total noninterest expense 395,239 310,236 1,147,021 904,768 - ---------------------------------------------------------------------------------------------------------------------------------- PRETAX INCOME 131,249 84,522 363,670 227,989 Applicable income taxes 42,240 18,575 123,275 67,096 - ---------------------------------------------------------------------------------------------------------------------------------- Income before debt restructurings and cumulative effect of changes in accounting principles 89,009 65,947 240,395 160,893 Debt restructurings -- -- (3,225) -- Cumulative effect of changes in accounting principles -- -- (8,168) -- - ---------------------------------------------------------------------------------------------------------------------------------- NET INCOME $ 89,009 $ 65,947 $ 229,002 $ 160,893 ================================================================================================================================== EARNINGS PER COMMON SHARE BEFORE DEBT RESTRUCTURINGS AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES (Note 3) $ .70 $ .51 $ 1.88 $ 1.24 EARNINGS PER COMMON SHARE (Note 3) .70 .51 1.79 1.24 - ---------------------------------------------------------------------------------------------------------------------------------- DILUTED EARNINGS PER COMMON SHARE BEFORE DEBT RESTRUCTURINGS AND CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES (Note 3) $ .68 $ .50 $ 1.82 $ 1.22 DILUTED EARNINGS PER COMMON SHARE (Note 3) .68 .50 1.74 1.22 - ---------------------------------------------------------------------------------------------------------------------------------- WEIGHTED AVERAGE SHARES OUTSTANDING 127,156,679 129,494,136 128,109,322 130,164,417 - ---------------------------------------------------------------------------------------------------------------------------------- <FN> See accompanying notes to consolidated financial statements. </FN> </TABLE>
<TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY First Tennessee National Corporation - --------------------------------------------------------------------------------------------- (Dollars in thousands)(Unaudited) 2001 2000 - --------------------------------------------------------------------------------------------- <S> <C> <C> BALANCE, JANUARY 1 $ 1,384,156 $ 1,241,467 Net income 229,002 160,893 Other comprehensive income: Cumulative effect of change in accounting principle 1,449 -- Unrealized market adjustments, net of tax and reclassification adjustment 17,675 17,238 - --------------------------------------------------------------------------------------------- Comprehensive income 248,126 178,131 - --------------------------------------------------------------------------------------------- Cash dividends declared (83,842) (85,462) Common stock issued: For exercise of stock options 63,268 6,813 Elliot Ames, Inc. acquisition -- 1,385 Tax benefit from non-qualified stock options 25,376 -- Common stock repurchased (214,982) (48,476) Amortization on restricted stock incentive plans 1,426 1,503 Other 13,173 14,742 - --------------------------------------------------------------------------------------------- BALANCE, SEPTEMBER 30 $ 1,436,701 $ 1,310,103 ============================================================================================= <FN> See accompanying notes to consolidated financial statements. </FN> </TABLE>
<TABLE> <CAPTION> CONSOLIDATED STATEMENTS OF CASH FLOWS First Tennessee National Corporation - ----------------------------------------------------------------------------------------------- Nine Months Ended September 30 -------------------------------- (Dollars in thousands)(Unaudited) 2001 2000 - ----------------------------------------------------------------------------------------------- <S> <C> <C> OPERATING ACTIVITIES: Net income $ 229,002 $ 160,893 Adjustments to reconcile net income to net cash provided/(used) by operating activities: Provision for loan losses 59,203 49,167 Provision for deferred income tax 6,595 32,213 Depreciation and amortization of premises and equipment 42,320 43,904 Amortization and impairment of mortgage servicing rights 169,934 57,749 Amortization of intangible assets 8,434 8,170 Net other amortization and accretion 10,220 31,138 Net increase in net derivative product assets (7,545) (7,781) Market value adjustment on foreclosed property 7,282 5,961 Loss on sale of securitized loans -- 1,315 Equity securities (gains)/losses 3,264 (206) Debt securities (gains)/losses 238 (1,245) Net losses on disposal of fixed assets 7,513 1,402 Gains on divestitures (81,467) (40,921) Net (increase)/decrease in: Trading securities (191,648) (435,185) Loans held for sale (459,320) 8,990 Capital markets receivables (1,016,575) (78,544) Interest receivable 20,973 (2,650) Other assets 80,136 (159,691) Net increase/(decrease)in: Capital markets payables 1,024,289 108,938 Interest payable (20,120) 695 Other liabilities 174,365 (31,440) - ----------------------------------------------------------------------------------------------- Total adjustments (161,909) (408,021) - ----------------------------------------------------------------------------------------------- Net cash (used)/provided by operating activities 67,093 (247,128) - ----------------------------------------------------------------------------------------------- INVESTING ACTIVITIES: Held to maturity securities: Maturities 123,817 102,640 Purchases -- (500) Available for sale securities: Sales 118,221 356,905 Maturities 541,807 414,520 Purchases (634,102) (578,837) Premises and equipment: Sales 174 723 Purchases (17,265) (33,007) Proceeds from loan securitizations -- 184,379 Net increase in loans (321,256) (1,041,935) Net increase in investment in bank time deposits (1,941) (1,167) Proceeds from divestitures 453,279 57,565 Acquisitions, net of cash and cash equivalents acquired (1,925) -- - ----------------------------------------------------------------------------------------------- Net cash (used)/provided by investing activities 260,809 (538,714) - ----------------------------------------------------------------------------------------------- FINANCING ACTIVITIES: Common stock: Exercise of stock options 60,320 6,831 Cash dividends (84,352) (85,777) Repurchase of shares (214,981) (48,542) Term borrowings: Issuance 324,151 101,200 Payments (190,333) (50,288) Net increase/(decrease) in: Deposits (390,287) 1,809,584 Short-term borrowings 263,566 (1,181,779) - ----------------------------------------------------------------------------------------------- Net cash (used)/provided by financing activities (231,916) 551,229 - ----------------------------------------------------------------------------------------------- Net increase/(decrease) in cash and cash equivalents 95,986 (234,613) - ----------------------------------------------------------------------------------------------- Cash and cash equivalents at beginning of period 960,399 1,235,614 - ----------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 1,056,385 $ 1,001,001 =============================================================================================== Total interest paid $ 444,858 $ 567,278 Total income taxes paid 90,208 86,228 - ----------------------------------------------------------------------------------------------- <FN> See accompanying notes to consolidated financial statements. </FN> </TABLE>
NOTE 1 - FINANCIAL INFORMATION The unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles. In the opinion of management, all necessary adjustments have been made for a fair presentation of financial position and results of operations for the periods presented. The operating results for the three-month and nine-month periods ended September 30, 2001, are not necessarily indicative of the results that may be expected going forward. For further information, refer to the audited consolidated financial statements and footnotes included in the financial appendix to the 2001 Proxy Statement. On June 30, 2001, the Financial Accounting Standards Board finalized Statement of Financial Accounting Standards No. 141, Business Combinations, and SFAS No. 142 Goodwill and Other Intangible Assets. Under SFAS No. 141 all business combinations initiated after June 30, 2001 must be accounted for using the purchase method. With the adoption of SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life. Rather, goodwill will be subject to an assessment for impairment using a fair-value-based test at least annually. Goodwill associated with equity-method investments is also no longer amortized, but impairment analysis is governed by existing impairment guidance for equity-method investments and not the new impairment rules. Also under the new rules, acquired intangible assets should be separately recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold or otherwise transferred, regardless of the acquirer's intent to do so. These new rules are expected to result in more intangible assets being separated from goodwill than generally occurs today. The resulting assets will be amortized over their useful lives. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001, which for First Tennessee will mean January 1, 2002. First Tennessee estimates the impact of adopting these new standards will be to reduce noninterest expense annually by approximately $7 million pre-tax without regard to any new acquisitions or future impairment that may occur, the effect of which cannot be predicted at this time. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS No. 144 addresses accounting and reporting issues related to the impairment of long-lived assets and for long-lived assets to be disposed of. This standard is effective for fiscal years beginning after December 15, 2001, which for First Tennessee will be January 1, 2002. First Tennessee anticipates the impact of adopting this standard will be immaterial. On January 1, 2001, First Tennessee adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" and EITF Issue 99-20: Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets. SFAS No. 133 establishes accounting standards requiring that every derivative instrument (including certain instruments embedded in other contracts) be recorded on the balance sheet as either an asset or liability measured at its fair value. It requires that changes in the instrument's fair value be recognized currently in earnings (or other comprehensive income). If certain criteria are met, changes in the fair value of the asset or liability being hedged are also recognized currently in earnings. Upon adoption of SFAS No. 133 all derivative instruments were measured at fair value with differences between the previous book value and fair value reported as part of a cumulative effect adjustment, except to the extent that they related to hedges of the variable cash flow exposure of forecasted transactions. To the extent the adoption adjustment related to hedges of the variable cash flow exposure of a forecasted transaction, the remainder of the accounting adjustment, a $1.4 million gain (after-tax) was reported as a cumulative effect adjustment of comprehensive income in first quarter 2001. Offsetting gains and losses on hedged assets and liabilities were recognized as adjustments of their respective book values at the adoption date as part of this cumulative effect adjustment. Additionally, EITF Issue 99-20, which provides impairment and interest income recognition and measurement guidance for interests retained in a securitization transaction accounted for as a sale, was adopted. The initial impact of adopting SFAS No. 133 and EITF Issue 99-20 was an $8.2 million loss
(after-tax) net transition adjustment that was recognized as the cumulative effect of a change in accounting principle in first quarter 2001. Fair value is determined on the last business day of a reporting period. This point in time measurement of derivative fair values and the related hedged item fair values may be well suited to the measurement of hedge effectiveness, as well as reported earnings, when hedge time horizons are short. The same measurement however may not consistently reflect the effectiveness of longer-term hedges and, in First Tennessee's view, can distort short-term measures of reported earnings. First Tennessee uses a combination of derivative financial instruments to hedge certain components of the interest rate risk associated with its portfolio of capitalized mortgage servicing rights, which currently have an average life of approximately seven years. Over this long-term time horizon this combination of derivatives can be effective in significantly mitigating the effects of interest rate changes on the value of the servicing portfolio. However, these derivative financial instruments can and do demonstrate significant price volatility depending upon prevailing conditions in the financial markets. If a reporting period ends during a period of volatile financial market conditions, the effect of such point in time conditions on reported earnings does not reflect the underlying economics of the transactions or the true value of the hedges to First Tennessee over their estimated lives. The fact that the fair value of a particular derivative is unusually low or high on the last day of the reporting period is meaningful in evaluating performance during the period only if First Tennessee sells the derivative within the period of time before fair value changes and does not replace the hedge coverage with another derivative. First Tennessee believes the effect of such volatility on short-term measures of earnings ($8.2 million pre-tax gain for the nine-month period ending September 30, 2001) is not indicative of the expected long-term performance of this hedging practice. Certain provisions of SFAS No. 133 continue to undergo significant discussion and debate by the Financial Accounting Standards Board (FASB). One such potential issue involves the assessment of hedge effectiveness (and its impact on qualifying for hedge accounting) when hedging fair value changes of prepayable assets due to changes in the benchmark interest rate. As the FASB continues to deliberate interpretation of the new rules, the potential exists for a difference between First Tennessee's interpretation and that of the FASB, the effects of which cannot presently be anticipated. Adoption of SFAS No. 133 was not retroactive, therefore, the manner in which derivatives historically have been accounted for was not affected, but significant changes have been made in accounting policies related to derivatives and hedges in 2001. Included below are certain accounting policies that were impacted by the adoption of SFAS No. 133. First Tennessee's mortgage lenders originate first-lien mortgage loans primarily for the purpose of selling them in the secondary market. Mortgage loans held for sale (the warehouse), are recorded at the lower of aggregate cost or market value. Gains and losses realized from the sale of these assets and adjustments to market value are included in noninterest income. In certain cases, mortgage banking continues to service securitized mortgage loans and has also retained interest-only strips. The interest-only strips are financial assets that represent rights to receive earnings from serviced assets that exceed contractually specified servicing fees and are recognized on the balance sheet at fair value in trading securities. Mortgage banking has also completed proprietary securitizations of loans from the warehouse with prime quality jumbo fixed rate loans. The resulting securities are sold as senior and subordinate bonds, while servicing rights and a principal cashflow tranche are retained. The retained principal-only strip (PO strip) is initially valued by allocating the total cost between the assets sold, the servicing right and the PO strip based on their relative fair values. The PO strip is recognized on the balance sheet at fair value in trading securities.
Servicing rights related to the mortgages sold have historically been mostly retained. Currently, only limited amounts of servicing rights are being retained as mortgage banking intends to curtail growth in the servicing portfolio. Accounting standards require the recognition of mortgage servicing rights (MSRs) as separate assets by allocating the total cost between the loan and the servicing right based on their relative fair values. First Tennessee uses a cash flow valuation model to determine the fair value of the servicing rights created. These valuations are tested for reasonableness against prices obtained from flow and bulk sales of servicing and are validated through an independent market valuation. Model assumptions are periodically reviewed and may be revised from time to time to more accurately reflect current assumptions such as prepayment speeds. For purposes of impairment evaluation and measurement, the MSRs are stratified based on the predominant risk characteristics of the underlying loans. These strata currently include adjustable and fixed rate loans. The fixed rate loans are further stratified by 150 basis-point interest rate bands. Previously the strata included adjustable rate conventional and government and fixed rate conventional and government by interest rate band. The MSRs are amortized as noninterest expense over the period of and in proportion to the estimated net servicing revenues. A quarterly value impairment analysis is performed using a discounted cash flow methodology that is disaggregated by predominant risk characteristics. Impairment, if any, is generally recognized through a valuation allowance for individual strata. Forward contracts used by mortgage banking operations to hedge against interest rate risk in the warehouse are reviewed periodically for correlation with expected changes in value. Interest rate derivative contracts used to hedge against interest rate risk in the servicing portfolio are designated to specific risk tranches of servicing. Derivative contracts utilized in trading activities by capital markets are measured at fair value, with changes in fair value recognized currently in capital markets noninterest income. Related assets are recorded on the balance sheet as capital markets securities inventory or receivables and any liabilities are recognized as capital markets payables. Any contracts that fail to qualify for hedge accounting are measured at fair value with any gains or losses included in current earnings in noninterest income. In September 2000, the FASB issued SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." This Statement replaces SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS No. 140 revises the standards for accounting for securitizations and other transfers of financial assets and collateral and requires substantial disclosures, but carries over most of SFAS No. 125's provisions without reconsideration. This Statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishment of liabilities. Those standards are based on consistent application of a financial-components approach that focuses on control. Under that approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished. This Statement provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. The disclosure provisions of the statement were effective immediately and have been adopted by First Tennessee. Other provisions became effective for transactions occurring after March 31, 2001. Adoption of the new provisions of SFAS No. 140 was not material to First Tennessee's consolidated financial position or results of operations. On January 1, 1999, First Tennessee adopted SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained after Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise." This Statement amends SFAS No. 65,
which required that retained securities be classified as trading securities. SFAS No. 134 allows these securities to be classified as trading, held to maturity or available for sale based on the intent and ability of the enterprise. On January 1, 1999, First Tennessee adopted Statement of Position 98-5, "Reporting on the Costs of Start-up Activities." This Statement requires that the costs of start-up activities, including organization costs, be expensed as incurred. The impact of adopting this standard was immaterial to First Tennessee.
NOTE 2 - DIVESTITURES/ACQUISITIONS On June 6, 2001, First Tennessee Bank National Association (FTBNA), the primary banking subsidiary of First Tennessee, along with its partner, International Business Machines Corporation (IBM) completed the sale of its interests in Check Solutions Company to Carreker Corporation of Dallas, Texas. First Tennessee recognized a divestiture gain of $44.9 million. On April 27, 2001, First Tennessee completed the sale of its wholly owned subsidiary, Peoples and Union Bank, of Lewisburg, Tennessee to First Farmers & Merchants National Bank, of Columbia, Tennessee. First Tennessee recognized a divestiture gain of $13.1 million. On April 2, 2001, FTBNA sold its existing portfolio of education loans totaling $342.1 million to Educational Funding of the South, Inc. The transaction resulted in a divestiture gain of $11.8 million. On January 17, 2001, FTBNA completed the sale of $31.4 million of its affinity, co-branded, and certain single relationship credit card accounts and assets, to MBNA Corporation for $37.9 million. The transaction resulted in a divestiture gain of $5.9 million. On October 18, 2000, FTBNA sold its corporate and municipal trust business to The Chase Manhattan Bank. This transaction resulted in an additional divestiture gain of $4.5 million due to an earn-out received in first quarter 2001. On November 15, 2000, First Tennessee Securities Corporation (FTSC), a wholly owned subsidiary of FTBNA, signed a definitive purchase agreement to acquire certain assets of Midwest Research-Maxus Group Limited, a Cleveland-based institutional equity research firm. This transaction was completed for approximately $13.7 million on January 2, 2001.
NOTE 3 - EARNINGS PER SHARE The following table shows a reconciliation of earnings per share to diluted earnings per share. <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30 September 30 ----------------------------- ------------------------------- (Dollars in thousands, except per share data) 2001 2000 2001 2000 - --------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Income before debt restructurings and cumulative effect of changes in accounting principles $ 89,009 $ 65,947 $ 240,395 $ 160,893 Debt restructurings -- -- (3,225) -- Cumulative effect of changes in accounting principles -- -- (8,168) -- - --------------------------------------------------------------------------------------------------------------------------- Net income $ 89,009 $ 65,947 $ 229,002 $ 160,893 =========================================================================================================================== Weighted average shares outstanding 126,275,965 128,880,550 127,355,285 129,626,781 Shares attributable to deferred compensation 880,714 613,586 754,037 537,636 - --------------------------------------------------------------------------------------------------------------------------- Total weighted average shares 127,156,679 129,494,136 128,109,322 130,164,417 =========================================================================================================================== EARNINGS PER COMMON SHARE: Income before debt restructurings and cumulative effect of changes in accounting principles $ .70 $ .51 $ 1.88 $ 1.24 Debt restructurings -- -- (.03) -- Cumulative effect of changes in accounting principles -- -- (.06) -- - --------------------------------------------------------------------------------------------------------------------------- Net income $ .70 $ .51 $ 1.79 $ 1.24 =========================================================================================================================== Weighted average shares outstanding 127,156,679 129,494,136 128,109,322 130,164,417 Dilutive effect due to stock options 3,701,735 1,521,154 3,763,035 1,634,388 - --------------------------------------------------------------------------------------------------------------------------- Total weighted average shares, as adjusted 130,858,414 131,015,290 131,872,357 131,798,805 =========================================================================================================================== DILUTED EARNINGS PER COMMON SHARE COMPUTATION: Income before debt restructurings and cumulative effect of changes in accounting principles $ .68 $ .50 $ 1.82 $ 1.22 Debt restructurings -- -- (.02) -- Cumulative effect of changes in accounting principles -- -- (.06) -- - --------------------------------------------------------------------------------------------------------------------------- Net income $ .68 $ .50 $ 1.74 $ 1.22 =========================================================================================================================== </TABLE>
NOTE 4 - LOANS The composition of the loan portfolio at September 30 is detailed below: <TABLE> <CAPTION> (Dollars in thousands) 2001 2000 - ---------------------------------------------------------------------------------------- <S> <C> <C> Commercial: Commercial, financial and industrial $ 4,046,209 $ 3,837,824 Real estate commercial 908,647 916,427 Real estate construction 453,020 423,303 Retail: Real estate residential 3,638,433 3,432,069 Real estate construction 196,063 164,199 Consumer 480,449 846,116 Credit card receivables 278,852 548,521 - ---------------------------------------------------------------------------------------- Loans, net of unearned income $10,001,673 $10,168,459 Allowance for loan losses 151,180 145,923 - ---------------------------------------------------------------------------------------- Total net loans $ 9,850,493 $10,022,536 ======================================================================================== </TABLE> The following table presents information concerning nonperforming loans at September 30: <TABLE> <CAPTION> (Dollars in thousands) 2001 2000 - ---------------------------------------------------------------------------------------- <S> <C> <C> Impaired loans $ 45,296 $ 15,736 Other nonaccrual loans 24,188 25,480 - ---------------------------------------------------------------------------------------- Total nonperforming loans $ 69,484 $ 41,216 ======================================================================================== </TABLE> Nonperforming loans consist of impaired loans, other nonaccrual loans and certain restructured loans. An impaired loan is a loan that management believes the contractual amount due probably will not be collected. Impaired loans are generally carried on a nonaccrual status. Nonaccrual loans are loans on which interest accruals have been discontinued due to the borrower's financial difficulties. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral is sufficient to recover the principal balance and accrued interest. Generally, interest payments received on impaired loans are applied to principal. Once all principal has been received, additional payments are recognized as interest income on a cash basis. The following table presents information concerning impaired loans: <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30 September 30 -------------------------------------------------------- (Dollars in thousands) 2001 2000 2001 2000 - ------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Total interest on impaired loans $ 213 $ 118 $ 405 $ 312 Average balance of impaired loans 50,442 12,351 52,979 9,203 - ------------------------------------------------------------------------------------------------- </TABLE> An allowance for loan losses is maintained for all impaired loans. Activity in the allowance for loan losses related to non-impaired loans, impaired loans, and for the total allowance for the nine months ended September 30, 2001 and 2000, is summarized as follows: <TABLE> <CAPTION> (Dollars in thousands) Non-impaired Impaired Total - ------------------------------------------------------------------------------------------- <S> <C> <C> <C> Balance on December 31, 1999 $ 136,978 $ 2,625 $ 139,603 Provision for loan losses 45,660 3,507 49,167 Securitization adjustment (2,173) -- (2,173) Charge-offs 43,185 3,798 46,983 Less loan recoveries 4,987 1,322 6,309 - ------------------------------------------------------------------------------------------- Net charge-offs 38,198 2,476 40,674 - ------------------------------------------------------------------------------------------- Balance on September 30, 2000 $ 142,267 $ 3,656 $ 145,923 =========================================================================================== Balance on December 31, 2000 $ 128,339 $15,357 $ 143,696 Provision for loan losses 44,405 14,798 59,203 Divestiture (1,337) -- (1,337) Charge-offs 44,246 14,497 58,743 Less loan recoveries 6,785 1,576 8,361 - ------------------------------------------------------------------------------------------- Net charge-offs 37,461 12,921 50,382 - ------------------------------------------------------------------------------------------- BALANCE ON SEPTEMBER 30, 2001 $ 133,946 $17,234 $ 151,180 =========================================================================================== </TABLE>
NOTE 5 - BUSINESS SEGMENT INFORMATION First Tennessee provides traditional retail/commercial banking and other financial services to its customers. These products and services are categorized into two broad groups: a regional banking group and national lines of business. The regional banking group provides a comprehensive package of financial services including traditional banking, trust services, investments, asset management, insurance, and credit card services to its customers. The national lines of business include mortgage banking, capital markets and transaction processing. The Other segment is used to isolate corporate items such as debt restructurings and the cumulative effect of changes in accounting principles SFAS No. 133 and EITF 99-20 which were adopted on January 1, 2001. The Other segment also includes expense related to guaranteed preferred beneficial interests in First Tennessee's junior subordinated debentures and securities gains or losses which include any venture capital gains or losses and related incentive costs. Total revenue, expense and asset levels reflect those which are specifically identifiable or which are allocated based on an internal allocation method. Because the allocations are based on internally developed assignments and allocations, they are to an extent subjective. This assignment and allocation has been consistently applied for all periods presented. The following table reflects the approximate amounts of consolidated revenue, expense, tax, and assets for the quarterly and year to date periods ending September 30, 2001 and 2000. <TABLE> <CAPTION> Regional Banking Mortgage Capital Transaction (Dollars in thousands) Group Banking Markets Processing Other Consolidated - ---------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> 3Q01 Interest income $ 215,605 $ 57,398 $ 10,448 $ 4,729 $ -- $ 288,180 Interest expense 74,727 31,741 8,469 304 -- 115,241 - ---------------------------------------------------------------------------------------------------------------------------- Net interest income 140,878 25,657 1,979 4,425 -- 172,939 Other revenues 68,754 193,109 90,601 23,825 38 376,327 Other expenses* 139,148 190,877 62,317 23,552 2,123 418,017 - ---------------------------------------------------------------------------------------------------------------------------- Pre-tax income 70,484 27,889 30,263 4,698 (2,085) 131,249 Income taxes 19,234 10,538 11,475 1,785 (792) 42,240 - ---------------------------------------------------------------------------------------------------------------------------- Net income $ 51,250 $ 17,351 $ 18,788 $ 2,913 $ (1,293) $ 89,009 ============================================================================================================================ Average assets $12,626,033 $ 4,539,356 $1,114,760 $556,296 $ -- $ 18,836,445 - ---------------------------------------------------------------------------------------------------------------------------- 3Q00 Interest income $ 261,387 $ 75,162 $ 11,598 $ 4,435 $ -- $ 352,582 Interest expense 127,672 63,579 10,643 539 -- 202,433 - ---------------------------------------------------------------------------------------------------------------------------- Net interest income 133,715 11,583 955 3,896 -- 150,149 Other revenues 75,109 119,631 37,598 29,098 (234) 261,202 Other expenses* 136,499 134,200 27,750 26,257 2,123 326,829 - ---------------------------------------------------------------------------------------------------------------------------- Pre-tax income 72,325 (2,986) 10,803 6,737 (2,357) 84,522 Income taxes 25,188 (12,335) 4,057 2,561 (896) 18,575 - ---------------------------------------------------------------------------------------------------------------------------- Net income $ 47,137 $ 9,349 $ 6,746 $ 4,176 $ (1,461) $ 65,947 ============================================================================================================================ Average assets $13,033,152 $ 5,237,054 $ 765,528 $540,145 $ -- $ 19,575,879 - ---------------------------------------------------------------------------------------------------------------------------- YEAR TO DATE 2001 Interest income $ 693,839 $ 178,511 $ 31,460 $ 12,629 $ -- $ 916,439 Interest expense 284,132 111,886 27,798 1,499 -- 425,315 - ---------------------------------------------------------------------------------------------------------------------------- Net interest income 409,707 66,625 3,662 11,130 -- 491,124 Other revenues 282,772 493,809 235,431 70,260 (3,502) 1,078,770 Other expenses* 458,842 503,005 163,004 75,004 6,369 1,206,224 - ---------------------------------------------------------------------------------------------------------------------------- Pre-tax income 233,637 57,429 76,089 6,386 (9,871) 363,670 Income taxes 74,376 21,396 28,828 2,426 (3,751) 123,275 - ---------------------------------------------------------------------------------------------------------------------------- Income before debt restructurings and cumulative effect of changes in accounting principles 159,261 36,033 47,261 3,960 (6,120) 240,395 Debt restructurings -- -- -- -- (3,225) (3,225) Cumulative effect of changes in accounting principles -- -- -- -- (8,168) (8,168) - ---------------------------------------------------------------------------------------------------------------------------- Net income $ 159,261 $ 36,033 $ 47,261 $ 3,960 $(17,513) $ 229,002 ============================================================================================================================ Average assets $12,868,503 $ 4,576,413 $ 994,805 $552,543 $ -- $ 18,992,264 - ---------------------------------------------------------------------------------------------------------------------------- Year to Date 2000 Interest income $ 754,332 $ 220,004 $ 29,229 $ 12,435 $ -- $ 1,016,000 Interest expense 352,897 186,915 27,164 1,525 -- 568,501 - ---------------------------------------------------------------------------------------------------------------------------- Net interest income 401,435 33,089 2,065 10,910 -- 447,499 Other revenues 205,765 360,056 81,774 85,379 1,451 734,425 Other expenses* 401,661 404,687 64,831 76,387 6,369 953,935 - ---------------------------------------------------------------------------------------------------------------------------- Pre-tax income 205,539 (11,542) 19,008 19,902 (4,918) 227,989 Income taxes 69,867 (15,534) 7,070 7,562 (1,869) 67,096 - ---------------------------------------------------------------------------------------------------------------------------- Net income $ 135,672 $ 3,992 $ 11,938 $ 12,340 $ (3,049) $ 160,893 ============================================================================================================================ Average assets $12,873,594 $ 5,256,025 $ 683,808 $559,715 $ -- $ 19,373,142 - ---------------------------------------------------------------------------------------------------------------------------- <FN> * Includes loan loss provision. </FN> </TABLE>
NOTE 6 - CONTINGENCIES In May 1996, FTBNA was named as a defendant in a purported nationwide class action lawsuit filed in federal court in Alabama in which plaintiffs assert that FTBNA and another defendant engaged in unfair and deceptive practices in connection with the financing of satellite dish television systems (satellite systems). The complaint alleges violations of the Truth in Lending Act (TILA) and the federal RICO statute, and fraud by suppression with respect to Alabama residents. In addition to these theories, plaintiffs proceed against FTBNA on an agency theory. This case has been certified as a nationwide class action on the TILA statutory damages claim which has a cap of $500,000 plus attorney fees. In addition to the Alabama lawsuit, in September 1997, a conditionally certified multi-state class action was filed in state court in Tennessee relating to the same satellite systems financing program. The complaint asserts that material facts were withheld from the purchasers in connection with the financing and that purchasers were misled as to the true nature and conditions of the program. The complaint also alleges unjust enrichment, violations of the Tennessee Consumer Protection Act, negligent training, supervision, and monitoring of persons presenting the terms of financing, as well as civil conspiracy and fraudulent concealment of the causes of action. Plaintiffs seek an accounting of monies received by FTBNA, unspecified compensatory damages, including treble damages as well as punitive damages, injunctive relief, attorney fees, costs, and expenses. The case is presently certified as a class action and FTBNA and First Tennessee have filed a request for an interlocutory appeal on this issue. Five additional satellite systems cases alleging similar causes of action have been filed in Mississippi. In one case, pending in federal court, plaintiffs seek $45 million in actual damages and $900 million in punitive damages. In two other satellite systems cases, filed in the Choctaw Tribal Court, plaintiffs seek unquantified actual and punitive damages, attorney fees, and injunctive relief. In a fourth case, filed by multiple plaintiffs in state court, plaintiffs demand unquantified compensatory and punitive damages, interest, and attorney fees. In a fifth case, also filed in state court, plaintiffs ask for actual, statutory, and compensatory damages of $1 million or greater and punitive damages of $5 million or greater for each of 32 plaintiffs, interest and attorney fees. FTBNA and First Tennessee deny liability, deny that any co-defendant is their agent, and intend to defend these actions vigorously. In 2001, the Tennessee Supreme Court affirmed the Court of Appeals judgment affirming an award of compensatory damages of $209,156 against FTBNA (as the successor by merger to Community Bank of Germantown) as well as a $60,000 award in favor of FTBNA against plaintiff, reversed the Court of Appeals' reversal of the award of punitive damages against FTBNA, vacated the trial court's award of punitive damages and remanded the case to the trial court to consider the record, take such additional evidence as necessary, and apply the factors outlined in a prior Tennessee Supreme Court opinion to arrive at an award of punitive damages. The punitive damages hearing, previously set for November 5, 2001, has been continued. No date has been set. In addition to these cases, various other claims and lawsuits are pending against First Tennessee and its subsidiaries. Although First Tennessee cannot predict the outcome of the foregoing actions, after consulting with counsel, it is management's opinion that when resolved, the amount, if any, will not have a material adverse effect on the consolidated financial statements of First Tennessee and its subsidiaries.
Numerous banks and other mortgage lenders, including a First Tennessee subsidiary, have been sued in actions seeking class certification in various courts by mortgage borrowers on the theory that yield spread premiums paid to mortgage brokers constitute referral fees in violation of the Real Estate Settlement Practices Act (RESPA). Under RESPA, the liability for an impermissible referral fee is three times the amount of the fees which are determined to be unlawful, and, accordingly, the amount of potential damages is substantial. The determination and the statements of the Eleventh Circuit referred to hereafter are inconsistent with holdings by other federal courts and in the HUD clarification of its policy statement mentioned below, HUD states that the Eleventh Circuit opinion is incorrect in its application of RESPA. On June 15, 2001, the Court of Appeals for the Eleventh Circuit issued an opinion against a lender unaffiliated with First Tennessee upholding class certification by the district court. Although the court's decision is procedural and does not contain a direct finding on liability, certain statements in the decision could be interpreted to suggest a liability standard, which would be favorable to the plaintiff borrowers. A petition for reconsideration of the Eleventh Circuit opinion and/or for rehearing of that appeal en banc was filed and denied. Subsequently, the Department of Housing and Urban Development issued a clarification of its 1999 Statement of Policy, regarding lender payments to mortgage brokers, which should be favorable to defendants. It is expected that the unaffiliated lender in the above mentioned case will file a petition for writ of certiorari before the United States Supreme Court. First Tennessee believes that its subsidiary's yield spread premium payments, which are consistent with industry practice, are lawful, and intends to defend vigorously the lawsuits against it. Because, however, the suits against the First Tennessee subsidiary are in an early stage of litigation, and the law in this area is not clearly established, First Tennessee cannot at this time evaluate with any degree of precision either the likelihood of an unfavorable outcome or the dollar amount of any potential loss exposure.
ITEM 2. FIRST TENNESSEE NATIONAL CORPORATION MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION GENERAL INFORMATION - ------------------- First Tennessee National Corporation (First Tennessee) is headquartered in Memphis, Tennessee, and is a nationwide, diversified financial services institution which provides banking and other financial services to its customers through various regional and national business lines. The Regional Banking Group includes the retail/commercial bank, the credit card division, and the trust division. The National Lines of Business include First Horizon Home Loan Corporation (also referred to as First Horizon Home Loans and mortgage banking), First Tennessee Capital Markets (also referred to as capital markets), and transaction processing (credit card merchant processing, payment processing operation, and check clearing). Based on management's best estimates, certain revenue and expenses are allocated and equity is assigned to the various business lines to reflect the inherent risk in each business line. These allocations are periodically reviewed and may be revised from time to time to more accurately reflect current business conditions and risks; the previous history is restated to ensure comparability. For the purpose of this management discussion and analysis (MD&A), noninterest income (also called fee income) and total revenue exclude securities gains and losses. Net interest income has been adjusted to a fully taxable equivalent (FTE) basis for certain tax-exempt loans and investments included in earning assets. Earning assets, including loans, have been expressed as averages, net of unearned income. First Tennessee Bank National Association, the primary bank subsidiary, is also referred to as FTBNA in this discussion. The following is a discussion and analysis of the financial condition and results of operations of First Tennessee for the three-month and nine-month periods ended September 30, 2001, compared to the three-month and nine-month periods ended September 30, 2000. To assist the reader in obtaining a better understanding of First Tennessee and its performance, this discussion should be read in conjunction with First Tennessee's unaudited consolidated financial statements and accompanying notes appearing in this report. Additional information including the 2000 financial statements, notes, and management's discussion and analysis is provided in the 2000 Annual Financial Disclosures and 2001 Proxy Statement. FORWARD-LOOKING STATEMENTS - -------------------------- Management's discussion and analysis may contain forward-looking statements with respect to First Tennessee's beliefs, plans, goals, expectations, and estimates. These statements are contained in certain sections that follow such as Noninterest Income, Net Interest Income and Other. Forward-looking statements are statements that are not based on historical information but rather are related to future operations, strategies, financial results or other developments. The words "believe", "expect", "anticipate", "intend", "estimate", "should", "is likely", "going forward", and other expressions which indicate future events and trends identify forward-looking statements. Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond a company's control, and many of which, with respect to future business decisions and actions (such as acquisitions and divestitures), are subject to change. Examples of uncertainties and contingencies include, among other important factors, general and local economic and business conditions; expectations of and actual timing and amount of interest rate movements (which can have a significant impact on a financial services institution); market and monetary fluctuations; inflation; competition within and outside the financial services industry; possible terrorist activity; technology; and new products and services in the industries in which First Tennessee operates. Other factors are those inherent in originating and servicing loans, including prepayment risks and fluctuation of collateral values and changes in customer profiles. Additionally, the policies of the Office of the Comptroller of the Currency (OCC) and the Board of Governors of the Federal Reserve System, unanticipated regulatory and judicial
proceedings, and changes in laws and regulations applicable to First Tennessee and First Tennessee's success in executing its business plans and strategies and managing the risks involved in the foregoing, could cause actual results to differ. First Tennessee assumes no obligation to update any forward-looking statements that are made from time to time. FINANCIAL SUMMARY (COMPARISON OF THIRD QUARTER 2001 TO THIRD QUARTER 2000) Reported earnings for third quarter 2001 were $89.0 million, an increase of 35 percent from last year's third quarter earnings of $66.0 million. Diluted earnings per common share were $.68 in 2001, an increase of 36 percent from the $.50 earned in 2000. Return on average shareholders' equity was 25.4 percent and return on average assets was 1.87 percent for third quarter 2001. For the same period in 2000, return on average shareholders' equity was 20.6 percent and return on average assets was 1.34 percent. On September 30, 2001, First Tennessee was ranked as one of the top 50 bank holding companies nationally in market capitalization ($4.7 billion) and total assets ($19.7 billion). On September 30, 2000, market capitalization was $2.6 billion and total assets were $19.2 billion. Total revenue increased 33 percent from third quarter 2000, with a 44 percent increase in fee income (noninterest income excluding securities gains and losses) and a 15 percent increase in net interest income. NONINTEREST INCOME - ------------------ Fee income provides the majority of First Tennessee's revenue. In third quarter 2001, fee income contributed 68 percent to total revenues compared with 64 percent for the same period in 2000. Third quarter 2001 fee income increased 44 percent to $376.4 million, from $261.5 million for 2000. Fee income in capital markets and mortgage banking increased 140 percent and 63 percent, respectively, over the levels achieved in third quarter 2000. A more detailed discussion follows. MORTGAGE BANKING First Horizon Home Loans, a subsidiary of FTBNA, originates and services residential mortgage loans. Following origination, the mortgage loans, primarily first-lien, are sold to investors in the secondary market while a majority (approximately 74 percent in third quarter 2001) of the rights to service such loans are sold under flow servicing sales agreements (in prior years a majority of the rights were retained). Various hedging strategies are used to mitigate changes in the market value of the loan during the time period beginning with a price commitment to the customer and ending when the loan is delivered to the investor. Closed loans held during this time period are referred to as the mortgage warehouse. Origination fees and gains or losses from the sale of loans are recognized at the time a mortgage loan is sold into the secondary market. Subsequent to the 2001 adoption of new accounting standards related to derivatives (Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133) and EITF 99-20), a portion of the gain or loss formerly recognized with the sale of a mortgage loan is now recognized at the time an interest rate lock commitment is made to the customer. Secondary marketing activities include gains or losses from mortgage warehouse hedging activities, product pricing decisions, and gains or losses from the sale of loans into the secondary market including the capitalized net present value of mortgage servicing rights. Servicing rights permit the collection of fees for gathering and processing monthly mortgage payments for the owner of the mortgage loans. First Horizon Home Loans employs hedging strategies intended to counter a change in the value of its mortgage servicing rights through changing interest rate environments. Miscellaneous income includes servicing rights net value changes (see also Other - Accounting for Derivative Instruments and Hedging Activities), income from the foreclosure repurchase program and other miscellaneous items including net gains or losses related to rebalancing hedges of mortgage servicing rights in 2000.
Mortgage banking fee income increased 63 percent to $189.7 million from $116.4 million for third quarter 2000 as shown in Table 1. TABLE 1 - MORTGAGE BANKING <TABLE> <CAPTION> Third Quarter Nine Months ------------------------- Growth -------------------------- Growth (Dollars in millions) 2001 2000 Rate (%) 2001 2000 Rate (%) - -------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> NONINTEREST INCOME: Loan origination fees $ 46.9 $ 36.1 29.7 $ 134.1 $ 96.6 38.9 Secondary marketing activities 82.1 38.1 115.7 204.5 83.4 145.3 - -------------------------------------------------------------------------------------------------------------------------------- Mortgage origination function 129.0 74.2 73.8 338.6 180.0 88.2 - -------------------------------------------------------------------------------------------------------------------------------- Servicing fees 40.3 41.5 (2.8) 119.3 119.3 .1 Gains/(losses) from trading securities 1.9 -- N/A (5.2) -- N/A Bulk sales of mortgage servicing rights -- (1.1) N/A -- 12.6 N/A Miscellaneous 18.5 1.8 903.5 28.7 (2.3) N/A - -------------------------------------------------------------------------------------------------------------------------------- Total noninterest income $ 189.7 $ 116.4 62.9 $ 481.4 $ 309.6 55.5 ================================================================================================================================ Refinance originations $ 2,904.1 $ 632.7 359.0 $ 9,727.8 $ 1,945.6 400.0 Home purchase-related originations 2,692.2 3,062.3 (12.1) 7,793.1 9,544.4 (18.3) - -------------------------------------------------------------------------------------------------------------------------------- Mortgage loan originations $ 5,596.3 $ 3,695.0 51.5 $17,520.9 $11,490.0 52.5 ================================================================================================================================ Servicing portfolio $44,221.4 $47,326.1 (6.6) $44,221.4 $47,326.1 (6.6) - -------------------------------------------------------------------------------------------------------------------------------- </TABLE> Origination activity increased 51 percent due to the impact that lower interest rates had on refinance activity, which increased $2.3 billion. Total origination volume, consisting of home purchase-related mortgages and refinanced mortgages was $5.6 billion in third quarter 2001 compared with $3.7 billion in the previous year. Home purchase-related mortgage originations decreased $.4 billion primarily due to the closing or other disposition of less profitable production offices in 2000. Fees from the mortgage origination process (loan origination fees, profits from the sale of loans, flow sales of mortgage servicing rights, and other secondary marketing activities) increased 74 percent to $129.0 million from $74.2 million in third quarter 2000. This increase was primarily the result of more loans sold into the secondary market due to increased production, improved margin management, and improvement in the results in hedging and other loan sale activities, as well as the recognition this year of the value of interest rate lock commitments. While the growth in refinance activity produced increased fee income, the impact of increased expenses from amortization and write-downs of mortgage servicing rights (See also Noninterest Expense) offset much of this revenue. Going forward, based upon a continuation of the trend in declining interest rates, the origination volume is expected to continue. Home purchase-related mortgage originations should reflect the relative strength of the economy, but should decrease from third quarter levels due to the seasonality of homebuyers' buying habits. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion. The mortgage servicing portfolio (which includes servicing for ourselves and others) decreased to $44.2 billion on September 30, 2001, from $47.3 billion on September 30, 2000, due to our stated goal of reducing its size. Mortgage servicing fees for third quarter 2001 were $40.3 million compared with $41.5 million for the same period in 2000. In third quarter 2001, there were no bulk purchases or sales of mortgage servicing rights. For third quarter 2001 a net gain of $1.9 million related to market value adjustments on interest only strips that were classified as trading securities in first quarter 2001 and related hedges was recognized in mortgage banking income. Miscellaneous mortgage income totaled $18.5 million for third quarter 2001, which included $13.2 million of net gains on hedges associated with write-downs of mortgage servicing rights (See also Noninterest Expense) of which $4.5 million is nonoperating servicing rights net value changes under SFAS No. 133 (See also Accounting for Derivative Instruments and Hedging Activities). This compares to miscellaneous mortgage income of $1.8 million in
third quarter 2000, which included $2.7 million in net losses on hedge instruments associated with the mortgage servicing portfolio. CAPITAL MARKETS First Tennessee Capital Markets generates fee income primarily from the purchase and sale of securities as both principal and agent. Inventory positions are limited to the procurement of securities solely for distribution to customers by the sales staff. Inventory is effectively hedged to protect against movements in interest rates. For third quarter 2001, capital markets fee income increased 140 percent to $90.3 million from $37.6 million in 2000. Total underwritings during third quarter 2001 were $15.1 billion compared to $2.9 billion for the same period in 2000. Total securities bought and sold were $339.2 billion for third quarter 2001, up from $197.4 billion for the same period in 2000. This increased activity reflects continued growth and penetration into our targeted institutional customer base and changes in product mix. Additionally, fee income was favorably impacted during third quarter 2001 by revenues from new products and services that capital markets began offering in the second half of 2000. These sources of revenue include portfolio advisory, underwriting for financial institutions, various other investment banking services, and the acquisition in first quarter 2001 of MidWest Research Group. This quarter's results include $25.9 million in revenues related to these new products and services, compared to $7.8 million in third quarter 2000. Additionally, capital markets 2001 fee income has benefited from an improvement from last year's distressed market conditions. Going forward, market conditions are likely to stabilize, and new products and services will continue to impact revenues favorably. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A. OTHER FEE INCOME Fee income from deposit transactions and cash management for third quarter 2001 increased 15 percent to $35.3 million from $30.7 million in 2000. Trust services and investment management fees decreased 20 percent to $13.8 million from $17.0 million in 2000, primarily due to the divestiture of corporate and municipal trust in fourth quarter 2000 and a decline in market values of managed portfolios which fell 15 percent to $8.3 billion on September 30, 2001, from $9.8 billion on September 30, 2000. Third quarter 2001 fee income from merchant processing decreased 9 percent to $11.7 million from $13.0 million in 2000 primarily due to a further slowdown in the hospitality industry. Cardholder fees decreased 30 percent to $5.4 million from $7.7 million in third quarter 2000 primarily due to the sales of certain single relationship credit card accounts in fourth quarter 2000 and first quarter 2001. All other income and commissions decreased 23 percent to $30.2 million from $39.1 million in third quarter 2000 primarily due to the sales of the MONEY BELT(R) ATM network in fourth quarter 2000 and First Tennessee's interest in Check Solutions Company in second quarter 2001. NET INTEREST INCOME - ------------------- Net interest income increased 15 percent to $173.5 million from $150.8 million in third quarter 2000, primarily due to lower funding costs. Earning assets decreased 4 percent to $15.8 billion in third quarter 2001 from $16.4 billion for the same period in 2000. The consolidated net interest margin (margin) increased to 4.39 percent for third quarter 2001 compared with 3.68 percent in 2000. The margin was positively impacted by the lower funding costs and improvement in the negative impact from mortgage banking due to a steeper yield curve. For third quarter 2001, the regional banking group's margin increased to 5.19 percent from 4.80 percent primarily due to the lower funding costs. Table 2 details the computation of the net interest margin for the regional banking group and the impact that the other business lines had on the consolidated margin for the third quarters of 2001 and 2000.
TABLE 2 - NET INTEREST MARGIN <TABLE> <CAPTION> Third Quarter ---------------------- 2001 2000 - ----------------------------------------------------------------------------------- <S> <C> <C> REGIONAL BANKING GROUP: Yields on earning assets 7.34 % 8.63 % Rates paid on interest-bearing liabilities 3.05 4.95 - ----------------------------------------------------------------------------------- Net interest spread 4.29 3.68 - ----------------------------------------------------------------------------------- Effect of interest-free sources .74 .97 Loan fees .16 .14 FRB interest and penalties -- .01 - ----------------------------------------------------------------------------------- Net interest margin - Regional banking group 5.19 % 4.80 % MORTGAGE BANKING (.58) (.98) CAPITAL MARKETS (.24) (.16) TRANSACTION PROCESSING .02 .02 - ----------------------------------------------------------------------------------- Net interest margin 4.39 % 3.68 % =================================================================================== </TABLE> As shown in Table 2, the margin is affected by the activity levels and related funding for First Tennessee's national lines of business as these nonbank business lines typically produce different margins than traditional banking activities. Mortgage banking can affect the overall margin based on a number of factors, including the size of the mortgage warehouse, the time it takes to deliver loans into the secondary market, the amount of custodial balances, and the level of mortgage servicing rights. Capital markets tends to compress the margin because of its strategy to reduce market risk by hedging its inventory in the cash markets which effectively eliminates net interest income on these positions. As a result, First Tennessee's consolidated margin cannot be readily compared to that of other bank holding companies. Going forward, if short-term rates remain at current levels and the slope of the yield curve does not flatten, the margin is likely to remain stable. Given the current operating environment, with historically low short-term interest rates, First Tennessee's margin may begin to move toward a more normal level as the yield curve flattens; however, it should remain favorable to this year's average level. However, the consolidated margin will continue to be influenced by the activity levels in the nonbanking lines of business, especially mortgage banking. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion. NONINTEREST EXPENSE - ------------------- Total noninterest expense for third quarter 2001 increased 27 percent to $395.2 million from $310.2 million in 2000. The type and level of activity in mortgage banking and capital markets effect changes in personnel and total noninterest expense. Excluding mortgage banking and capital markets, total noninterest expense decreased 4 percent. Going forward, capital markets, mortgage banking and investments in efficiency and revenue enhancement programs will influence the level of noninterest expense. Employee compensation, incentives and benefits (personnel expense), the largest component of noninterest expense, increased 28 percent in third quarter 2001, primarily due to higher activity levels in mortgage banking and capital markets. Excluding mortgage banking and capital markets, personnel expense decreased 1 percent. Additional business line information related to expenses is provided in Table 3 and the discussion that follows.
TABLE 3 - NONINTEREST EXPENSE COMPOSITION <TABLE> <CAPTION> Third Quarter Nine Months ------------------------ Growth ----------------------- Growth (Dollars in millions) 2001 2000 Rate(%) 2001 2000 Rate(%) - ----------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Mortgage banking $ 190.0 $ 134.2 41.6 $ 499.3 $ 404.7 23.4 Regional banking group 117.2 119.9 (2.3) 403.3 352.5 14.4 Capital markets 62.3 27.7 124.6 163.0 64.8 151.4 Transaction processing 23.5 26.2 (10.3) 75.0 76.4 (1.8) Other 2.2 2.2 -- 6.4 6.4 -- - ----------------------------------------------------------------------------------------------------------------------------- Total operating expense $ 395.2 $ 310.2 27.4 $1,147.0 $ 904.8 26.8 ============================================================================================================================= </TABLE> Mortgage banking expenses increased 42 percent from the previous year. Expense growth for this business line varies with the volume and type of activity. The increase was impacted by a $21.9 million write-down of the book value of mortgage servicing rights due primarily to the increase in actual mortgage prepayments over the projected level as a result of the decrease in mortgage interest rates since third quarter 2000. Also impacting this growth rate was $22.7 million in loss from the establishment of a mortgage servicing rights impairment valuation reserve primarily due to the increase in expected future prepayment speeds (see also Noninterest Income - Mortgage Banking for increase in refinance origination volume). In addition, amortization of mortgage servicing rights increased 38 percent to $29.5 million in third quarter 2001 from $21.3 million in 2000 primarily due to faster projected prepayment speeds associated with lower mortgage interest rates. The increase was also impacted by growth in personnel expense, due to the higher activity levels in third quarter 2001. Partially offsetting these increases was a decrease of $9.7 million in the amount of hedge expense reflected in noninterest expense due to the repositioning of the mortgage servicing hedge portfolio in 2000 and the adoption of SFAS No. 133 in 2001. Going forward, the levels of amortization and write-downs of mortgage servicing rights will be influenced by the volume of mortgages refinanced from the servicing portfolio. Capital markets expenses grew 125 percent from third quarter 2000 primarily due to higher commissions and incentives recognized in third quarter 2001 which caused total personnel expense for this segment to increase 135 percent, or $32.0 million from 2000. Expenses for the regional banking group decreased 2 percent from third quarter 2000, and transaction processing expenses for third quarter 2001 decreased 10 percent from the previous year. The decreases in these segments were primarily due to divestitures and efficiency programs implemented since fourth quarter 2000. PROVISION FOR LOAN LOSSES/ASSET QUALITY - --------------------------------------- The provision for loan losses is the charge to operating earnings that management determines to be necessary to maintain the allowance for loan losses at an adequate level reflecting management's estimate of the risk of loss inherent in the loan portfolio. An analytical model based on historical loss experience, current trends and economic conditions, and reasonable foreseeable events is used to determine the amount of provision to be recognized and to test the adequacy of the loan loss allowance. The provision for loan losses increased for third quarter 2001 to $22.8 million from $16.5 million in third quarter 2000, reflecting economic conditions including the impact of increased nonperforming loans and higher charge-offs. The ratio of allowance for loan losses to total loans, net of unearned income, was 1.51 percent on September 30, 2001, compared to 1.44 percent on September 30, 2000. Additional asset quality information is provided in Table 4 - Asset Quality Information and Table 5 - Charge-off Ratios.
TABLE 4 - ASSET QUALITY INFORMATION <TABLE> <CAPTION> September 30 ---------------------------- (Dollars in thousands) 2001 2000 - --------------------------------------------------------------------------------------------- <S> <C> <C> REGIONAL BANKING GROUP: Nonperforming loans $ 46,593 $ 15,527 Foreclosed real estate 8,160 5,183 Other assets 140 94 - --------------------------------------------------------------------------------------------- Total nonperforming assets - Regional Banking Group 54,893 20,804 - --------------------------------------------------------------------------------------------- MORTGAGE BANKING: Nonperforming loans 22,891 25,689 Foreclosed real estate 10,658 10,486 - --------------------------------------------------------------------------------------------- Total nonperforming assets - Mortgage Banking 33,549 36,175 - --------------------------------------------------------------------------------------------- Total nonperforming assets $ 88,442 $ 56,979 ============================================================================================= Loans and leases 30 to 89 days past due $ 93,836 $100,734 Loans and leases 90 days past due $ 35,101 $ 36,365 Potential problem assets* $108,141 $110,651 </TABLE> <TABLE> <CAPTION> Third Quarter ---------------------------- 2001 2000 ---------------------------- <S> <C> <C> ALLOWANCE FOR LOAN LOSSES: Beginning balance at June 30 $ 148,658 $ 142,722 Provision for loan losses 22,778 16,593 Charge-offs (23,542) (15,574) Loan recoveries 3,286 2,182 - --------------------------------------------------------------------------------------------- Ending balance at September 30 $ 151,180 $ 145,923 ============================================================================================= </TABLE> <TABLE> <CAPTION> September 30 --------------------- 2001 2000 --------------------- <S> <C> <C> Allowance to total loans 1.51% 1.44% Allowance to nonperforming loans 218 354 Nonperforming assets to total loans, foreclosed real estate and other assets (Regional Banking Group only) .60 .22 Nonperforming assets to unpaid principal balance of servicing portfolio (Mortgage Banking only) .08 .08 - ---------------------------------------------------------------------------------------------- <FN> * Includes loans and leases 90 days past due. </FN> </TABLE> The ratio of total net charge-offs to average loans increased to .81 percent for third quarter 2001 from .53 percent for third quarter 2000. The increase in commercial loan net charge-offs from the unsustainable low levels in the third quarter of 2000 was primarily from loans to two Tennessee domiciled commercial customers that were previously classified as nonperforming loans since third quarter 2000. The increase in consumer loan net charge-offs was due to deterioration in economic conditions and increased charge-offs of loans with a higher risk and reward profile. The credit card receivables charge-off ratio decreased to 3.99 percent for third quarter 2001 from 4.39 percent for third quarter 2000, due primarily to the sale of the single relationship credit card accounts.
TABLE 5 - CHARGE-OFF RATIOS <TABLE> <CAPTION> Third Quarter -------------------- 2001 2001 - -------------------------------------------------------------------------------- <S> <C> <C> Commercial .48% .01% Consumer real estate .82 .39 Other consumer 2.58 1.86 Credit card receivables 3.99 4.39 Total net charge-offs .81 .53 - -------------------------------------------------------------------------------- </TABLE> As regional banking group nonperforming assets increased to $54.9 million on September 30, 2001, the ratio of nonperforming assets to total loan increased to .60 percent. This compares to nonperforming assets of $20.8 million on September 30, 2000, and a nonperforming assets ratio of .22 percent. The growth in nonperforming assets occurred primarily due to two large Tennessee domiciled commercial customers and related parties with total balances of approximately $24 million that were classified as nonperforming loans since third quarter 2000. Mortgage banking nonperforming assets decreased $2.7 million to $33.5 million on September 30, 2001. First Tennessee has not sold any nonperforming loans during 2001 but continues to internally resolve asset quality issues. On September 30, 2001, First Tennessee had no concentrations of 10 percent or more of total loans in any single industry. Recent acts of terrorism have had a negative impact on the passenger airline and property and casualty insurance industries. First Tennessee does not have a material credit exposure in these industries. Going forward, asset quality indicators should reflect the relative strength of the economy and the resolution of existing asset quality issues. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion. INCOME TAX EXPENSE - ------------------ The effective tax rate for third quarter 2001 was 32 percent up from 22 percent for third quarter 2000. This variance was primarily due to a tax benefit last year related to the issuance of cumulative preferred stock by an affiliate of First Tennessee in third quarter 2000. BALANCE SHEET REVIEW EARNING ASSETS - -------------- Earning assets primarily consist of loans, loans held for sale and investment securities. For third quarter 2001, earning assets averaged $15.8 billion compared with $16.4 billion for third quarter 2000. On September 30, 2001, First Tennessee reported total assets of $19.7 billion compared with $19.2 billion on September 30, 2000. Average total assets decreased 4 percent to $18.8 billion from $19.6 billion in third quarter 2000. LOANS Since third quarter 2000, First Tennessee has sold approximately $300 million of its single-relationship credit card receivables, approximately $340 million of student loans, and Peoples and Union Bank with total loans of approximately $110 million. Excluding the impact of these divestitures, average loans increased approximately 13 percent since third quarter 2000 with growth in commercial loans of 5 percent and approximately 8 percent growth in retail loans. Including the impact of these divestitures, average loans decreased 1 percent to $10.0 billion from $10.1 billion in 2000 and retail loans decreased 7 percent. Additional loan information is provided in Table 6.
TABLE 6 - AVERAGE LOANS <TABLE> <CAPTION> Three Months Ending September 30 ----------------------------------------------------------------------- PERCENT GROWTH Percent (Dollars in thousands) 2001 OF TOTAL RATE 2000 of Total - ------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Commercial: Commercial, financial and industrial $ 4,028.5 41% 5.0 % $ 3,837.8 38% Real estate commercial 930.9 9 3.2 902.0 9 Real estate construction 435.4 4 4.7 416.0 4 Retail: Real estate residential 3,609.3 36 7.5 3,358.4 34 Real estate construction 184.4 2 18.7 155.3 2 Other consumer 484.1 5 (42.2) 837.1 8 Credit card receivables 279.4 3 (48.9) 546.7 5 - ------------------------------------------------------------------------------------------------------------------------- Total loans, net of unearned $ 9,952.0 100% (1.0)% $10,053.3 100% ========================================================================================================================= </TABLE> During years prior to 2001 certain retail loans have been securitized. The majority of these securities are owned by subsidiaries of First Tennessee, including FTBNA, and are classified as investment securities. LOANS HELD FOR SALE/INVESTMENT SECURITIES Loans held for sale, consisting primarily of mortgage loans, decreased 18 percent to $2.2 billion from $2.7 billion due to the earlier delivery of loans out of the warehouse in 2001. Average investment securities decreased 9 percent in third quarter 2001 to $2.5 billion from $2.8 billion primarily due to certain securities available for sale being transferred to trading securities and declining balances of retained securitization interests, which are paying down without being replenished. DEPOSITS AND OTHER SOURCES OF FUNDS - ----------------------------------- Since the third quarter of 2000, total average core deposits increased 3 percent to $9.2 billion from $8.9 billion. While interest-bearing core deposits remained relatively flat at $5.9 billion, noninterest-bearing core deposits increased 12 percent to $3.3 billion from $3.0 billion primarily due to expanded usage of a cash management investment product and growth in mortgage escrow accounts. Short-term purchased funds decreased 21 percent to $6.5 billion from $8.2 billion for the previous year as an increase in core deposits provided additional funding and the mortgage warehouse, which is funded with purchased funds, decreased. CAPITAL - ------- Total capital (shareholders' equity plus qualifying capital securities and subsidiary preferred stock) on September 30, 2001, was $1.6 billion, up 12 percent from $1.4 billion on September 30, 2000. Shareholders' equity (excluding the qualifying capital securities and subsidiary preferred stock) was $1.4 billion on September 30, 2001, an increase of 10 percent from $1.3 billion on September 30, 2000. The increase in total capital was primarily due to the retention of net income after dividends. The change in capital was reduced by share repurchases, primarily related to stock option exercises, which totaled $215.0 million, or 6.5 million shares, since September 30, 2000. On October 16, 2001, the board of directors approved the repurchase of 4.2 million shares of First Tennessee's common stock for use in connection with various stock option plans. The repurchases will occur within the option exercise period. In addition the board of directors extended from June 30, 2002, until December 31, 2004, the non-stock option plan-related repurchases of shares, previously approved in October 2000. Repurchases will be made in the open market or through privately negotiated transactions and will be subject to market conditions, accumulation of excess equity and prudent capital management.
Average shareholders' equity increased 9 percent since third quarter 2000 to $1.4 billion from $1.3 billion, reflecting internal capital generation. The average total equity to average assets ratio was 8.14 percent and the average shareholders' equity to average assets ratio was 7.37 percent for third quarter 2001. This compares with 7.01 percent and 6.50 percent, respectively, for third quarter 2000. Unrealized market valuations had no material effect on the ratios during third quarter 2001. On September 30, 2001, the corporation's Tier 1 capital ratio was 9.19 percent, the total capital ratio was 12.46 percent and the leverage ratio was 7.34 percent. On September 30, 2001, First Tennessee's bank affiliates had sufficient capital to qualify as well-capitalized institutions. FINANCIAL SUMMARY (COMPARISON OF FIRST NINE MONTHS OF 2001 TO FIRST NINE MONTHS OF 2000) Earnings for 2001 were $240.4 million before debt restructurings and the cumulative effect of changes in accounting principles related to derivatives (SFAS No. 133 and EITF 99-20). Diluted earnings per common share before debt restructurings and the cumulative effect of changes in accounting principles were $1.82 in 2001. Earnings for 2001 after debt restructurings and the cumulative effect of changes in accounting principles were $229.0 million or $1.74 diluted earnings per common share. Earnings in 2000 were $160.9 million or $1.22 diluted earnings per common share. For the first nine months of 2001, return on average shareholders' equity was 22.2 percent and return on average assets was 1.61 percent, while in 2000 these ratios were 17.0 percent and 1.11 percent, respectively. Total revenue increased 33 percent, with a 48 percent increase in fee income and a 10 percent increase in net interest income. Fee income contributed 69 percent to total revenue in 2001 compared with 62 percent in 2000. INCOME STATEMENT REVIEW - ----------------------- Noninterest income, excluding securities gains and losses, increased 48 percent for the first nine months of 2001 to $1,082.3 million from $733.0 million for the same period last year. Mortgage banking fee income increased 56 percent to $481.4 million from $309.6 million. See Table 1 - Mortgage Banking for a breakout of noninterest income as well as mortgage banking origination volume and servicing portfolio levels. Fee income from capital markets increased 190 percent to $234.8 million from $80.9 million for 2000. For the first nine months of 2001, fee income in deposit transactions and cash management grew 9 percent to $94.7 million from $86.8 million. For 2001, gains from divestitures were $81.5 million due to gains from the sale of First Tennessee's partnership interest in Check Solutions Company ($45 million), the sale of Peoples and Union Bank ($13 million), the sale of a portfolio of student loans ($12 million), the sale of certain single relationship credit card accounts ($7 million), and an earn-out in 2001 related to the fourth quarter 2000 divestiture of First Tennessee's corporate and municipal trust business ($4 million). There were divestiture gains of $40.9 million in 2000 from the sale of the HomeBanc Mortgage division. Trust services and investment service fees decreased 12 percent to $43.4 million from $49.1 million and merchant-processing fees decreased 4 percent to $34.7 million from $36.3 million. Cardholder fees decreased 31 percent to $15.0 million from $21.7 million. All other income and commissions decreased 10 percent to $96.8 million from $107.7 million. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed. Net interest income increased 10 percent to $492.8 million from $449.4 million for the first nine months of 2000 while earning assets decreased 1 percent to $15.9 billion from $16.1 billion for 2000. Year-to-date consolidated margin increased to 4.12 percent in 2001 from 3.72 percent in 2000. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed. In the regional banking group the year-to-date margin increased to 4.93 percent from 4.88 percent primarily due to lower funding costs. Noninterest expense for the first nine months of 2001 increased 27 percent to $1,147.0 million from $904.8 million. See Table 3 - Noninterest Expense Compensation for a breakdown of total expenses by business line. Mortgage banking expenses increased 23 percent to $499.3 million from $404.7 million. During this period, amortization of capitalized mortgage servicing rights increased 43 percent to $82.7 million from $57.7 million. Also included in this growth is the $64.5 million write-down in 2001 of the book value of mortgage servicing rights primarily due to the increase in actual mortgage prepayments over the projected
level as a result of the decrease in mortgage interest rates since third quarter 2000. In addition, $22.7 million in loss was recognized in 2001 from the establishment of a mortgage servicing rights impairment valuation reserve primarily due to the increase in expected future prepayment speeds. Capital markets expenses increased 151 percent over this same period to $163.0 million from $64.8 million. Expense growth for mortgage banking and capital markets varies with the volume and type of activity. Expenses in the regional banking group grew 14 percent from the previous year to $403.3 million from $352.5 million due primarily to the nonoperating expenses associated with asset write-offs, lease abandonment, branch closures, major marketing campaigns to attract new retail customers, litigation losses, consulting fees, and personnel costs related to early retirement and severance. Transaction processing expenses decreased 2 percent for the nine-month period primarily due to divestiture of the MONEY BELT(R) ATM network in fourth quarter 2000. The provision for loan losses increased 20 percent to $59.2 million from $49.1 million for the previous year. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed. DEBT RESTRUCTURINGS - ------------------- In second quarter 2001, there was a $5.1 million pre-tax ($3.2 million after-tax) loss related to debt restructurings. For financial statement presentation purposes this nonoperating loss is treated as an extraordinary item and therefore, net income and earnings per share are indicated before and after the after-tax loss. CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES - ----------------------------------------------------- SFAS No. 133 and EITF 99-20 were adopted on January 1, 2001. At that date all freestanding derivative instruments were measured at fair value with differences between the previous book value and fair value reported as a one-time accounting adjustment. Likewise, offsetting gains and losses on hedged assets, liabilities and firm commitments were recognized as adjustments of their respective book values at the adoption date as part of this accounting adjustment, except to the extent that they related to hedges of the variable cash flow exposure of a forecasted transaction. To the extent the adoption adjustment related to hedges of the variable cash flow exposure of a forecasted transaction, the accounting adjustment, a $1.4 million after-tax gain, was reported as a cumulative effect adjustment of comprehensive income. Additionally, the new rules regarding the recognition of impairment and income of interest-only strips were adopted. The net one-time accounting adjustments reported on the income statement as the cumulative effect of changes in accounting principles were an $8.2 million after-tax loss. BALANCE SHEET REVIEW - -------------------- For the first nine months of 2001, total assets averaged $19.0 billion compared with $19.4 billion in 2000. Average loans grew 3 percent to $10.1 billion from $9.8 billion for the first nine months of 2000. Average commercial loans increased 9 percent to $5.4 billion from $5.0 billion. Retail loans decreased 3 percent with an average of $4.7 billion in 2001 compared with $4.8 billion in 2000. Average investment securities decreased 9 percent to $2.6 billion from $2.9 billion for 2000. Loans held for sale, consisting primarily of mortgage loans, decreased 15 percent to $2.2 billion from $2.6 billion. For the first nine months of 2001, average core deposits increased 3 percent to $9.2 billion from $8.9 billion. While interest-bearing core deposits remained relatively flat at $6.0 billion, noninterest-bearing deposits increased 12 percent to $3.2 billion from $2.9 billion in 2000. Short-term purchased funds decreased 15 percent for the nine-month period to $6.8 billion from $8.0 billion. The reasons for the year-to-date balance sheet trends were similar to the quarterly trend information already discussed. OTHER
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES - ------------------------------------------------------------ SFAS No. 133, which was adopted on January 1, 2001, establishes accounting standards requiring that every derivative instrument be recorded on the balance sheet as either an asset or liability measured at its fair value. It requires that changes in the instrument's fair value be recognized currently in earnings (or other comprehensive income). If certain criteria are met, changes in the fair value of the asset or liability being hedged are also recognized currently in earnings. The initial impact of adopting SFAS No. 133 resulted in a net transition adjustment that was recognized as the cumulative effect of a change in accounting principle. Fair value is determined on the last business day of a reporting period. This point in time measurement of derivative fair values and the related hedged item fair values may be well suited to the measurement of hedge effectiveness, as well as reported earnings, when hedge time horizons are short. The same measurement however may not consistently reflect the effectiveness of longer-term hedges and, in First Tennessee's view, can distort short-term measures of reported earnings. First Tennessee uses a combination of derivative financial instruments to hedge certain components of the interest rate risk associated with its portfolio of capitalized mortgage servicing rights, which currently have an average life of approximately seven years. Over this long-term time horizon this combination of derivatives can be effective in significantly mitigating the effects of interest rate changes on the value of the servicing portfolio. However, these derivative financial instruments can and do demonstrate significant price volatility depending upon prevailing conditions in the financial markets. If a reporting period ends during a period of volatile financial market conditions, the effect of such point in time conditions on reported earnings does not reflect the underlying economics of the transactions or the true value of the hedges to First Tennessee over their estimated lives. The fact that the fair value of a particular derivative is unusually low or high on the last day of the reporting period is meaningful in evaluating performance during the period only if First Tennessee sells the derivative within the period of time before fair value changes and does not replace the hedge coverage with another derivative. First Tennessee believes the effect of such volatility on short-term measures of earnings is not indicative of the expected long-term performance of this hedging practice. First Tennessee believes that difficulties in interpreting the effects of SFAS No. 133 are sufficiently great that it may be worthwhile to be able to identify and isolate these effects and to determine what net income would be excluding certain SFAS No. 133 adjustments related to mortgage banking capitalized servicing rights. Therefore, this analysis has been added as a recurring part of management's discussion of operating results. This new item, servicing rights net value changes under SFAS No. 133, represents the change in the fair value of hedged interest rate risk of capitalized mortgage servicing rights, net of changes in the fair value of derivative financial instruments designated to hedge such risks excluding the impact of cash settlements and interest accruals on derivatives with periodic cash flows and changes in fair value due to the passage of time including time decay of options, and beginning in the third quarter, the time price convergence of forward instruments. For the first nine months of 2001, a pre-tax gain of $8.2 million ($5.2 million after tax) was recognized as servicing right net value changes under SFAS No. 133. For the third quarter, a pre-tax gain of $4.5 million ($2.9 million after tax) was recognized. The impact on earnings from hedging of the mortgage servicing rights portfolio is included on the Statement of Income in noninterest income. First Tennessee believes a review of the trend, if any, of the servicing rights net value changes under SFAS No. 133 over a long period of time, preferably over an interest rate business cycle, is a more meaningful measure to determine the effectiveness of hedging strategies. For its internal evaluation of performance for each applicable period, First Tennessee subtracts SFAS No. 133 gains from reported net income and adds SFAS No. 133 losses to reported net income. The internal evaluation of long-term performance will include the long-term trend, if any, in SFAS No. 133 gains or losses.
FURTHER INTERPRETATIONS OF SFAS NO. 133 - --------------------------------------- Certain provisions of SFAS No. 133 continue to undergo significant discussion and debate by the Financial Accounting Standards Board (FASB). One such potential issue involves the assessment of hedge effectiveness (and its impact on qualifying for hedge accounting) when hedging fair value changes of prepayable assets due to changes in the benchmark interest rate. As the FASB continues to deliberate interpretation of the new rules, the potential exists for a difference between First Tennessee's interpretation and that of the FASB, the effects of which cannot presently be anticipated. ACCOUNTING CHANGES - ------------------ On June 30, 2001, the FASB finalized SFAS No. 141, "Business Combinations", and SFAS No. 142, "Goodwill and Other Intangible Assets". Under SFAS No. 141 all business combinations initiated after June 30, 2001, must be accounted for using the purchase method. With the adoption of SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life. Rather, goodwill will be subject to an assessment for impairment using a fair-value-based test at least annually. Goodwill associated with equity-method investments is also no longer amortized, but impairment analysis is governed by existing impairment guidance for equity-method investments and not the new impairment rules. Also under the new rules, acquired intangible assets should be separately recognized if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold or otherwise transferred, regardless of the acquirer's intent to do so. These new rules are expected to result in more intangible assets being separated from goodwill than generally occurs today. The resulting assets will be amortized over their useful lives. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001, which for First Tennessee will mean January 1, 2002. First Tennessee estimates the impact of adopting these new standards will be to reduce noninterest expense annually by approximately $7 million pre-tax without regard to any new acquisitions or future impairment that may occur, the effect of which cannot be predicted at this time. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS No. 144 addresses accounting and reporting issues related to the impairment of long-lived assets and for long-lived assets to be disposed of. This standard is effective for fiscal years beginning after December 15, 2001, which for First Tennessee will be January 1, 2002. First Tennessee anticipates the impact of adopting this standard will be immaterial.
Item 3. Quantitative and Qualitative Disclosures About Market Risk - ------------------------------------------------------------------ The information called for by this item is incorporated herein by reference to Management's Discussion and Analysis included as Item 2 of Part I of this report and to Notes 1 and 24 of the Consolidated Financial Statements and the "Risk Management-Interest Rate Risk Management" subsection of the Management's Discussion and Analysis section contained in the financial appendix to the Corporation's 2001 Proxy Statement.
Part II. OTHER INFORMATION Items 1, 2, 3, 4 and 5 - ---------------------- As of the end of the third quarter, 2001, the answers to Items 1, 2, 3, 4 and 5 were either inapplicable or negative, and therefore, these items are omitted.
Item 6 - Exhibits and Reports on Form 8-K. (a) Exhibits. Exhibit No. Description - ----------- ----------- 3(ii) Bylaws of the Corporation, as amended and restated. 4 Instruments defining the rights of security holders, including indentures.* **10(a) Management Incentive Plan, as amended and restated. **10(c) 1997 Employee Stock Option Plan, as amended and restated, incorporated herein by reference to Exhibit 10(c) to the Corporation's 2000 Annual Report on Form 10-K and 10-16-01 amendment. <FN> * The Corporation agrees to furnish copies of the instruments, including indentures, defining the rights of the holders of the long-term debt of the Corporation and its consolidated subsidiaries to the Securities and Exchange Commission upon request. ** This is a management contract or compensatory plan required to be filed as an exhibit. </FN> (b) Reports on Form 8-K. No report on Form 8-K was filed during the third quarter of 2001.
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. FIRST TENNESSEE NATIONAL CORPORATION ------------------------------------ (Registrant) DATE: 11/13/01 By: /s/ Elbert L. Thomas Jr. --------------------- --------------------------------- Elbert L. Thomas Jr. Executive Vice President and Chief Financial Controller (Duly Authorized Officer and Principal Financial Officer)
EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 3(ii) Bylaws of the Corporation, as amended and restated. 4 Instruments defining the rights of security holders, including indentures.* **10(a) Management Incentive Plan, as amended and restated. **10(c) 1997 Employee Stock Option Plan, as amended and restated, incorporated herein by reference to Exhibit 10(c) to the Corporation's 2000 Annual Report on Form 10-K and 10-16-01 amendment. <FN> * The Corporation agrees to furnish copies of the instruments, including indentures, defining the rights of the holders of the long-term debt of the Corporation and its consolidated subsidiaries to the Securities and Exchange Commission upon request. ** This is a management contract or compensatory plan required to be filed as an exhibit. </FN>