Back to GetFilings.com



Table of Contents

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549
FORM 10-Q

(X) QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED
September 30, 2004

COMMISSION FILE NUMBER 0-10161

FIRSTMERIT CORPORATION

(Exact name of registrant as specified in its charter)
     
OHIO   34-1339938
(State or other jurisdiction of   (IRS Employer
incorporation or organization)   Identification Number)

III CASCADE PLAZA, 7TH FLOOR, AKRON, OHIO
44308-1103
(Address of principal executive offices)

(330) 996-6300
(Telephone Number)

     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 (   )

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
YES (X) NO (
   )

     As of October 31, 2004, 84,287,452 shares of the registrant’s common stock, without par value, were outstanding.

 


TABLE OF CONTENTS

PART I — FINANCIAL STATEMENTS
ITEM 1. FINANCIAL STATEMENTS
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4. CONTROLS AND PROCEDURES
PART II — OTHER INFORMATION
ITEM 6. EXHIBITS
CONSOLIDATED BALANCE SHEETS
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
CONSOLIDATED STATEMENT OF CASH FLOWS
Notes to Consolidated Financial Statements
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4. CONTROLS AND PROCEDURES
PART II — OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
ITEM 6. EXHIBITS
Exhibit Index
SIGNATURES
EX-10.6 AMENDED AND RESTATED 2002 STOCK PLAN
Exhibit 31.1 302 Certification for CEO
Exhibit 31.2 302 Certification for CFO
Exhibit 32.1 906 Certification for CEO and CFO


Table of Contents

FIRSTMERIT CORPORATION

PART I — FINANCIAL STATEMENTS

ITEM 1. FINANCIAL STATEMENTS

     The following statements included in the quarterly unaudited report to shareholders are incorporated by reference:

Consolidated Balance Sheets as of September 30, 2004 (unaudited), December 31, 2003 and September 30, 2003 (unaudited)

Consolidated Statements of Income and Comprehensive Income for the three-month and nine-month periods ended September 30, 2004 (unaudited) and 2003 (unaudited)

Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 (unaudited) and 2003 (unaudited)

Notes to Consolidated Financial Statements as of September 30, 2004 (unaudited)

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s Discussion and Analysis of Financial Condition as of September 30, 2004, December 31, 2003 and September 30, 2003 and Results of Operations for the three-month and nine-month periods ended September 30, 2004 and 2003.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

ITEM 4. CONTROLS AND PROCEDURES

Management’s Evaluation of Internal Control over Financial Reporting for the Quarter Ended September 30, 2004.

PART II — OTHER INFORMATION

ITEM 6. EXHIBITS

 


Table of Contents

CONSOLIDATED BALANCE SHEETS
FIRSTMERIT CORPORATION AND SUBSIDIARIES

                         
             
(in thousands)   September 30   December 31   September 30
(Unaudited, except December 31, 2003, which is derived from the audited financial statements)
  2004
  2003
  2003
ASSETS
                       
Cash and due from banks
  $ 184,428       199,049       218,619  
Investment securities (at fair value) and federal funds sold
    2,874,878       3,061,497       2,590,456  
Loans held for sale
    41,141       63,319       37,697  
Loans
                       
Commercial loans
    3,289,907       3,352,014       3,409,925  
Mortgage loans
    633,545       614,073       602,244  
Installment loans
    1,631,269       1,668,421       1,670,973  
Home equity loans
    665,127       637,749       632,758  
Credit card loans
    140,635       144,514       139,202  
Manufactured housing loans
                634,694  
Leases
    101,258       134,828       151,744  
 
   
 
     
 
     
 
 
Total loans
    6,461,741       6,551,599       7,241,540  
Less allowance for loan losses
    (106,110 )     (97,553 )     (120,472 )
 
   
 
     
 
     
 
 
Net loans
    6,355,631       6,454,046       7,121,068  
Premises and equipment, net
    120,891       119,079       111,452  
Goodwill
    139,245       139,245       139,245  
Intangible assets
    4,869       5,536       5,759  
Accrued interest receivable and other assets
    443,015       431,864       424,005  
 
   
 
     
 
     
 
 
Total assets
  $ 10,164,098       10,473,635       10,648,301  
 
   
 
     
 
     
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                       
Deposits:
                       
Demand-non-interest bearing
  $ 1,388,745       1,346,574       1,357,835  
Demand-interest bearing
    814,103       773,514       742,619  
Savings and money market accounts
    2,430,188       2,461,265       2,431,555  
Certificates and other time deposits
    2,744,072       2,921,431       3,046,497  
 
   
 
     
 
     
 
 
Total deposits
    7,377,108       7,502,784       7,578,506  
 
   
 
     
 
     
 
 
Securities sold under agreements to repurchase
    1,361,442       1,525,804       1,390,434  
Wholesale borrowings
    300,784       311,038       542,572  
Accrued taxes, expenses, and other liabilities
    145,124       146,834       150,626  
 
   
 
     
 
     
 
 
Total liabilities
    9,184,458       9,486,460       9,662,138  
 
   
 
     
 
     
 
 
Commitments and contingencies
                       
Shareholders’ equity:
                       
Preferred stock, without par value:
                       
authorized and unissued 7,000,000 shares
                 
Preferred stock, Series A, without par value:
                       
designated 800,000 shares; none outstanding
                 
Convertible preferred stock, Series B, without par value:
                       
designated 220,000 shares; 0, 0 and 42,036 shares outstanding at September 30, 2004, December 31, 2003 and September 30, 2003, respectively
                987  
Common stock, without par value:
                       
authorized 300,000,000 shares; issued 92,026,350 at September 30, 2004, December 31, 2003 and September 30, 2003
    127,937       127,937       127,937  
Capital surplus
    110,296       110,473       112,052  
Accumulated other comprehensive loss
    (13,385 )     (9,475 )     (25,402 )
Retained earnings
    951,319       943,492       959,232  
Treasury stock, at cost, 7,197,488, 7,302,057 and 7,537,719 shares at September 30, 2004, December 31, 2003 and September 30, 2003, respectively
    (196,527 )     (185,252 )     (188,643 )
 
   
 
     
 
     
 
 
Total shareholders’ equity
    979,640       987,175       986,163  
 
   
 
     
 
     
 
 
Total liabilities and shareholders’ equity
  $ 10,164,098       10,473,635       10,648,301  
 
   
 
     
 
     
 
 

The accompanying notes are an integral part of the consolidated financial statements.

 


Table of Contents

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
FIRSTMERIT CORPORATION AND SUBSIDIARIES

                                 
    Three months ended   Nine months ended
(Unaudited)   September 30
  September 30
   
(In thousands except per share data)
  2004
  2003
  2004
  2003
Interest income:
                               
Interest and fees on loans, including held for sale
  $ 96,374       115,841       287,127       356,713  
Interest and dividends on investment securities and federal funds sold
    27,454       23,936       84,886       76,542  
 
   
 
     
 
     
 
     
 
 
Total interest income
    123,828       139,777       372,013       433,255  
 
   
 
     
 
     
 
     
 
 
Interest expense:
                               
Interest on deposits:
                               
Demand-interest bearing
    579       272       1,448       838  
Savings and money market accounts
    5,009       4,351       13,835       14,508  
Certificates and other time deposits
    19,848       23,950       61,077       79,922  
Interest on securities sold under agreements to repurchase
    6,668       4,776       19,077       14,049  
Interest on wholesale borrowings
    4,352       7,998       13,095       24,824  
 
   
 
     
 
     
 
     
 
 
Total interest expense
    36,456       41,347       108,532       134,141  
 
   
 
     
 
     
 
     
 
 
Net interest income
    87,372       98,430       263,481       299,114  
Provision for loan losses
    8,952       22,540       64,090       69,478  
 
   
 
     
 
     
 
     
 
 
Net interest income after provision for loan losses
    78,420       75,890       199,391       229,636  
 
   
 
     
 
     
 
     
 
 
Other income:
                               
Trust department income
    5,228       5,153       16,280       15,481  
Service charges on deposits
    15,903       16,823       47,027       47,003  
Credit card fees
    9,581       10,322       27,791       31,037  
ATM and other service fees
    3,168       3,124       8,987       9,215  
Bank owned life insurance income
    2,992       3,238       9,201       9,626  
Investment services and insurance
    2,931       2,825       10,290       9,259  
Manufactured housing income
    5       387       155       1,446  
Investment securities gains, net
    29       992       1,511       6,964  
Loan sales and servicing income
    2,694       10,657       7,137       21,268  
Other operating income
    2,611       4,140       9,599       12,095  
 
   
 
     
 
     
 
     
 
 
Total other income
    45,142       57,661       137,978       163,394  
 
   
 
     
 
     
 
     
 
 
Other expenses:
                               
Salaries, wages, pension and employee benefits
    42,160       38,860       122,391       112,487  
Net occupancy expense
    5,546       5,274       17,089       16,817  
Equipment expense
    3,140       3,535       9,998       11,105  
Stationery, supplies and postage
    2,606       2,801       7,895       8,566  
Bankcard, loan processing and other costs
    6,261       7,533       17,952       21,334  
Professional services
    2,780       2,812       9,903       8,173  
Amortization of intangibles
    222       222       667       666  
Other operating expenses
    15,972       15,159       49,325       46,637  
 
   
 
     
 
     
 
     
 
 
Total other expenses
    78,687       76,196       235,220       225,785  
 
   
 
     
 
     
 
     
 
 
Income before income tax expense
    44,875       57,355       102,149       167,245  
Federal income taxes
    13,764       18,077       27,304       52,758  
 
   
 
     
 
     
 
     
 
 
Net income
  $ 31,111       39,278       74,845       114,487  
 
   
 
     
 
     
 
     
 
 
Other comprehensive income (loss), net of tax expense (benefit):
                               
Unrealized securities’ holding gains (losses), net of tax expense (benefit), arising during period
    28,235       (22,132 )     (2,928 )     (24,799 )
Less: reclassification adjustment for securities’ gains (losses) realized in net income, net of tax expense (benefit)
    (19 )     (645 )     (982 )     (4,527 )
 
   
 
     
 
     
 
     
 
 
Net unrealized income (losses), net of tax expense (benefit)
    28,216       (22,777 )     (3,910 )     (29,326 )
 
   
 
     
 
     
 
     
 
 
Comprehensive income
  $ 59,327       16,501       70,935       85,161  
 
   
 
     
 
     
 
     
 
 
Net income applicable to common shares
  $ 31,111       39,261       74,845       114,434  
 
   
 
     
 
     
 
     
 
 
Net income used in diluted EPS calculation
    31,119       39,285       74,867       114,511  
 
   
 
     
 
     
 
     
 
 
Weighted average number of common shares outstanding - basic
    84,544       84,505       84,707       84,496  
 
   
 
     
 
     
 
     
 
 
Weighted average number of common shares outstanding - diluted
    84,962       84,982       85,087       84,883  
 
   
 
     
 
     
 
     
 
 
Basic Earnings per Share
  $ 0.36       0.46       0.88       1.35  
 
   
 
     
 
     
 
     
 
 
Diluted Earnings per Share
  $ 0.37       0.46       0.88       1.35  
 
   
 
     
 
     
 
     
 
 
Dividend per Share
  $ 0.27       0.26       0.79       0.76  
 
   
 
     
 
     
 
     
 
 

The accompanying notes are an integral part of the consolidated financial statements.

 


Table of Contents

CONSOLIDATED STATEMENT OF CASH FLOWS
FIRSTMERIT CORPORATION AND SUBSIDIARIES

                 
    Nine months ended
(Unaudited)   September 30,
   
(In thousands)
  2004
  2003
Operating Activities
               
Net income
  $ 74,845       114,487  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    64,090       69,478  
Provision for depreciation and amortization
    10,319       10,966  
Amortization of investment securities premiums, net
    5,608       9,592  
Accretion of income for lease financing
    (5,485 )     (8,728 )
Gains on sales of investment securities, net
    (1,511 )     (6,964 )
Decrease in interest receivable
    1,236       6,240  
Decrease in interest payable
    (16 )     (4,772 )
Decrease in employee pension liability
    (3,773 )     (28,614 )
Originations of loans held for sale
    (313,276 )     (891,809 )
Proceeds from sales of loans, primarily mortgage loans sold in the secondary mortgage markets
    336,205       1,029,716  
Gains on sales of loans, net
    (751 )     (5,635 )
Amortization of intangible assets
    667       666  
Other changes
    (7,987 )     (7,795 )
 
   
 
     
 
 
NET CASH PROVIDED BY OPERATING ACTIVITIES
    160,171       286,828  
 
   
 
     
 
 
Investing Activities
               
Dispositions of investment securities:
               
Available-for-sale - sales
    127,461       870,160  
Available-for-sale - maturities
    429,384       971,891  
Purchases of investment securities available-for-sale
    (380,686 )     (1,962,631 )
Net increase (decrease) in loans and leases, except sales
    39,810       (90,303 )
Purchases of premises and equipment
    (12,929 )     (8,009 )
Sales of premises and equipment
    798       1,873  
 
   
 
     
 
 
NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES
    203,838       (217,019 )
 
   
 
     
 
 
Financing Activities
               
Net increase in demand, savings and money market accounts
    51,683       407,237  
Net decrease in certificates and other time deposits
    (177,359 )     (539,990 )
Net increase (decrease) in securities sold under agreements to repurchase
    (164,362 )     169,613  
Net decrease in wholesale borrowings
    (9,903 )     (57,671 )
Cash dividends - common and preferred
    (67,018 )     (64,493 )
Purchase of treasury shares
    (14,600 )     (2,036 )
Proceeds from exercise of stock options, conversion of debentures or conversion of preferred stock
    2,929       2,582  
 
   
 
     
 
 
NET CASH USED BY FINANCING ACTIVITIES
    (378,630 )     (84,758 )
 
   
 
     
 
 
Decrease in cash and cash equivalents
    (14,621 )     (14,949 )
Cash and cash equivalents at beginning of period
    199,049       233,568  
 
   
 
     
 
 
Cash and cash equivalents at end of period
  $ 184,428       218,619  
 
   
 
     
 
 
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS INFORMATION:
               
Cash paid during the nine months ended September 30:
               
Interest, net of amounts capitalized
  $ 52,748       62,305  
 
   
 
     
 
 
Federal income taxes
  $ 25,297       62,178  
 
   
 
     
 
 

The accompanying notes are an integral part of the consolidated financial statements.

 


Table of Contents

FirstMerit Corporation and Subsidiaries
Notes to Consolidated Financial Statements
September 30, 2004 (Unaudited) (Dollars in thousands)

1. Company Organization and Financial Presentation — FirstMerit Corporation (“Corporation”), is a bank holding company whose principal assets are the common stock of its wholly owned subsidiary, FirstMerit Bank, N. A. The Corporation’s other subsidiaries include Citizens Savings Corporation of Stark County, FirstMerit Capital Trust I, FirstMerit Community Development Corporation, FirstMerit Credit Life Insurance Company, FMT, Inc., SF Development Corp and Realty Facility Holdings XV, L.L.C.

     The consolidated balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements at that date. The accompanying unaudited interim financial statements reflect all adjustments (consisting only of normally recurring accruals) that are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted in accordance with the rules of the Securities and Exchange Commission. The consolidated financial statements of the Corporation as of September 30, 2004 and 2003, and for the three and nine months ended September 30, 2004 and September 30, 2003 are not necessarily indicative of the results that may be achieved for the full fiscal year or for any future period. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the fiscal year ended December 31, 2003.

     Certain previously reported amounts have been reclassified to conform to the current reporting presentation.

2. Recent Accounting Pronouncements — During December 2003 the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 132 (revised 2003) “Employers’ Disclosure about Pensions and other Postretirement Benefits an Amendment of FASB Statements No. 87, 88, and 106.” This statement revised employers’ disclosures about pension plans and other postretirement benefit plans. It did not change the measurement or recognition of those plans required by SFAS No. 87 “Employers’ Accounting for Pensions,” No. 88 “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” and No. 106 “Postretirement Benefits Other than Pensions.” This statement retains the disclosure requirements contained in the original SFAS No. 132 and requires additional disclosures about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. These additional disclosures have been included in Note 10 of these consolidated financial statements.

     In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” SFAS No. 148 is an amendment of SFAS No. 123 (“Accounting for Stock-Based Compensation”) and provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Corporation currently accounts for stock-based employee compensation under the provisions of Accounting Principles Board (“APB”) No. 25 “Accounting for Stock Issued to Employees” and related interpretations. No stock based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings

 


Table of Contents

per share if the Corporation had applied the fair value recognition provisions of SFAS No. 123 to stock based employee compensation. The Black-Scholes option-pricing model was used to estimate the fair market value of the options at the date of grant. This model was originally developed for use in estimating the fair value of traded options, which have different characteristics from the Corporation’s employee stock options. The model is also sensitive to changes in subjective assumptions, which can materially affect fair value estimates. As a result, management believes that the Black-Scholes model may not necessarily provide a reliable single measure of the fair value of employee stock options. Other models are currently under review and may be used by the Corporation for future disclosure.

                                 
    Three   Three   Nine   Nine
    months   months   months   months
    ended   ended   ended   ended
    September 30,   September 30,   September 30,   September 30,
(Dollars in thousands)
  2004
  2003
  2004
  2003
Net income, as reported
  $ 31,111       39,278       74,845       114,487  
Deduct: total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
    (893 )     (632 )     (2,600 )     (1,862 )
 
   
 
     
 
     
 
     
 
 
Pro forma net income
  $ 30,218       38,646       72,245       112,625  
 
   
 
     
 
     
 
     
 
 
Pro forma EPS - Basic
  $ 0.36       0.46       0.85       1.33  
Pro forma EPS - Diluted
  $ 0.36       0.45       0.85       1.33  
Reported EPS - Basic
  $ 0.36       0.46       0.88       1.35  
Reported EPS - Diluted
  $ 0.37       0.46       0.88       1.35  
Assumptions:
                               
Dividend yield
    3.99 %     4.52 %     4.09 %     4.52 %
Expected volatility
    29.41 %     31.31 %     30.00 %     32.66 %
Risk free interest rate
    3.45 - 3.48 %     3.31 %     2.94 - 3.91 %     2.90 - 3.3 %
Expected lives
  5 Years   5 Years   5 Years   3-5 Years

     On October 13, 2004, the FASB voted to give public companies until their first fiscal quarter beginning after June 15, 2005 to adopt the standard requiring the expensing of stock options (SFAS No. 123r) postponing its previously announced adoption date for fiscal years beginning after December 15, 2004.

     In December 2003, President Bush signed the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“Modernization Act”), which introduces a prescription drug benefit under Medicare, into law. On May 19, 2004, FASB issued FASB Staff Position FAS No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP FAS No. 106-2”) which provides guidance on accounting for the effects of the new Medicare prescription drug legislation by employers whose prescription drug benefits are actuarially equivalent to the drug benefit under Medicare

 


Table of Contents

Part D. The Corporation early adopted this FSP in the first quarter of 2004 and has recognized the effect of the Modernization Act in the calculation of its postretirement benefit liability as of January 1, 2004. This change is more fully described in Note 10 (Benefit Plans) of these consolidated financial statements.

     On March 9, 2004, the SEC issued SEC Staff Accounting Bulletin No. 105 (“SAB No. 105”) which summarized the views of the SEC staff regarding the application of generally accepted accounting principles to loan commitments accounted for as derivative instruments. Specifically, SAB No. 105 indicated that the fair value of loan commitments that are required to follow derivative accounting under SFAS No. 133, should not consider the expected future cash flows related to the associated servicing of the future loan. Prior to SAB No.105, the Corporation did not consider the expected future cash flows related to the associated servicing in determining the fair value of loan commitments. The adoption of SAB No. 105 did not have a material effect on the Corporation’s financial result.

     On September 30, 2004, the Emerging Issues Task Force (“EITF”) of the FASB issued a final FASB Staff Position, FSP EITF Issue 03-1-1, which delayed the effective date for the measurement and recognition guidance included in EITF Issue 03-1 which prescribed the criteria that should be used to determine when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. The disclosures about unrealized losses that have not been recognized as other-than-temporary impairments have not been deferred and appear in Footnote 4 (Investments) in the 2003 Form 10-K. Management is currently evaluating the impact of this accounting guidance on the Corporation’s financial condition and results of operations.

3. Critical Accounting Policies — The accounting and reporting policies of the Corporation are in accordance with accounting principles generally accepted within the United States of America and conform to general practices within the banking industry. Accounting and reporting policies for the allowance for loan losses, income taxes, mortgage servicing rights, derivative instruments and hedging activities, and pension and postretirement benefits are deemed critical since they involve the use of estimates and require significant management judgments. Application of assumptions different than those used by management could result in material changes in the Corporation’s financial position or results of operations. Note 1 (Summary of Significant Accounting Policies) and Note 5 (Allowance for Loan Losses), as described in the 2003 Form 10-K, provide considerable detail with regard to the Corporation’s methodology and reporting of the allowance for loan losses. Additional information for income tax accounting is contained within Note 1, as well as in Note 11 (Federal Income Taxes) as described in the 2003 Form 10-K. Within the “Other Income” section of this Form 10-Q, the Corporation’s basis for accounting for mortgage servicing rights, which is based on a discounted cash flow model believed to be comparable to those used by other financial institutions, is discussed in more detail. Accounting for mortgage servicing rights was also discussed in the 2003 Form 10-K in Note 1 and Note 6 (Mortgage Servicing Rights and Mortgage Servicing Activity). Derivative instruments and hedging activities are described more fully in Note 9 (Accounting for Derivatives) in these consolidated financial statements, as well as Note 1, Note 16 (Fair Value Disclosure of Financial Instruments), and Note 17(Financial Instruments with Off-Balance-Sheet Risk) of the 2003 Form 10-K. A description of the plans and the assumptions used to estimate the liabilities for pension and postretirement benefits is described in Note 12 (Benefit Plans) to the 2003 Form 10-K as well as Note 10 (Benefit Plans) in these consolidated financial statements.

 


Table of Contents

4. Investment Securities — All investment securities of the Corporation are classified as available for sale. The available for sale classification provides the Corporation with more flexibility to respond, through the portfolio, to changes in market interest rates, or to increases in loan demand or deposit withdrawals.

The book value and market value of investment securities classified as available for sale are as follows:

                                 
    September 30, 2004
    Amortized   Gross Unrealized   Gross Unrealized   Fair
(Dollars in thousands)
  Cost
  Gains
  Losses
  Value
US Treasuries and agencies
  $ 777,410       514       7,485       770,439  
Obligations of state and political subdivisions
    104,654       3,546       21       108,179  
Mortgage-backed securities
    1,751,839       8,612       18,761       1,741,690  
Other securities
    259,059       1,215       5,704       254,570  
 
   
 
     
 
     
 
     
 
 
 
  $ 2,892,962       13,887       31,971       2,874,878  
 
   
 
     
 
     
 
     
 
 
                 
    Book Value
  Fair Value
Due in one year or less
  $ 71,699       71,946  
Due after one year through five years
    2,213,466       2,201,693  
Due after five years through ten years
    455,718       451,765  
Due after ten years
    152,079       149,474  
 
   
 
     
 
 
 
  $ 2,892,962       2,874,878  
 
   
 
     
 
 

     Expected maturities will differ from contractual maturities based on the issuers’ rights to call or prepay obligations with or without call or prepayment penalties. Securities with remaining maturities over five years consist of mortgage and asset backed securities.

     The carrying amount of investment securities pledged to secure trust and public deposits and for purposes required or permitted by law amounted to approximately $2.2 billion at September 30, 2004, $2.0 billion at December 31, 2003, and $1.8 billion at September 30, 2003.

5. Allowance for loan losses (“ALL”) — The Corporation’s Credit Policy Division manages credit risk by establishing common credit policies for its subsidiary bank, participating in approval of their loans, conducting reviews of loan portfolios, providing centralized consumer

 


Table of Contents

underwriting, collections and loan operation services, and overseeing loan workouts. The Corporation’s objective is to minimize losses from its commercial lending activities and to maintain consumer losses at acceptable levels that are stable and consistent with growth and profitability objectives.

The activity within the ALL for the current and prior year quarters, and the full year ended 12/31/03 is shown in the following table:

Allowance for Loan Losses Activity

                         
    Quarter ended   Year Ended   Quarter ended
    September 30,   December 31,   September 30,
(Dollars in thousands)   2004
  2003
  2003
Allowance for loan losses-beginning of period
  $ 107,561       122,790       119,192  
Provision for loan losses
    8,952       102,211       22,540  
Loans charged off
    (16,119 )     (119,877 )     (26,870 )
Recoveries on loans previously charged off
    5,716       21,856       5,610  
Allowance related to loans sold
          (29,427 )      
 
   
 
     
 
     
 
 
Allowance for loan losses-end of period
  $ 106,110       97,553       120,472  
 
   
 
     
 
     
 
 

6. Goodwill and Intangible Assets – The following table summarizes goodwill and intangible assets:

                                                                         
    At September 30, 2004
  At December 31, 2003
  At September 30, 2003
    Gross   Accumulated   Net   Gross   Accumulated   Net   Gross   Accumulated   Net
(Dollars in thousands)   Amount
  Amortization
  Amount
  Amount
  Amortization
  Amount
  Amount
  Amortization
  Amount
Amortizable intangible assets:
                                                                       
Deposit base intangible assets
  $ 10,137       5,267       4,870       10,137       4,601       5,536       10,137       4,378       5,759  
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 
Unamortizable intangible assets:
                                                                       
Goodwill
  $ 139,245               139,245       139,245               139,245       139,245               139,245  
 
   
 
             
 
     
 
             
 
     
 
             
 
 

Amortization expense for intangible assets was $0.22 million for both quarters ending September 30, 2004 and 2003. The following table shows the estimated future amortization expense for deposit base intangible assets based on existing asset balances at December 31, 2003 for the years ended:

         
December 31, 2004
  $ 889  
December 31, 2005
    889  
December 31, 2006
    889  
December 31, 2007
    889  
December 31, 2008
    573  

     During the first quarter of 2004, the Corporation conducted its annual impairment testing as required by SFAS No. 142 “Goodwill and Other Intangible Assets,” and concluded that goodwill was not impaired. There have been no events subsequent to that date which would change the conclusions reached.

 


Table of Contents

7. Earnings per share — The reconcilation between basic and diluted earnings per share(“EPS”) is presented as follows:

                                 
                    Nine   Nine
    Quarter ended   Quarter ended   months ended   months ended
    September 30,   September 30,   September 30,   September 30,
(Dollars in thousands except EPS)   2004
  2003
  2004
  2003
BASIC EPS:
                               
Net income
  $ 31,111       39,278       74,845       114,487  
Less preferred stock dividends
          (17 )           (53 )
 
   
 
     
 
     
 
     
 
 
Net income applicable to common shares
  $ 31,111       39,261       74,845       114,434  
 
   
 
     
 
     
 
     
 
 
Average common shares outstanding
    84,544       84,505       84,707       84,496  
Net income per share - basic
  $ 0.36       0.46       0.88       1.35  
 
   
 
     
 
     
 
     
 
 
DILUTED EPS:
                               
Net income available to common shares
  $ 31,111       39,261       74,845       114,434  
Add: preferred stock dividends
          17             53  
Add: interest expense on convertible bonds
    8       7       22       24  
 
   
 
     
 
     
 
     
 
 
Net income used in diluted EPS calculation
  $ 31,119       39,285       74,867       114,511  
 
   
 
     
 
     
 
     
 
 
Avg common shares outstanding
    84,544       84,505       84,707       84,496  
Add: Equivalents from stock options
    364       306       326       208  
Add: Equivalents-convertible bonds
    54       57       54       60  
Add: Equivalents from convertible preferred stock
          114             119  
 
   
 
     
 
     
 
     
 
 
Average common shares and equivalents outstanding
    84,962       84,982       85,087       84,883  
Net income per common share - diluted
  $ 0.37       0.46       0.88       1.35  
 
   
 
     
 
     
 
     
 
 

For the quarters ended September 30, 2004 and 2003, options to purchase 2.3 million and 4.6 million shares, respectively were outstanding but not included in the computation of diluted earnings per share because they were antidilutive.

8. Segment Information — The Corporation provides a diversified range of banking and certain nonbanking financial services and products through its various subsidiaries. Management reports the Corporation’s results through its major segment classification, Supercommunity Banking. Included in the Parent Company, Other Subsidiaries and Eliminations category are certain nonbanking affiliates, and eliminations of certain intercompany transactions. Also included are portions of certain assets, capital, and support functions not specifically identifiable with Supercommunity Banking.

     The Corporation’s business is conducted solely in the United States. The following tables present a summary of financial results as of and for the three-month and nine-month periods ended September 30, 2004 and 2003 and the full year ended December 31, 2003:

 


Table of Contents

                                                 
                    Parent Company, Other    
    Supercommunity Banking
  Subsidiaries, Eliminations
  FirstMerit Consolidated
September 30, 2004
  3rd Qtr
  YTD
  3rd Qtr
  YTD
  3rd Qtr
  YTD
OPERATIONS (thousands) :
                                               
Net interest income
  $ 86,086       259,905       1,286       3,576       87,372       263,481  
Provision for loan losses
    8,951       64,139       1       (49 )     8,952       64,090  
Other income
    44,943       137,400       199       578       45,142       137,978  
Other expenses
    78,508       234,528       179       692       78,687       235,220  
Net income
  $ 30,243       72,503       868       2,342       31,111       74,845  
AVERAGES (millions) :
                                               
Assets
  $ 10,183       10,321       79       62       10,262       10,383  
Loans
    6,471       6,510       4       4       6,475       6,514  
Earnings assets
    9,428       9,569       13       14       9,441       9,583  
Deposits
    7,544       7,536       (84 )     (89 )     7,460       7,447  
Shareholders’ equity
  $ 774       786       195       198       969       984  
 
                    Parent Company, Other    
    Supercommunity Banking
  Subsidiaries, Eliminations
  FirstMerit Consolidated
December 31, 2003
          YTD
          YTD
          YTD
OPERATIONS (thousands):
                                               
Net interest income
          $ 389,008               4,605               393,613  
Provision for loan losses
            101,593               618               102,211  
Other income
            208,774               1,372               210,146  
Other expenses
            325,717               1,235               326,952  
Net income
          $ 118,264               2,705               120,969  
AVERAGES (millions) :
                                               
Assets
          $ 10,558               33               10,591  
Loans
            7,134               5               7,139  
Earnings assets
            9,824               20               9,844  
Deposits
            7,755               (83 )             7,672  
Shareholders’ equity
          $ 779               197               976  
 
                    Parent Company, Other    
    Supercommunity Banking
  Subsidiaries, Eliminations
  FirstMerit Consolidated
September 30, 2003
  3rd Qtr
  YTD
  3rd Qtr
  YTD
  3rd Qtr
  YTD
OPERATIONS (thousands) :
                                               
Net interest income
  $ 97,378       295,564       1,052       3,550       98,430       299,114  
Provision for loan losses
    22,561       69,124       (21 )     354       22,540       69,478  
Other income
    57,374       162,322       287       1,072       57,661       163,394  
Other expenses
    76,002       224,743       194       1,042       76,196       225,785  
Net income
  $ 38,576       112,368       702       2,119       39,278       114,487  
AVERAGES (millions):
                                               
Assets
  $ 10,614       10,573       33       35       10,647       10,608  
Loans
    7,196       7,171       5       5       7,201       7,176  
Earnings assets
    9,889       9,847       14       22       9,903       9,869  
Deposits
    7,768       7,780       (87 )     (81 )     7,681       7,699  
Shareholders’ equity
  $ 776       779       198       197       974       976  

9. Accounting for Derivatives — The Corporation follows the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” in accounting for its derivative activities. At September 30, 2004, the Corporation had various interest rate swaps in place that were accounted for as fair value hedges under SFAS No. 133 since their purpose is to “swap”

 


Table of Contents

fixed interest rate liabilities and assets to a variable interest rate basis. All but one of the interest rate swaps are associated with the Corporation’s fixed-rate commercial loan swap program that was initiated during the first quarter of 2003 and the remaining interest rate swap converts the fixed interest rate of mandatorily redeemable trust preferred securities to a variable rate. All of these interest rate swaps, with the exception of the one associated with the mandatorily redeemable trust preferred securities, qualify for the “shortcut method of accounting” as prescribed in SFAS No. 133. The shortcut method of accounting requires that the hedge and the hedged item meet certain qualifying criteria. If the swap qualifies for the shortcut method of accounting then no hedge ineffectiveness can be assumed and the need to test for ongoing effectiveness is eliminated. For hedges that qualify for the shortcut method of accounting, the fair value of the swap and the fair value of the hedged item are recorded on the balance sheets and statements of income and comprehensive income. The remaining hedge does not meet all the criteria necessary to be considered for the shortcut method of accounting. Therefore, the long-haul method of accounting is utilized. The long-haul method of accounting requires periodic testing of hedge effectiveness with the portion of the hedge deemed to be ineffective reported in earnings.

     In the third quarter of 2004, the Corporation entered into forward swap agreements which, in effect, fix the borrowing costs of certain variable rate liabilities in the future. These transactions do not qualify for the short-cut method of accounting under SFAS No. 133 as previously discussed. The Corporation classifies these transactions as cash flow hedges, with any hedge ineffectiveness being reported in current earnings. It is anticipated that the hedge will prove to be highly effective. A correlation analysis performed at quarter-end proved that the hedge was effective.

     Additionally, in the normal course of business, the Corporation sells originated mortgage loans into the secondary mortgage loan markets. The Corporation maintains a risk management program to protect and manage interest-rate risk and pricing associated with its mortgage commitment pipeline. The Corporation’s mortgage commitment pipeline included interest-rate lock commitments (“IRLCs”) that have been extended to borrowers who have applied for loan funding and met certain defined credit and underwriting standards. During the term of the IRLCs, the Corporation is exposed to interest-rate risk, in that the value of the IRLCs may change significantly before the loans close. To mitigate this interest-rate risk, the Corporation enters into various derivatives by selling loans forward to investors using forward commitments. In accordance with SFAS No. 133, the Corporation classifies and accounts for IRLCs as nondesignated derivatives that are recorded at fair value with changes in value recorded to current earnings. The forward sale commitments used to manage the risk on the IRLCs are also classified and accounted for as nondesignated derivatives and, therefore, recorded at fair value with changes recorded to current earnings. During 2003, the Corporation implemented a SFAS No. 133 hedging program for its mortgage loan warehouse to gain protection for the changes in fair value of the mortgage loan warehouse and the forward commitments. As such, both the mortgage loan warehouse the forward commitments are recorded at fair value with changes in value recorded to current earnings.

     In 2003, the Corporation began to enter into derivative contracts by purchasing To Be Announced Mortgage Backed Securities (“TBA Securities”) to help mitigate the interest-rate risk associated with its mortgage servicing rights (“MSR”). During the third quarter of 2004, options on treasury securities, options on mortgage-backed securities and swaptions were utilitzed to enhance the effectiveness of the economic hedge associated with the MSR. Within the “Other Income” section of these consolidated financial statements and Note 6 to the 2003 Form 10-K, the Corporation’s basis for accounting for mortgage servicing rights is discussed in more detail. In accordance with SFAS No. 133, the Corporation classifies and accounts for these

 


Table of Contents

instruments as nondesignated derivatives. Accordingly, these securities are recorded at fair value with changes in value recorded to current earnings.

10. Benefit Plans – The Corporation sponsors several qualified and nonqualified pension and other postretirement benefit plans for certain of its employees. The net periodic benefit cost is based on estimated values provided by outside actuaries. The components of net periodic benefit cost are as follows:

                                 
    Pension Benefits
                    Nine months   Nine months
    Quarter ended   Quarter ended   ended   ended
    September 30,   September 30,   September 30,   September 30,
(Dollars in thousands)   2004
  2003
  2004
  2003
Components of Net Periodic Pension Cost
                               
Service Cost
  $ 1,922       1,667       5,765       5,001  
Interest Cost
    2,057       1,847       6,172       5,540  
Expected return on assets
    (2,851 )     (2,238 )     (8,554 )     (6,714 )
Amorization of unrecognized:
                               
Transition (asset)
    (9 )     (9 )     (26 )     (26 )
Prior service costs
    69       69       205       205  
Cumulative net (gain) loss
    567       76       1,702       229  
 
   
 
     
 
     
 
     
 
 
Net periodic pension cost
  $ 1,755       1,412       5,264       4,235  
 
   
 
     
 
     
 
     
 
 
 
    Postretirement Benefits
                    Nine months   Nine months
    Quarter ended   Quarter ended   ended   ended
    September 30,   September 30,   September 30,   September 30,
    2004
  2003
  2004
  2003
Components of Net Periodic Postretirement Cost
                               
Service Cost
  $ 192       324       576       971  
Interest Cost
    502       612       1,505       1836  
Expected return on assets
                       
Amorization of unrecognized:
                               
Transition (asset)
    39       156       117       469  
Prior service costs
    (102 )           (305 )      
Cumulative net (gain) loss
    92       35       277       106  
 
   
 
     
 
     
 
     
 
 
Net periodic postretirement cost
  $ 723       1,127       2,170       3,382  
 
   
 
     
 
     
 
     
 
 

     The Corporation made a contribution to the pension plan in the amount of $7.7 million during the quarter ended September 30, 2004. On December 8, 2003, President Bush signed the new Medicare legislation into law as disclosed in Note 2 of these consolidated Financial statements. This law provides for a federal subsidy to sponsors of

 


Table of Contents

retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to the benefit established by the law. The federal subsidy in the law results in a $1.6 million reduction in our accumulated postretirement benefit obligation. Concurrently, the Corporation amended its postretirement benefits plan to limit and cap benefits prospectively. The total impact of both changes on our actuarial liability was a decrease of $13.6 million and is being accounted for as an actuarial gain that will be amortized as a reduction of our periodic cost and liability. The full year impact for 2004 is anticipated to be $2.2 million and $0.5 million for the quarter ending September 30, 2004.

     On May 19, 2004 the FASB issued FSP No. 106-2 that provided final guidance on the accounting for the effects of the new prescription drug legislation by employers whose prescription drug benefits are actuarially equivalent to the drug benefit under Medicare Part D. The Corporation early adopted the provisions of the FSP during the first quarter of 2004 in accordance with the final guidance.

11. Contingencies — The nature of the Corporation’s business results in a certain amount of litigation. Accordingly, FirstMerit Corporation and its subsidiaries are subject to various pending and threatened lawsuits in which claims for monetary damages are asserted. Management, after consultation with legal counsel, is of the opinion that the ultimate liability of such pending matters would not have a material effect on the Corporation’s financial condition and results of operations.

 


Table of Contents

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Fully-tax Equivalent Interest Rates and Interest Differential

FIRSTMERIT CORPORATION AND SUBSIDIARIES

                                                                         
    Three months ended   Year ended Three months ended
    September 30, 2004
  December 31, 2003
September 30, 2003
    Average           Average   Average           Average   Average           Average
(Dollars in thousands)
  Balance
  Interest
  Rate
  Balance
  Interest
  Rate
  Balance
  Interest
  Rate
ASSETS
                                                                       
Cash and due from banks
  $ 219,025                       195,060                       197,597                  
Investment securities:
                                                                       
U.S. Treasury securities and U.S. Government agency obligations (taxable)
    2,550,174       23,871       3.72 %     2,273,030       87,402       3.85 %     2,288,173       20,623       3.58 %
Obligations of states and political subdivisions (tax exempt)
    104,296       1,839       7.01 %     103,531       7,182       6.94 %     103,390       1,727       6.63 %
Other securities
    256,796       2,397       3.71 %     249,271       9,197       3.69 %     238,674       2,122       3.53 %
 
   
 
     
 
             
 
     
 
             
 
     
 
         
Total investment securities
    2,911,266       28,107       3.84 %     2,625,832       103,781       3.95 %     2,630,237       24,472       3.69 %
Federal funds sold
    2,129       7       1.31 %     4,258       45       1.06 %     3,643       9       0.98 %
Loans held for sale
    53,461       535       3.98 %     75,451       3,418       4.53 %     68,351       730       4.24 %
Loans
    6,474,512       95,858       5.89 %     7,138,673       462,609       6.48 %     7,200,899       115,158       6.34 %
 
   
 
     
 
             
 
     
 
             
 
     
 
         
Total earning assets
    9,441,368       124,507       5.25 %     9,844,214       569,853       5.79 %     9,903,130       140,369       5.62 %
Allowance for loan losses
    (107,111 )                     (117,332 )                     (119,466 )                
Other assets
    709,182                       669,472                       665,485                  
 
   
 
                     
 
                     
 
                 
Total assets
  $ 10,262,464                       10,591,414                       10,646,746                  
 
   
 
                     
 
                     
 
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
                                                                       
Deposits:
                                                                       
Demand - non-interest bearing
  $ 1,396,593                   1,306,347                   1,340,484              
Demand - interest bearing
    809,707       579       0.28 %     750,434       1,151       0.15 %     748,646       272       0.14 %
Savings and money market accounts
    2,495,659       5,009       0.80 %     2,381,004       18,981       0.80 %     2,466,018       4,351       0.70 %
Certificates and other time deposits
    2,757,968       19,848       2.86 %     3,234,673       102,955       3.18 %     3,125,692       23,950       3.04 %
 
   
 
     
 
             
 
     
 
             
 
     
 
         
Total deposits
    7,459,927       25,436       1.36 %     7,672,458       123,087       1.60 %     7,680,840       28,573       1.48 %
Securities sold under agreements to repurchase
    1,394,398       6,668       1.90 %     1,226,648       18,978       1.55 %     1,289,908       4,776       1.47 %
Wholesale borrowings
    300,477       4,352       5.76 %     541,251       31,591       5.84 %     542,171       7,998       5.85 %
 
   
 
     
 
             
 
     
 
             
 
     
 
         
Total interest bearing liabilities
    7,758,209       36,456       1.87 %     8,134,010       173,656       2.13 %     8,172,435       41,347       2.01 %
Other liabilities
    138,965                       174,634                       159,485                  
Shareholders’ equity
    968,697                       976,423                       974,342                  
 
   
 
                     
 
                     
 
                 
Total liabilities and shareholders’ equity
  $ 10,262,464                       10,591,414                       10,646,746                  
 
   
 
                     
 
                     
 
                 
Net yield on earning assets
  $ 9,441,368       88,051       3.71 %     9,844,214       396,197       4.02 %     9,903,130       99,022       3.97 %
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 
Interest rate spread
                    3.38 %                     3.66 %                     3.61 %
 
                   
 
                     
 
                     
 
 

Notes:  Interest income on tax-exempt securities and loans have been adjusted to a fully-taxable equivalent basis.

Nonaccrual loans have been included in the average balances.

 


Table of Contents

RESULTS OF OPERATIONS

     FirstMerit Corporation reported third quarter 2004 net income of $31.1 million, or $0.37 per diluted share (“EPS”), compared to $39.3 million, or $0.46 per diluted share for the 2003 third quarter. Net interest income in the quarter was $11.1 million lower than the year ago quarter due to contraction in the net interest margin and a decline in average earning assets. Annualized return on average equity (“ROE”) and return on average assets (“ROA”) were 12.78% and 1.21%, respectively, compared with 15.99% and 1.46% for the third quarter of 2003.

     For the first nine months of 2004, the Corporation reported net income of $74.8 million or $0.88 per diluted share. This compares with $114.5 million, or $1.35 per diluted share, for the first nine months of 2003. ROE and ROA were 10.16% and 0.96%, respectively, compared with 15.68% and 1.44% for the prior-year period.

     Total operating revenue, which consists of net interest income on a fully-tax equivalent (“FTE”) basis plus non-interest income, excluding gains from the sale of securities, was $133.2 million for the third quarter of 2004, compared to $155.7 million reported in the prior-year quarter. FTE net interest income declined 11.1% to $88.1 million, reflecting the impact of a 26 basis point decline in the net interest margin to 3.71% and a 4.7% decline in average earning assets to $9.4 billion.

     Non-interest income for the third quarter of 2004 totaled $45.1 million, compared to $57.7 million for the third quarter of 2003. Excluding securities gains and income from the Corporation’s discontinued manufactured housing business, non-interest income was $45.1 million in the third quarter of 2004 and $56.3 million in the same period last year. The 19.9% decline primarily stems from a $4.7 million drop in mortgage banking and a $4.8 million decline in other income.

     Non-interest expense totaled $78.7 million for the third quarter of 2004, compared to $76.2 million for the third quarter of 2003, an increase of 3.3%. The increase resulted primarily from an 8.5% growth in salary and benefits expense, largely due to higher employment counts from the net addition of 108 full time equivalent employees (3.4% increase from third quarter, 2003). Excluding salary expenses, non-interest expenses were virtually unchanged compared with the third quarter of 2003. The efficiency ratio for the quarter was 58.9%, compared with 48.8% for the year ago quarter.

     As of September 30, 2004, nonperforming assets were $47.8 million, or 0.74% of period-end loans plus ORE, compared to $48.8 million, or 0.75%, for the linked quarter and $95.6 million or 1.32%, twelve months ago. The lower level of nonperforming assets this quarter reflects the Corporation’s sale of non-accrual commercial loans during the second quarter and a continued improvement in credit quality trends from the linked and year ago quarters. Net charge-offs for the second quarter were $10.4 million, compared to $14.2 million for the linked quarter and $21.3 million in the prior-year period. Annualized net charge-offs for the third quarter of 2004 were 0.64% of average loans compared to 0.87% for the linked quarter and 1.17% for the third quarter of 2003.

     Assets at September 30, 2004 totaled $10.2 billion, down 4.5% from September 30, 2003. The decline primarily reflects the sale of the Corporation’s manufactured housing finance business in the fourth quarter of 2003; excluding this business line, the total loan portfolio of $6.5 billion was down 2.2% from the prior year. Mortgage and home equity loans increased

 


Table of Contents

5.2% and 5.1%, respectively, providing some offset to a 3.5% decline in commercial loans. Investment securities increased 11.0% over the year ago quarter but have declined 6.1% for the nine months.

     Deposits totaled $7.4 billion at September 30, 2004, a decline of 2.7% over the last twelve months. Time deposits declined 9.9%. Core deposits now account for 62.8% of deposits, compared to 59.8% at September 30, 2003.

     Shareholders’ equity was $979.6 million on September 30, 2004. The Corporation’s tangible equity to assets was 8.34% at quarter end compared to 8.01% for the prior-year quarter end. Common dividends per share were $0.27 for the quarter, a $0.01 increase from the prior-year quarter. Period-end common shares outstanding were 84.3 million reflecting the Corporation’s repurchase of 562,538 shares during the 2004 third quarter.

Net Interest Income

     Net interest income, the Corporation’s principal source of earnings, is the difference between interest income generated by earning assets (primarily loans and investment securities) and interest paid on interest-bearing funds (namely customer deposits, securities sold under agreements to repurchase and wholesale borrowings). Net interest income for the quarter ended September 30, 2004 was $87.4 million compared to $98.4 million for the three months ended September 2003. The $11.1 million decline in net interest income occurred because the $4.9 million decline in interest expense, compared to the same quarter last year was less than the $15.9 million decline in interest income during the same period. For the purpose of this remaining discussion, net interest income is presented on a fully tax-equivalent (“FTE”) basis, to provide a comparison among all types of interest earning assets. That is, interest on tax-free securities and tax-exempt loans has been restated as if such interest were taxed at the statutory Federal income tax rate of 35%, adjusted for the non-deductible portion of interest expense incurred to acquire the tax-free assets. Net interest income presented on an FTE basis is a non-GAAP financial measure widely used by financial services corporations. The FTE adjustment was $0.7 million and $0.6 million for the quarters ending September 30, 2004 and 2003, respectively.

     FTE net interest income for the quarter ended September 30, 2004 was $88.1 million compared to $99.0 million for the three months ended September 30, 2003. The $11.0 million decline in FTE net interest income occurred because the $4.9 million decline in interest expense, compared to the same quarter last year, was less than the $15.9 million decline in interest income during the same period. As illustrated in the following rate/volume analysis table, interest income and interest expense both declined due to the continuing low interest rate environment.

     Consistent with current year third quarter results, the nine-month FTE net interest income of $265.5 was less than last year’s $301.1 million because the $25.2 million decrease in interest expense was less than the $61.2 million decline in interest income.

     As illustrated in the following table, the lower amount of interest income recorded in the 2004 third quarter compared to the same 2003 period, was primarily rate driven as lower yields on loans lessened interest income by $8.5 million during those periods. The table also depicts similar three-month declines in interest expense, again caused by the continued drop in interest rates from 2003 through the second quarter of 2004. The lower rates paid on customer

 


Table of Contents

deposits and wholesale borrowings in the 2004 quarter and nine-month periods compared to the same 2003 periods decreased interest expense by $8.2 million and $35.1 million, respectively.

                                                 
                            Nine months ended September 30, 2004 and
(Dollars in thousands)   Quarters ended September 30, 2004 and 2003
  2003
    Increases (Decreases)
  Increases (Decreases)
RATE/VOLUME ANALYSIS
  Volume
  Rate
  Total
  Volume
  Rate
  Total
INTEREST INCOME FTE
                                               
Investment securities
  $ 2,637       998       3,635       11,303       (2,764 )     8,539  
Loans held for sale
    (149 )     (46 )     (195 )     (706 )     (570 )     (1,276 )
Loans
    (10,754 )     (8,546 )     (19,300 )     (29,050 )     (39,354 )     (68,404 )
Federal funds sold
    (5 )     3       (2 )     (25 )     2       (23 )
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total interest income
  $ (8,271 )     (7,591 )     (15,862 )     (18,478 )     (42,686 )     (61,164 )
 
   
 
     
 
     
 
     
 
     
 
     
 
 
INTEREST EXPENSE
                                               
Demand deposits-interest bearing
  $ 44       263       307       88       522       610  
Savings and money market accounts
    59       599       658       847       (1,520 )     (673 )
Certificates of deposits and other time deposits
    (2,646 )     (1,456 )     (4,102 )     (11,802 )     (7,043 )     (18,845 )
Securities sold under agreements to repurchase
    500       1,392       1,892       4,062       966       5,028  
Wholesale borrowings
    (3,501 )     (145 )     (3,646 )     (10,858 )     (511 )     (11,369 )
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total interest expense
  $ (5,544 )     653       (4,891 )     (17,663 )     (7,586 )     (25,249 )
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Net interest income
  $ (2,727 )     (8,244 )     (10,971 )     (815 )     (35,100 )     (35,915 )
 
   
 
     
 
     
 
     
 
     
 
     
 
 

Net Interest Margin

     The following table provides 2004 FTE net interest income and net interest margin totals as well as 2003 comparative amounts:

                                 
    Quarters ended   Nine months ended
    September 30,
  September 30,
(Dollars in thousands)
  2004
  2003
  2004
  2003
Net interest income
  $ 87,372       98,430       263,481       299,114  
Tax equivalent adjustment
    679       592       2,043       1,965  
 
   
 
     
 
     
 
     
 
 
Net interest income - FTE
  $ 88,051       99,022       265,524       301,079  
 
   
 
     
 
     
 
     
 
 
Average earning assets
  $ 9,441,368       9,903,130       9,583,520       9,868,618  
 
   
 
     
 
     
 
     
 
 
Net interest margin
    3.71 %     3.97 %     3.70 %     4.08 %
 
   
 
     
 
     
 
     
 
 

     Average loan outstandings for the current year and prior year third quarters totaled $6.5 billion and $7.2 billion, respectively. Increases in average loan balances from third quarter 2003 to third quarter this year occurred in installment, credit card, residential mortgage and home equity loans, while commercial and leases declined. The manufactured housing portfolio was sold during the fourth quarter, 2003. This sale was more fully described in Note 5 of the 2003 Form 10-K. The loan migration toward higher-yielding consumer credits continues to be consistent with the Corporation’s loan strategy. Efforts to grow loan outstandings continue to be

 


Table of Contents

tempered by the less than robust economy that currently exists in the Corporation’s primary lending areas.

     Specific changes in average loan outstandings, compared to third quarter 2003, were as follows: commercial loans down $121.2 million or 3.6%; installment loans, direct and indirect on a combined basis, up $11.4 million or 0.7%; home equity loans as a result of targeted marketing rose $25.4 million or 4.0%; credit card loans up $1.8 million or 1.3%; residential mortgage loans were up $62.7 million or 10.9%; manufactured housing loans, for which new origination ceased October 31, 2001 and the remaining portfolio was sold in December 2003, were down $653.5 million; and leases were down $52.9 million, or 33.2%. The majority of fixed-rate mortgage loan originations are sold to investors through the secondary mortgage loan market. Average outstanding loans for the 2004 and 2003 third quarters equaled 68.6% and 72.7% of average earning assets, respectively. The decline in this percentage illustrates the increase in short-term investments, as liquidity remains high and overall loan demand remains flat.

     Average deposits were $7.5 billion during the 2004 third quarter, down $220.9 million, or 2.9%, from the same period last year. Growth occurred in core deposits, which are defined as checking accounts, savings accounts and money market savings products. For the quarter ended September 30, 2004, average core deposits increased $146.8 million or 3.2% and represented 63.0% of total average deposits compared to 59.3% for the 2003 third quarter. Average certificates of deposit (“CDs”) declined $367.7 million or 11.8% compared to the prior year quarter. Average wholesale borrowings decreased $241.7 million and as a percentage of total interest-bearing funds equaled 3.9% for the 2004 third quarter and 6.6% for the same quarter one year ago. Securities sold under agreements to repurchase increased $104.5 million and as a percentage of total interest bearing funds equaled 18.0% for the 2004 third quarter and 15.8% for the 2003 third quarter. The decrease of higher costing CDs was not completely offset by the influx of more liquid core deposits and was offset by an increase in securities sold under agreements to repurchase. Average interest-bearing liabilities funded 82.2% of average earning assets in the current year quarter and 82.5% during the three months ended September 30, 2003.

     In summary, loan growth over the past year occurred mainly in higher-yielding installment, residential mortgage, home equity and credit card outstandings, resulting in a lower concentration of leases and commercial loans. Also, the funding mix for the quarter changed favorably as lower cost core deposits grew and more expensive CDs declined.

Other Income

     Other (non-interest) income for the quarter totaled $45.1 million, a decrease of $12.6 million from the $57.7 million earned during the same period one year ago.

     Other income, net of securities gains, as a percentage of net revenue for the second quarter was 33.9% compared to 36.4% for the same quarter one year ago. Net revenue is defined as net interest income, on a fully tax-equivalent (“FTE”) basis, plus other income, less gains from securities sales. Other income as a percentage of net revenue for the 2004 nine-month period was 33.95% compared to 34.2% in 2003.

     Loan sales and servicing income accounted for $8.0 million of the overall $12.6 million decrease in other income and consisted of: a $1.7 million decrease in origination fees; a $6.6 decrease in the recovery of mortgage servicing rights valuation allowance and a $2.4 million decrease in the

 


Table of Contents

gain on sale of mortgages; offset by a $2.7 million decrease in the amortization of mortgage servicing assets.

     The remaining changes in other income, compared to the third quarter last year, were primarily as follows: trust department income, which benefited from the continuing improvement in the capital markets, was $5.2 million, up 1.5%; service charges on deposit accounts totaled $15.9 million, were down 5.5% due in part to commercial accounts offsetting fees with increased balances; and investment services and insurance fees increased 3.8%. Credit card fees decreased $0.7 million or 7.2% and offsetting the revenue decline were lower processing costs of $1.3 million associated with the exit of low-margin merchant relationships; ATM and other service fees increased 1.41%; income from bank owned life insurance decreased $0.2 million; manufactured housing income decreased $0.4 million due to the December 2003 manufactured housing portfolio sale; and investment securities gains decreased $1.0 million.

     A significant component of loan sales and servicing income category is the income derived from mortgage servicing activities. The following is a summary of changes in capitalized Mortgage Servicing Rights (“MSR”), net of accumulated amortization and valuation allowance, included in the consolidated Statements of Income and Comprehensive Income:

                                         
            Quarter   Quarter   Quarter    
    Quarter ended   ended   ended   ended,   Quarter ended
    September 30,   June 30,   March 31,   December 31,   September 30,
(Dollars in thousands)
  2004
  2004
  2004
  2003
  2003
Balance at beginning of period
  $ 18,258       16,424       18,127       17,992       10,611  
Addition of mortgage servicing rights
    1,117       1,495       855       1,190       4,698  
Amortization
    (931 )     (1,422 )     (1,429 )     (3,201 )     (3,587 )
Impairment
    (345 )     1,761       (1,129 )     2,146       6,270  
 
   
 
     
 
     
 
     
 
     
 
 
Balance at end of period
  $ 18,099       18,258       16,424       18,127       17,992  
 
   
 
     
 
     
 
     
 
     
 
 

     On a quarterly basis, the Corporation assesses its capitalized servicing rights for impairment based on their current fair value. As permitted, the Corporation disaggregates its servicing rights portfolio based on loan type and interest rate which are the predominant risk characteristics of the underlying loans. If any impairment results after current market assumptions are applied, the value of the servicing rights is reduced through the use of a valuation allowance, the balance of which is $0.3 million, $0.6 million, and $3.8 million at September 30, 2004, December 31, 2003 and September 30, 2003, respectively.

     These balances represent the rights to service approximately $2.0 billion, $2.1 billion and $1.9 billion of mortgage loans at September 30, 2004, December 31, 2003, and September 30, 2003, respectively. The portfolio primarily consists of conventional mortgages.

     The MSR’s are amortized over the period of and in proportion to the estimated net servicing revenues. A monthly valuation impairment analysis is performed using a discounted cash flow methodology that is disaggregated by predominant risk characteristics. Impairment, if any, is recognized through a valuation allowance for each individual strata.

 


Table of Contents

     The Corporation continues to focus upon non-interest income (fee income) as a means by which to diversify revenue.

Other Expenses

     Other (non-interest) expenses totaled $78.7 million for the third quarter compared to $76.2 million in 2003, an increase of $2.5 million, or 3.3%.

     For the three months ended September 30, 2004, increases in operating costs compared to third quarter 2003 occurred as follows: salaries, wages, pension and employee benefits, rose $3.3 million, primarily due to additional staff added to revenue-generating positions created to implement strategic revenue initiatives, higher healthcare costs for employees and retirees, and higher pension expense; bankcard, transaction and loan processing costs decreased $1.3 million as a result of reduced refinancing/new origination activity; other operating expense increased $0.8 million primarily due to increases in the operating and collection costs.

     The efficiency ratio of 58.92% for third quarter 2004 was worse than the efficiency ratio of 48.80% recorded for the third quarter, 2003. The efficiency ratio for the three months ended September 30, 2004 indicates 58.92 cents of operating costs were spent in order to generate each dollar of net revenue.

FINANCIAL CONDITION

Investment Securities

     The September 30, 2004 amortized cost and market value of investment securities, including mortgage-backed securities, by average remaining term, are included in Note 4 (Investment Securities) to the unaudited consolidated financial statements.

     These securities are purchased within an overall strategy to maximize future earnings taking into account an acceptable level of interest rate risk. While the maturities of the mortgage and asset-backed securities are beyond five years, these instruments provide periodic principal payments and include securities with adjustable interest rates, reducing the interest rate risk associated with longer-term investments.

Allowance for loan losses

     During the quarter ended March 31, 2004, we observed that rising input costs such as plastic resins, steel and petroleum would impact certain segments of our commercial and industrial loan portfolio. We also observed a higher level of nonaccrual loans from within previously identified criticized loan levels while the economy was in an early stage of recovery. These observations led us to change some of the assumptions used in the Corporation’s allowance for loan losses methodology by shortening the historical period used for estimating loss migration factors which had the effect of more heavily weighting recent loss history in the portfolio. During the quarter ended March 31, 2004, the Corporation strengthened the allowance for loan losses by $22.7 million above net charge-offs. Note 1 (Summary of Significant Accounting Policies) and Note 4 (Allowance for Loan Losses) in the 2003 Form 10-K more fully describe the components of the model.

 


Table of Contents

                                 
                    Nine   Nine
    Quarter ended   Quarter ended   months ended   months ended
    September 30,   September 30,   September 30,   September 30,
(Dollars in thousands)   2004
  2003
  2004
  2003
Allowance for loan losses-beginning of period
  $ 107,561       119,192       97,553       122,790  
Loans charged off:
                               
Commercial
    2,866       5,532       20,828       22,873  
Mortgage
    306       456       598       753  
Installment
    8,540       10,384       26,762       31,025  
Home equity
    995       1,016       2,322       2,691  
Credit cards
    3,009       2,972       8,705       9,264  
Manufactured housing
    130       5,761       443       17,180  
Leases
    273       749       1,468       4,195  
 
   
 
     
 
     
 
     
 
 
Total charge-offs
  $ 16,119       26,870       61,126       87,981  
 
   
 
     
 
     
 
     
 
 
Recoveries:
                               
Commercial
    1,477       521       4,841       1,803  
Mortgage
          3       32       7  
Installment
    2,747       3,066       8,788       9,049  
Home equity
    392       361       1,073       855  
Credit cards
    791       595       2,265       1,532  
Manufactured housing
    219       920       896       2,463  
Leases
    90       144       369       476  
 
   
 
     
 
     
 
     
 
 
Total recoveries
  $ 5,716       5,610       18,264       16,185  
 
   
 
     
 
     
 
     
 
 
Net charge-offs
  $ 10,403       21,260       42,862       71,796  
 
   
 
     
 
     
 
     
 
 
Allowance related to loans sold
                (12,671 )      
Provision for loan losses
    8,952       22,540       64,090       69,478  
 
   
 
     
 
     
 
     
 
 
Allowance for loan losses-end of period
  $ 106,110       120,472       106,110       120,472  
 
   
 
     
 
     
 
     
 
 
Annualized net charge offs as a % of average loans
    0.64 %     1.17 %     0.88 %     1.34 %
Allowance for loan losses as a % of loans outstanding at end of period
    1.64 %     1.66 %     1.64 %     1.66 %
Allowance for loan losses as a multiple of annualized net charge offs
    2.56 X     1.43 X     1.85 X     1.26 X

     The strengthening of the loan loss allowance in the first quarter of 2004 positioned the Corporation to sell during the second quarter, a $35.0 million portfolio of nonperforming loans for which proceeds of $22.3 million was received. The allowance related to the loans sold totaled $12.7 million which resulted in a net basis in the loans sold that was essentially equal to the sale proceeds. In addition to the loan sale, we were able to reach settlement on $5.2 million of additional nonperforming loans.

     During the third quarter of 2004, we analyzed and subsequently made further refinements our allowance for loan losses model assumptions and methodology to better reflect current loss expectations. Criticized assets are down as well as retail delinquencies and charge-offs. We shortened the retail recovery period from five to three years, matching the retail loss period. We also averaged the Corporation’s commercial loan five year migration loss ratios with the Corporation’s two year loss ratios to better reflect the new underwriting standards that have been in effect for the last two years.

 


Table of Contents

Loans

     Total loan outstandings at September 30, 2004 were $6.5 billion compared to $6.6 billion at December 31, 2003 and $7.2 billion at September 30, 2004.

     The commercial loan portfolio and leasing portfolio were impacted by lower demand for credit in light of current economic conditions. As previously noted, the manufactured housing portfolio was sold during December 2003. While the Corporation originated $137.6 million of mortgage loans in the third quarter, 2004, compared to $460.6 million in same quarter of 2003, and $2.1 billion for the full year ended December 31. 2003, the majority of these loans were fixed rate mortgages and sold with servicing rights retained. Further discussion of the Corporation’s loan mix strategy as well as changes in average balances for the quarter ended September 30, 2004 compared to the quarter ended September 30, 2003 can be found in the Net Interest Income section of this document.

                         
    As of   As of   As of
    September 30,   December 31,   September 30,
(Dollars in thousands)
  2004
  2003
  2003
Commercial loans
  $ 3,289,907       3,352,014       3,409,925  
Mortgage loans
    633,545       614,073       602,244  
Installment loans
    1,631,269       1,668,421       1,670,973  
Home equity loans
    665,127       637,749       632,758  
Credit card loans
    140,635       144,514       139,202  
Manufactured housing (“MH”)loans
                634,694  
Leases
    101,258       134,828       151,744  
 
   
 
     
 
     
 
 
Total Loans
  $ 6,461,741       6,551,599       7,241,540  
 
   
 
     
 
     
 
 

     Expected cash flow and interest rate information for commercial loans is presented in the following table:

         
(Dollars in thousands)   As of
    September 30, 2004
Commercial Loan Cash Flow Schedule
       
Due in one year or less
  $ 1,458,867  
Due after one year but within five years
    1,527,184  
Due after five years
    303,856  
 
   
 
 
Totals
  $ 3,289,907  
 
   
 
 
Due after one year with a predetermined fixed interest rate
  $ 1,002,548  
Due after one year with a floating interest rate
    828,492  
 
   
 
 
Totals
  $ 1,831,040  
 
   
 
 

 


Table of Contents

     The following table summarizes the Corporation’s nonperforming assets:

Nonperforming Assets

                         
    September 30,   December 31,   September 30,
(Dollars in thousands)   2004
  2003
  2003
Nonperforming Commercial Loans:
                       
Nonaccrual
  $ 33,812       63,388       77,381  
Restructured
          35       40  
 
   
 
     
 
     
 
 
Total nonperforming commercial loans
    33,812       63,423       77,421  
 
   
 
     
 
     
 
 
Other Loans:
                       
Nonaccrual
    8,054       10,216       12,253  
Restructured
                 
 
   
 
     
 
     
 
 
Total nonperforming loans
    41,866       73,639       89,674  
Other real estate (“ORE”)
    5,923       7,527       5,928  
 
   
 
     
 
     
 
 
Total nonperforming assets
  $ 47,789       81,166       95,602  
 
   
 
     
 
     
 
 
Loans past due 90 day or more accruing interest
  $ 30,882       27,515       32,439  
 
   
 
     
 
     
 
 
Total nonperforming assets as a percentage of total loans and ORE
    0.74 %     1.24 %     1.32 %
 
   
 
     
 
     
 
 

     The $12 million increase from the prior quarter in loans past due 90 days or more accruing interest is primarily attributable to three commercial loans that have matured but not renewed. The borrowers have continued to make payments and the loans are fully collateralized. Two of the loans are under contract to be sold and the third is in negotiation between the land owner and building owner. The Corporation does not anticipate any loss to result from the final disposition of these loans.

     The following is a nonaccrual commercial loan flow analysis:

                                         
(Dollars in thousands)                    
Period End   3Q04   2Q04   1Q04   4Q03   3Q03
Nonaccrual commercial loans beginning of period
  $ 33,080       71,596       63,424       77,421       71,127  
Credit Actions:
                                       
New
    9,094       10,211       26,754       24,519       19,225  
Loan and lease losses
    (1,857 )     (7,253 )     (7,650 )     (2,671 )     (1,764 )
Charged down
    (1,009 )     (1,859 )     (1,387 )     (4,083 )     (3,786 )
Return to accruing status
    (345 )     (744 )     (3,295 )     (8,841 )     (1,958 )
Payments
    (5,151 )     (3,937 )     (6,250 )     (11,948 )     (5,423 )
Sales
          (34,934 )           (10,973 )      
 
   
 
     
 
     
 
     
 
     
 
 
Nonaccrual commercial loans end of period
  $ 33,812       33,080       71,596       63,424       77,421  
 
   
 
     
 
     
 
     
 
     
 
 

     The quarterly flow of new nonaccrual commercial loans has slowed significantly reflecting the impact of an improved regional economy and improved underwriting standards. The allowance for loan losses covers nonperforming loans by 253.4% compared to 134.3% at

 


Table of Contents

the end of the prior year quarter. See Note 1 (Summary of Significant Accounting Policies) of the 2003 Form 10-K for a summary of the Corporation’s nonaccrual and charge off policies.

Deposits

     The following schedule illustrates the change in composition of the average balances of deposits and average rates paid for the noted periods:

                                                 
    Quarter Ended   Year Ended   Quarter Ended
    September 30, 2004
  December 31, 2003
  September 30, 2003
    Average   Average   Average   Average   Average   Average
(Dollars in thousands)   Balance
  Rate
  Balance
  Rate
  Balance
  Rate
Non-interest DDA
  $ 1,396,593             1,306,347             1,340,484        
Interest-bearing DDA
    809,707       0.28 %     750,434       0.15 %     748,646       0.14 %
Savings and money market accounts
    2,495,659       0.80 %     2,381,004       0.80 %     2,466,018       1.70 %
CDs and other time deposits
    2,757,968       2.86 %     3,234,673       3.18 %     3,125,692       3.04 %
 
   
 
             
 
             
 
         
Total customer deposits
  $ 7,459,927       1.36 %     7,672,458       1.60 %     7,680,840       1.66 %
Securities sold under agreements to repurchase
    1,394,398       1.90 %     1,226,648       1.55 %     1,289,908       1.47 %
Wholesale borrowings
    300,477       5.76 %     541,251       5.84 %     542,171       5.85 %
 
   
 
             
 
             
 
         
Total funds
  $ 9,154,802               9,440,357               9,512,919          
 
   
 
             
 
             
 
         

     Interest-bearing and non-interest-bearing demand deposits, on a combined basis, averaged $2.2 billion during the 2004 third quarter, up $117.2 million or 5.6% from third quarter 2003. Savings deposits, including money market savings accounts averaged $2.5 billion, $29.6 million or 1.2% higher than the year ago quarter. The sum of demand and savings accounts, often referred to as “core deposits,” grew $146.8 million or 3.22%, and represented 63.0% of total average deposits for the third quarter, 2004 compared to 59.3% last year.

     The weighted-average yield paid on interest-bearing core deposits during the quarter at 0.67% was 10 basis points more than last year’s average core deposits rate. Average CDs, still the largest individual component of deposits, totaled $2.8 billion for the third quarter, down 11.8% from the same quarter last year. Average rates paid on CDs fell 18 basis points from 3.04% in the 2003 quarter to 2.86% this year. On a percentage basis, average CDs were 35.6% and 38.3%, respectively, of total interest-bearing funds for the September 30, 2004 and 2003 quarters.

     Securities sold under agreements to repurchase increased to 18.0% of interest-bearing funds during the three months ended September 30, 2004 from 15.8% for the September 30, 2003 quarter. Interest-bearing liabilities funded 82.2% of average earning assets during the quarter ended September 30, 2004 and 82.5% during the quarter ended September 30, 2003. Wholesale funds decreased to 3.9% of interest-bearing funds during the third quarter, 2004 from 6.6% in the year ago quarter. In summary, there was a significant increase in average core deposits during the quarter compared to the same period in 2003. The Corporation’s change in

 


Table of Contents

funding mix from higher priced CDs toward less expensive core deposits has helped to mitigate the decline in net interest margin.

     The following table summarizes scheduled maturities of CDs of $100 thousand or more (“Jumbo CDs”) that were outstanding as of September 30, 2004:

(Dollars in thousands)

         
     
Maturing in:
  Amount
Under 3 months
  $ 430,125  
3 to 12 months
    214,966  
Over 12 months
    156,467  
 
   
 
 
 
  $ 801,558  
 
   
 
 

Market Risk

     Market risk refers to potential losses arising from changes in interest rates, foreign exchange rates, equity prices and commodity prices, including the correlation among these factors and their volatility. The Corporation is primarily exposed to interest rate risk as a result of offering a wide array of financial products to its customers.

     Changes in market interest rates may result in changes in the fair market value of the Corporation’s financial instruments, cash flows, and net interest income. The Corporation seeks to achieve consistent growth in net interest income and capital while managing volatility arising from shifts in market interest rates. The Asset and Liability Committee (“ALCO”) oversees market risk management, establishing risk measures, limits, and policy guidelines for managing the amount of interest rate risk and its effect on net interest income and capital. According to these policies, responsibility for measuring and the management of interest rate risk resides in the Corporate Treasury function.

     Interest rate risk on the Corporation’s consolidated balance sheets consists of reprice, option, and basis risks. Reprice risk results from differences in the maturity, or repricing, of asset and liability portfolios. Option risk arises from “embedded options” present in many financial instruments such as loan prepayment options, deposit early withdrawal options and interest rate options. These options allow customers opportunities to benefit when market interest rates change, which typically results in higher net revenue for the Corporation. Basis risk refers to the potential for changes in the underlying relationship between market rates or indices, which subsequently result in a narrowing of profit spread on an earning asset or liability. Basis risk is also present in administered rate liabilities, such as interest-bearing checking accounts, savings accounts and money market accounts where historical pricing relationships to market rates may change due to the level or directional change in market interest rates.

     The interest rate risk position is measured and monitored using risk management tools, including earnings simulation modeling and economic value of equity sensitivity analysis, which capture both near-term and long-term interest rate risk exposures. Combining the results from these separate risk measurement processes allows a reasonably comprehensive view of short-term and long-term interest rate risk in the Corporation.

 


Table of Contents

     Earnings simulation involves forecasting net interest earnings under a variety of scenarios including changes in the level of interest rates, the shape of the yield curve, and spreads between market interest rates. The sensitivity of net interest income to changes in interest rates is measured using numerous interest rate scenarios including shocks, gradual ramps, curve flattening, curve steepening as well as forecasts of likely interest rates scenarios. Presented below is the Corporation’s interest rate risk profile as of September 30, 2004:

     Immediate Change in Rates and Resulting Percentage Increase/(Decrease) in Net Interest Income:

                         
    -50 basis points
  +100 basis points
  +200 basis points
September 30, 2004
    (1.47 %)     0.35 %     0.06 %

     Modeling the sensitivity of net interest earnings to changes in market interest rates is highly dependent on numerous assumptions incorporated into the modeling process. To the extent that actual performance is different than what was assumed, actual net interest earnings sensitivity may be different than projected. The assumptions used in the models are management’s best estimate based on studies conducted by the ALCO department. The ALCO department uses a data-warehouse to study interest rate risk at a transactional level and uses various ad-hoc reports to refine assumptions continuously. Assumptions and methodologies regarding administered rate liabilities (e.g., savings, money market and interest-bearing checking accounts), balance trends, and repricing relationships reflect management’s best estimate of expected behavior and these assumptions are reviewed regularly.

     The Corporation also has longer-term interest rate risk exposure, which may not be appropriately measured by earnings sensitivity analysis. ALCO uses economic value of equity, or EVE, sensitivity analysis to study the impact of long-term cash flows on earnings and capital. Economic value of equity involves discounting present values of all cash flows on the balance sheet and off balance sheet items under different interest rate scenarios. The discounted present value of all cash flows represents the Corporation’s economic value of equity. The analysis requires modifying the expected cash flows in each interest rate scenario, which will impact the discounted present value. The amount of base-case measurement and its sensitivity to shifts in the yield curve allow management to measure longer-term repricing and option risk in the balance sheet. Presented below is the Corporation’s EVE profile as of September 30, 2004:

Immediate Change in Rates and Resulting Percentage Increase/(Decrease) in EVE:

                         
    -50 basis points
  +100 basis points
  +200 basis points
September 30, 2004
    (1.12 %)     (2.63 %)     (6.11 %)

 


Table of Contents

Capital Resources

     Shareholders’ equity at September 30, 2004 totaled $979.6 million compared to $987.2 million at December 31, 2003 and $986.2 million at September 30, 2003.

The following table reflects the various measures of capital:

                                                 
    September 30,   December 31,   September 30,
(In thousands)   2004
  2003
  2003
Consolidated
                                               
Total equity
  $ 979,640       9.64 %     987,175       9.43 %     986,163       9.26 %
Common equity
    979,640       9.64 %     987,175       9.43 %     985,176       9.25 %
Tangible common equity (a)
    835,526       8.34 %     842,394       8.16 %     840,172       8.00 %
Tier 1 capital (b)
    865,570       11.00 %     869,535       10.82 %     884,846       10.24 %
Total risk-based capital (c)
    1,113,615       14.16 %     1,116,662       13.89 %     1,142,592       13.22 %
Leverage (d)
    865,570       8.52 %     869,535       8.36 %     884,846       8.42 %
Bank Only
                                               
Total equity
  $ 787,505       7.77 %     781,734       7.48 %     780,880       7.35 %
Common equity
    787,505       7.77 %     781,734       7.48 %     780,880       7.35 %
Tangible common equity (a)
    643,391       6.44 %     636,953       6.18 %     635,876       6.07 %
Tier 1 capital (b)
    762,453       9.71 %     755,435       9.40 %     770,924       8.92 %
Total risk-based capital (c)
    1,008,025       12.84 %     1,002,484       12.45 %     1,028,435       11.88 %

(a)   Common equity less all intangibles; computed as a ratio to total assets less intangible assets.
 
(b)   Shareholders’ equity minus net unrealized holding gains on equity securities, plus or minus net unrealized holding losses or gains on available for sale debt securities, less goodwill; computed as a ratio to risk-adjusted assets, as defined in the 1992 risk-based capital guidelines.
 
(c)   Tier 1 capital plus qualifying loan loss allowance, computed as a ratio to risk-adjusted assets, as defined in the 1992 risk-based capital guidelines.
 
(d)   Tier 1 capital; computed as a ratio to the latest quarter’s average assets less goodwill.

The risk-based capital guidelines issued by the Federal Reserve Bank in 1988 require banks to maintain adequate capital equal to 8% of risk-adjusted assets effective December 31, 1993. At September 30, 2004, the Corporation’s risk-based capital equaled 14.16% of risk-adjusted assets, exceeding minimum guidelines.

 


Table of Contents

     The cash dividend of $0.27 paid in the third quarter has an indicated annual rate of $1.06 per share.

Liquidity Risk Management

     Liquidity risk is the possibility of the Corporation being unable to meet current and future financial obligations in a timely manner. Liquidity is managed to ensure stable, reliable and cost-effective sources of funds to satisfy demand for credit, deposit withdrawals and investment opportunities. The Corporation considers core earnings, strong capital ratios and credit quality essential for maintaining high credit ratings, which allow the Corporation cost-effective access to market-based liquidity. The Corporation relies on a large, stable core deposit base and a diversified base of wholesale funding sources to manage liquidity risk.

     The Treasury Group is responsible for identifying, measuring and monitoring the Corporation’s liquidity profile. The position is evaluated daily, weekly and monthly by analyzing the composition of all funding sources, reviewing projected liquidity commitments by future month and identifying sources and uses of funds. The Treasury Group also prepares a contingency funding plan that details the potential erosion of funds in the event of a systemic financial market crisis or institutional-specific stress. In addition, the overall management of the Corporation’s liquidity position is integrated into retail deposit pricing policies to ensure a stable core deposit base.

     The Corporation’s primary source of liquidity is its core deposit base, raised through its retail branch system, along with unencumbered, or unpledged, investment securities and unused wholesale sources of liquidity. The Corporation also has available unused wholesale sources of liquidity, including advances from the Federal Home Loan Bank of Cincinnati, issuance through dealers in the capital markets and access to certificates of deposits issued through brokers. Liquidity is also provided by unencumbered, or un-pledged investment securities that totaled $427.0 million at quarter end 2004.

     Funding Trends for the Quarter - During the three months ended September 30, 2004, total deposits decreased $25.7 million from the linked quarter as much higher cost certificates of deposit were allowed to mature without rollover.

     Parent Company Liquidity — The Corporation manages its liquidity principally through dividends from the bank subsidiary. During the third quarter ended September 30, 2004, FirstMerit Bank paid FirstMerit Corporation $63 million in dividends. As of September 30, 2004, FirstMerit Bank had an additional $44.5 million available to pay dividends without regulatory approval.

Forward-looking Safe-harbor Statement

     The Corporation cautions that any forward-looking statements contained in this report, in a report incorporated by reference to this report or made by management of the Corporation, involve risks and uncertainties and are subject to change based upon various factors. Actual results could differ materially from those expressed or implied. Reference is made to the section titled “Forward-looking Statements” in the Corporation’s Form 10-K for the period ended December 31, 2003.

 


Table of Contents

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     See Market Risk Section in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

ITEM 4. CONTROLS AND PROCEDURES

     Management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, has made an evaluation of the effectiveness of the design and operation of the Corporation’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15.

     During the period covered by the report, there was no change in internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, the Corporation’s internal control over financial reporting.

     Based upon the evaluation, the Chief Executive Officer and Chief Financial Officer have concluded, as of the end of the period covered by this report, that the Corporation’s disclosure controls and procedures are effective to ensure that all material information required to be filed in this report has been made known to them, as appropriate to allow timely decisions regarding required disclosure.

 


Table of Contents

PART II — OTHER INFORMATION

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

     (a) On August 18, 2004, the Corporation issued 1,056 shares of common stock to Christopher J. Maurer Executive Vice President, Human Resources, in a private transaction exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended, in connection with an exercise of an incentive stock option for 6,667 shares granted pursuant to the Amended and Restated 2002 Stock Option Plan, at an exercise price of $19.96 per share.

     (b) Not applicable.

     (c) The following table provides information with respect to purchases the Corporation made of its common stock during the third quarter of the 2004 fiscal year:

                                 
                    (c) Total Number of   (d) Maximum
                    Shares Purchased   Number of Shares
                    as Part of Publicly   that May Yet be
    (a) Total Number of   (b) Average Price   Announced Plans   Purchased Under
    Shares Purchased   Paid per Share   or Programs   Plans or Programs
Balance as of June  30, 2004:
          $ 24.24               1,254,482  
July 15, 2004  (1)
                      (1,254,482 )
July 15, 2004  (1)
                      3,000,000  
July 1, 2004 - July 31, 2004
    50,000       25.93       50,000       2,950,000  
August 1, 2004 - August 31, 2004
    512,538       25.96       512,538       2,437,462  
August 1, 2004 - August 31, 2004 (2)
    11,381       26.05             2,437,462  
September 1, 2004 - September 30, 2004
                         
 
   
 
     
 
     
 
     
 
 
Balance as of September 30, 2004:
    573,919     $ 25.96             2,437,462  
 
   
 
     
 
     
 
     
 
 

(1)   On May 17, 2001, the Corporation announced that its Board of Directors authorized a common stock repurchase program. Under the program, the Company is authorized to repurchase up to 3 million shares of its common stock. On July 15, 2004 the Board of Directors authorized the repurchase of up to 3 million shares of its currently outstanding common stock superseding the repurchase program announced May 17, 2001.
 
(2)   Shares of common stock delivered or restricted shares of common stock withheld to pay income tax or other tax liabilities with respect to the vesting of restricted stock, exercise of stock options, or the settlement of performance share awards.

 


Table of Contents

ITEM 6. EXHIBITS

(a) Exhibits

Exhibit Index

Exhibit
Number

3.1   Amended and Restated Articles of Incorporation of FirstMerit Corporation, as amended (incorporated by reference from Exhibit 3.1 to the Form 10-K/A filed by the Registrant on April 29, 1999)
 
3.2   Amended and Restated Code of Regulations of FirstMerit Corporation (incorporated by reference from Exhibit 3(b) to the Form 10-K filed by the registrant on April 9, 1998)
 
4.1   Shareholders Rights Agreement dated October 21, 1993, between FirstMerit Corporation and FirstMerit Bank, N.A., as amended and restated May 20, 1998 (incorporated by reference from Exhibit 4 to the Form 8-A/A filed by the registrant on June 22, 1998)
 
4.2   Instrument of Assumption of Indenture between FirstMerit Corporation and NBD Bank, as Trustee, dated October 23, 1998 regarding FirstMerit Corporation’s 6 1/4% Convertible Subordinated Debentures, due May 1, 2008 (incorporated by reference from Exhibit 4(b) to the Form 10-Q filed by the registrant on November 13, 1998)
 
4.3   Supplemental Indenture, dated as of February 12, 1999, between FirstMerit and Firstar Bank Milwaukee, National Association, as Trustee relating to the obligations of the FirstMerit Capital Trust I, fka Signal Capital Trust I (incorporated by reference from Exhibit 4.3 to the Form 10-K filed by the Registrant on March 22, 1999)
 
4.4   Indenture dated as of February 13, 1998 between Firstar Bank Milwaukee, National Association, as trustee and Signal Corp (incorporated by reference from Exhibit 4.1 to the Form S-4 No. 333-52581-01, filed by FirstMerit Capital Trust I, fka Signal Capital Trust I, on May 13, 1998)
 
4.5   Amended and Restated Declaration of Trust of FirstMerit Capital Trust I, fka Signal Capital Trust I, dated as of February 13, 1998 (incorporated by reference from Exhibit 4.5 to the Form S-4 No. 333-52581-01, filed by FirstMerit Capital Trust I, fka Signal Capital Trust I, on May 13, 1998)
 
4.6   Form Capital Security Certificate (incorporated by reference from Exhibit 4.6 to the Form S-4 No. 333-52581-01, filed by FirstMerit Capital Trust I, fka Signal Capital Trust I, on May 13, 1998)
 
4.7   Series B Capital Securities Guarantee Agreement (incorporated by reference from Exhibit 4.7 to the Form S-4 No. 333-52581-01, filed by FirstMerit Capital Trust I, fka Signal Capital Trust I, on May 13, 1998)
 
4.8   Form of 8.67% Junior Subordinated Deferrable Interest Debenture, Series B (incorporated by reference from Exhibit 4.7 to the Form S-4 No. 333-52581-01, filed by FirstMerit Capital Trust I, fka Signal Capital Trust I, on May 13, 1998)
 
10.6   Amended and Restated 2002 Stock Plan *
 
31.1   Rule 13a-14(a)/Section 302 Certification of John R. Cochran, Chairman and Chief Executive Officer of FirstMerit Corporation
 
31.2   Rule 13a-14(a)/Section 302 Certification of Terrence E. Bichsel, Executive Vice President and Chief Financial Officer of FirstMerit Corporation
 
32.1   Rule 13a-14(b)/Section 906 Certifications of John R. Cochran, Chairman and Chief Executive Officer of FirstMerit Corporation, and Terrence E. Bichsel, Executive Vice President and Chief Financial Officer of FirstMerit Corporation

*Indicates management contract or compensatory plan or arrangement

 


Table of Contents

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.
         
  FIRSTMERIT CORPORATION
 
 
  By:   /s/TERRENCE E. BICHSEL    
    Terrence E. Bichsel, Executive Vice President   
    and Chief Financial Officer   
 

DATE:  November 8, 2004