e10vq
Table of Contents

 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 
Washington, D.C. 20549
 
FORM 10-Q
 
 
         
(Mark One)        
 
þ
 
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009
OR
            
         
         
         
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the transition period from          to          
Commission File No. 0-2989
 
 
COMMERCE BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
 
     
Missouri
(State of Incorporation)
  43-0889454
(IRS Employer Identification No.)
     
1000 Walnut,
Kansas City, MO
(Address of principal executive offices)
 
64106
(Zip Code)
     
(816) 234-2000
(Registrant’s telephone number, including area code)
   
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 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 þ     No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
 
  Yes o     No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer þ Accelerated filer o Non-accelerated filer o Smaller reporting company o
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
  Yes o     No þ
 
As of October 27, 2009, the registrant had outstanding 78,937,200 shares of its $5 par value common stock, registrant’s only class of common stock.
 


 

 
Commerce Bancshares, Inc. and Subsidiaries
 
Form 10-Q
 
                 
INDEX          
Page
 
  Financial Information        
                 
                 
                 
    Item 1.   Financial Statements        
                 
        Consolidated Balance Sheets as of September 30, 2009 (unaudited) and December 31, 2008     3  
                 
        Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2009 and 2008 (unaudited)     4  
                 
        Consolidated Statements of Changes in Equity for the Nine Months Ended September 30, 2009 and 2008 (unaudited)     5  
                 
        Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2009 and 2008 (unaudited)     6  
                 
        Notes to Consolidated Financial Statements     7  
                 
    Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations     33  
                 
    Item 3.   Quantitative and Qualitative Disclosures about Market Risk     60  
                 
    Item 4.   Controls and Procedures     60  
             
  Other Information        
                 
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds     61  
                 
    Item 6.   Exhibits     61  
Signatures     62  
         
    63  
 EX-31.1
 EX-31.2
 EX-32


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Table of Contents

 
PART I: FINANCIAL INFORMATION
 
Item 1.  FINANCIAL STATEMENTS
 
Commerce Bancshares, Inc. and Subsidiaries
 
CONSOLIDATED BALANCE SHEETS
                 
   
    September 30
    December 31
 
    2009     2008  
   
    (Unaudited)        
    (In thousands)  
 
ASSETS
Loans
  $ 10,282,690     $ 11,283,246  
Allowance for loan losses
    (190,466 )     (172,619 )
 
 
Net loans
    10,092,224       11,110,627  
 
 
Loans held for sale
    317,913       361,298  
Investment securities:
               
Available for sale ($538,419,000 and $525,993,000 pledged in 2009 and 2008, respectively, to secure structured repurchase agreements)
    6,075,632       3,630,753  
Trading
    9,242       9,463  
Non-marketable
    133,732       139,900  
 
 
Total investment securities
    6,218,606       3,780,116  
 
 
Federal funds sold and securities purchased under agreements to resell
    12,620       169,475  
Interest earning deposits with banks
    118,745       638,158  
Cash and due from banks
    342,949       491,723  
Land, buildings and equipment, net
    403,900       411,168  
Goodwill
    125,585       125,585  
Other intangible assets, net
    15,060       17,191  
Other assets
    305,505       427,106  
 
 
Total assets
  $ 17,953,107     $ 17,532,447  
 
 
 
LIABILITIES AND EQUITY
Deposits:
               
Non-interest bearing demand
  $ 1,512,529     $ 1,375,000  
Savings, interest checking and money market
    8,678,985       7,610,306  
Time open and C.D.’s of less than $100,000
    2,004,276       2,067,266  
Time open and C.D.’s of $100,000 and over
    1,645,005       1,842,161  
 
 
Total deposits
    13,840,795       12,894,733  
 
 
Federal funds purchased and securities sold under agreements to repurchase
    1,130,193       1,026,537  
Other borrowings
    821,941       1,747,781  
Other liabilities
    309,534       283,929  
 
 
Total liabilities
    16,102,463       15,952,980  
 
 
Commerce Bancshares, Inc. stockholders’ equity:
               
Preferred stock, $1 par value
               
Authorized and unissued 2,000,000 shares
           
Common stock, $5 par value
               
Authorized 100,000,000 shares; issued 79,036,499 shares in 2009 and 75,901,097 shares in 2008
    395,182       379,505  
Capital surplus
    710,588       621,458  
Retained earnings
    696,876       633,159  
Treasury stock of 22,146 shares in 2009 and 18,789 shares in 2008, at cost
    (825 )     (761 )
Accumulated other comprehensive income (loss)
    47,003       (56,729 )
 
 
Total Commerce Bancshares, Inc. stockholders’ equity
    1,848,824       1,576,632  
Non-controlling interest
    1,820       2,835  
 
 
Total equity
    1,850,644       1,579,467  
 
 
Total liabilities and equity
  $ 17,953,107     $ 17,532,447  
 
 
See accompanying notes to consolidated financial statements.


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Table of Contents

Commerce Bancshares, Inc. and Subsidiaries
 
CONSOLIDATED STATEMENTS OF INCOME
                                 
   
    For the Three Months Ended September 30     For the Nine Months Ended September 30  
(In thousands, except per share data)   2009     2008     2009     2008  
   
    (Unaudited)  
 
INTEREST INCOME
                               
Interest and fees on loans
  $ 138,614     $ 161,816     $ 422,446     $ 497,161  
Interest and fees on loans held for sale
    1,445       3,774       6,840       11,314  
Interest on investment securities
    61,416       41,749       164,403       123,956  
Interest on federal funds sold and securities purchased under agreements to resell
    52       2,125       202       7,790  
Interest on deposits with banks
    120             622        
 
 
Total interest income
    201,647       209,464       594,513       640,221  
 
 
INTEREST EXPENSE
                               
Interest on deposits:
                               
Savings, interest checking and money market
    7,695       14,802       23,726       49,769  
Time open and C.D.’s of less than $100,000
    13,485       16,128       42,777       61,855  
Time open and C.D.’s of $100,000 and over
    8,431       11,542       29,646       42,728  
Interest on federal funds purchased and securities sold under agreements to repurchase
    816       5,417       2,895       23,051  
Interest on other borrowings
    7,681       10,011       24,470       26,368  
 
 
Total interest expense
    38,108       57,900       123,514       203,771  
 
 
Net interest income
    163,539       151,564       470,999       436,450  
Provision for loan losses
    35,361       29,567       119,695       67,567  
 
 
Net interest income after provision for loan losses
    128,178       121,997       351,304       368,883  
 
 
NON-INTEREST INCOME
                               
Deposit account charges and other fees
    27,750       27,854       80,277       83,189  
Bank card transaction fees
    31,279       29,317       88,552       85,019  
Trust fees
    19,258       20,518       57,486       60,917  
Bond trading income
    4,834       2,604       16,381       9,951  
Consumer brokerage services
    3,045       3,439       9,566       10,259  
Loan fees and sales
    6,851       1,594       13,545       4,884  
Other
    9,118       10,267       27,321       36,267  
 
 
Total non-interest income
    102,135       95,593       293,128       290,486  
 
 
INVESTMENT SECURITIES GAINS (LOSSES), NET
                               
Impairment losses on securities
    (3,457 )           (35,422 )      
Less noncredit-related losses on securities not expected to be sold
    1,993             32,611        
 
 
Net impairment losses
    (1,464 )           (2,811 )      
Realized gains (losses) on sales and fair value adjustments
    519       1,149       (3,059 )     25,480  
 
 
Investment securities gains (losses), net
    (945 )     1,149       (5,870 )     25,480  
 
 
NON-INTEREST EXPENSE
                               
Salaries and employee benefits
    87,267       83,766       260,299       250,023  
Net occupancy
    11,752       11,861       34,652       34,735  
Equipment
    6,306       6,122       18,883       18,273  
Supplies and communication
    8,061       9,276       24,994       26,545  
Data processing and software
    15,500       14,229       44,854       41,951  
Marketing
    4,846       4,926       14,099       15,660  
Deposit insurance
    4,833       510       21,908       1,535  
Indemnification obligation
    (2,496 )     2,879       (2,496 )     (5,929 )
Loss on purchase of auction rate securities
          32,967             33,266  
Other
    18,420       17,910       50,193       55,633  
 
 
Total non-interest expense
    154,489       184,446       467,386       471,692  
 
 
Income before income taxes
    74,879       34,293       171,176       213,157  
Less income taxes
    23,415       9,534       52,264       67,320  
 
 
Net income before non-controlling interest
    51,464       24,759       118,912       145,837  
Less non-controlling interest expense (income)
    (185 )     86       (541 )     1,018  
 
 
Net income
  $ 51,649     $ 24,673     $ 119,453     $ 144,819  
 
 
Net income per common share – basic
  $ .66     $ .33     $ 1.55     $ 1.92  
Net income per common share – diluted
  $ .66     $ .32     $ 1.54     $ 1.90  
 
 
See accompanying notes to consolidated financial statements.


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Commerce Bancshares, Inc. and Subsidiaries
 
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
                                                         
   
    Commerce Bancshares, Inc. Shareholders              
                            Accumulated
             
                            Other
    Non-
       
(In thousands,
  Common
    Capital
    Retained
    Treasury
    Comprehensive
    Controlling
       
except per share data)   Stock     Surplus     Earnings     Stock     Income (Loss)     Interest     Total  
   
    (Unaudited)  
 
Balance January 1, 2009
  $ 379,505     $ 621,458     $ 633,159     $ (761 )   $ (56,729 )   $ 2,835     $ 1,579,467  
 
 
Net income
                    119,453                       (541 )     118,912  
Change in unrealized gain (loss) related to available for sale securities for which a portion of an other-than-temporary impairment has been recorded in earnings, net of tax
                                    7,309               7,309  
Change in unrealized gain (loss) on all other available for sale securities, net of tax
                                    95,048               95,048  
Amortization of pension loss, net of tax
                                    1,375               1,375  
                                                         
Total comprehensive income
                                                    222,644  
                                                         
Distributions to non-controlling interest
                                            (474 )     (474 )
Purchase of treasury stock
                            (462 )                     (462 )
Issuance of stock under open market sale program
    14,474       83,698                                       98,172  
Issuance of stock under purchase and equity compensation plans
    439       1,570               (39 )                     1,970  
Net tax benefit related to equity compensation plans
            138                                       138  
Stock-based compensation
            4,925                                       4,925  
Issuance of nonvested stock awards
    764       (1,201 )             437                        
Cash dividends paid ($.720 per share)
                    (55,736 )                             (55,736 )
 
 
Balance September 30, 2009
  $ 395,182     $ 710,588     $ 696,876     $ (825 )   $ 47,003     $ 1,820     $ 1,850,644  
 
 
Balance January 1, 2008
  $ 359,694     $ 475,220     $ 669,142     $ (2,477 )   $ 26,107     $ 2,470     $ 1,530,156  
 
 
Net income
                    144,819                       1,018       145,837  
Change in unrealized gain (loss) on available for sale securities, net of tax
                                    (30,856 )             (30,856 )
                                                         
Total comprehensive income
                                                    114,981  
                                                         
Distributions to non-controlling interest
                                            (366 )     (366 )
Purchase of treasury stock
                            (8,427 )                     (8,427 )
Issuance of stock under purchase and equity compensation plans
    1,153       1,708               9,991                       12,852  
Net tax benefit related to equity compensation plans
            1,456                                       1,456  
Stock-based compensation
            4,897                                       4,897  
Issuance of nonvested stock awards
    88       (840 )             752                        
Cash dividends paid ($.714 per share)
                    (54,003 )                             (54,003 )
Adoption of fair value guidelines allowing use of transaction price at initial measurement
                    903                               903  
Adoption of guidelines requiring recognition of liabilities for benefits payable under split-dollar life insurance arrangements
                    (716 )                             (716 )
 
 
Balance September 30, 2008
  $ 360,935     $ 482,441     $ 760,145     $ (161 )   $ (4,749 )   $ 3,122     $ 1,601,733  
 
 
See accompanying notes to consolidated financial statements.


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Commerce Bancshares, Inc. and Subsidiaries
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
                 
   
    For the Nine Months
 
    Ended September 30  
(In thousands)   2009     2008  
   
    (Unaudited)  
 
OPERATING ACTIVITIES:
               
Net income
  $ 119,453     $ 144,819  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Provision for loan losses
    119,695       67,567  
Provision for depreciation and amortization
    38,334       37,991  
Net amortization (accretion) of investment security premiums/discounts
    (811 )     4,143  
Investment securities (gains) losses, net(A)
    5,870       (25,480 )
Gains on sales of branches
    (644 )     (6,938 )
Net gains on sales of loans held for sale
    (9,689 )     (2,544 )
Originations of loans held for sale
    (465,020 )     (319,336 )
Proceeds from sales of loans held for sale
    504,305       164,824  
Net (increase) decrease in trading securities
    (6,371 )     13,270  
Stock-based compensation
    4,925       4,897  
Decrease in interest receivable
    1,318       10,161  
Decrease in interest payable
    (11,587 )     (33,957 )
Increase (decrease) in income taxes payable
    2,069       (2,156 )
Net tax benefit related to equity compensation plans
    (138 )     (1,456 )
Loss on purchase of auction rate securities
          33,266  
Other changes, net
    33,001       (645 )
 
 
Net cash provided by operating activities
    334,710       88,426  
 
 
INVESTING ACTIVITIES:
               
Cash paid in branch sales
    (3,494 )     (54,490 )
Proceeds from sales of investment securities(A)
    32,185       128,157  
Proceeds from maturities/pay downs of investment securities(A)
    1,012,734       1,146,089  
Purchases of investment securities(A)
    (3,319,666 )     (1,869,250 )
Net (increase) decrease in loans
    898,708       (448,842 )
Purchases of land, buildings and equipment
    (21,017 )     (31,891 )
Sales of land, buildings and equipment
    135       493  
 
 
Net cash used in investing activities
    (1,400,415 )     (1,129,734 )
 
 
FINANCING ACTIVITIES:
               
Net increase in non-interest bearing demand, savings, interest checking and money market deposits
    1,277,145       653  
Net decrease in time open and C.D.’s
    (258,380 )     (273,138 )
Net increase in federal funds purchased and securities sold under agreements to repurchase
    103,656       321,063  
Repayment of long-term borrowings
    (225,840 )     (8,126 )
Additional long-term borrowings
    100,000       375,000  
Net increase (decrease) in short-term borrowings
    (800,000 )     299,997  
Purchases of treasury stock
    (462 )     (8,427 )
Issuance of stock under open market stock sale program, stock purchase and equity compensation plans
    100,142       12,852  
Net tax benefit related to equity compensation plans
    138       1,456  
Cash dividends paid on common stock
    (55,736 )     (54,003 )
 
 
Net cash provided by financing activities
    240,663       667,327  
 
 
Decrease in cash and cash equivalents
    (825,042 )     (373,981 )
Cash and cash equivalents at beginning of year
    1,299,356       1,328,246  
 
 
Cash and cash equivalents at September 30
  $ 474,314     $ 954,265  
 
 
(A) Available for sale and non-marketable securities
               
 
 
Income tax net payments
  $ 51,096     $ 70,248  
Interest paid on deposits and borrowings
  $ 135,121     $ 237,734  
 
 
See accompanying notes to consolidated financial statements.


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Table of Contents

 
Commerce Bancshares, Inc. and Subsidiaries
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2009
(Unaudited)
 
1.  Principles of Consolidation and Presentation
 
The accompanying consolidated financial statements include the accounts of Commerce Bancshares, Inc. and all majority-owned subsidiaries (the Company). The consolidated financial statements in this report have not been audited. All significant intercompany accounts and transactions have been eliminated. Certain reclassifications were made to 2008 data to conform to current year presentation. In the opinion of management, all adjustments necessary to present fairly the financial position and the results of operations for the interim periods have been made. All such adjustments are of a normal recurring nature. The results of operations for the three and nine month periods ended September 30, 2009 are not necessarily indicative of results to be attained for the full year or any other interim periods. The Company evaluated subsequent events for recognition or disclosure through November 6, 2009, the date on which the financial statements were issued.
 
The significant accounting policies followed in the preparation of the quarterly financial statements are disclosed in the 2008 Annual Report on Form 10-K.
 
2.  Acquisitions and Dispositions
 
In February 2009, the Company sold its branch in Lakin, Kansas. In this transaction, the Company sold the bank facility and certain deposits totaling approximately $4.7 million and recorded a gain of $644 thousand.
 
During the second quarter of 2008, the Company sold its banking branch in Independence, Kansas. In this transaction, approximately $23.3 million in loans, $85.0 million in deposits, and various other assets and liabilities were sold, and the Company recorded a gain of $6.9 million.
 
3.  Loans and Allowance for Loan Losses
 
Major classifications within the Company’s held to maturity loan portfolio at September 30, 2009 and December 31, 2008 are as follows.
 
                 
   
    September 30
    December 31
 
(In thousands)   2009     2008  
   
 
Business
  $ 2,878,354     $ 3,404,371  
Real estate – construction and land
    687,828       837,369  
Real estate – business
    2,159,058       2,137,822  
Real estate – personal
    1,560,965       1,638,553  
Consumer
    1,390,077       1,615,455  
Home equity
    489,710       504,069  
Student
    337,339       358,049  
Consumer credit card
    765,377       779,709  
Overdrafts
    13,982       7,849  
 
 
Total loans
  $ 10,282,690     $ 11,283,246  
 
 
 
At September 30, 2009, loans of $3.1 billion were pledged at the Federal Home Loan Bank as collateral for borrowings and letters of credit obtained to secure public deposits. Additional loans of $1.2 billion were pledged at the Federal Reserve Bank as collateral for discount window borrowings and borrowings under the Term Auction Facility.
 
Included in the table above are impaired loans, which are generally those loans placed on non-accrual status. Such loans totaled $121.7 million at September 30, 2009 and $72.9 million at December 31, 2008. A loan is considered to be impaired when, based on current information and events, it is probable that all amounts due under the contractual terms of the agreement will not be collected. Such loans increased


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$48.8 million in the first nine months of 2009, mainly because of higher levels of impaired construction and land real estate loans and business loans. At September 30, 2009, 9.8% of the construction loan portfolio was considered to be impaired.
 
In addition to its basic portfolio, the Company originates loans which it intends to sell in secondary markets. Loans classified as held for sale primarily consist of loans originated to students while attending colleges and universities. The Company maintains contracts with the Federal Department of Education and various student loan agencies to sell student loans at various times while the student is attending school or shortly after graduation. Also included as held for sale are certain fixed rate residential mortgage loans which are sold in the secondary market, generally within three months of origination. The following table presents information about loans held for sale, including an impairment valuation allowance resulting from declines in fair value, which is discussed further in Note 14 on Fair Value Measurements. Previously recognized impairment losses amounting to $3.1 million were reversed during the first nine months of 2009, as certain impaired loans were sold in accordance with contractual terms.
 
                 
   
    September 30
    December 31
 
(In thousands)   2009     2008  
   
 
Balance outstanding:
               
Student
  $ 309,483     $ 358,556  
Residential mortgage
    8,430       2,742  
 
 
Total loans held for sale balance
  $ 317,913     $ 361,298  
 
 
Decline in fair value below cost
  $ (6,269 )   $ (9,398 )
 
 
 
                 
   
    For the Nine Months
 
    Ended September 30  
(In thousands)   2009     2008  
   
 
Net gains on sales:
               
Student
  $ 7,636     $ 1,737  
Residential mortgage
    2,053       807  
 
 
Total gains on sales of loans held for sale, net
  $ 9,689     $ 2,544  
 
 
 
The following is a summary of the allowance for loan losses.
 
                                 
   
    For the Three Months
    For the Nine Months
 
    Ended September 30     Ended September 30  
(In thousands)   2009     2008     2009     2008  
   
 
Balance, beginning of period
  $ 186,001     $ 145,198     $ 172,619     $ 133,586  
 
 
Additions:
                               
Provision for loan losses
    35,361       29,567       119,695       67,567  
 
 
Total additions
    35,361       29,567       119,695       67,567  
 
 
Deductions:
                               
Loan losses
    34,853       22,575       112,762       57,397  
Less recoveries on loans
    3,957       3,841       10,914       12,275  
 
 
Net loan losses
    30,896       18,734       101,848       45,122  
 
 
Balance, September 30
  $ 190,466     $ 156,031     $ 190,466     $ 156,031  
 
 


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4.  Investment Securities
 
Investment securities, at fair value, consisted of the following at September 30, 2009 and December 31, 2008.
 
                 
   
    September 30
    December 31
 
(In thousands)   2009     2008  
   
 
Available for sale:
               
U.S. government and federal agency obligations
  $ 391,143     $ 11,594  
Government-sponsored enterprise obligations
    142,443       141,957  
State and municipal obligations
    968,407       719,752  
Agency mortgage-backed securities
    2,356,855       1,711,404  
Non-agency mortgage-backed securities
    627,584       620,479  
Other asset-backed securities
    1,348,197       253,756  
Other debt securities
    201,230       121,861  
Equity securities
    39,773       49,950  
 
 
Total available for sale
    6,075,632       3,630,753  
 
 
Trading
    9,242       9,463  
Non-marketable
    133,732       139,900  
 
 
Total investment securities
  $ 6,218,606     $ 3,780,116  
 
 
 
Most of the Company’s investment securities are classified as available for sale, and this portfolio is discussed in more detail below. Securities which are classified as non-marketable include Federal Home Loan Bank (FHLB) stock and Federal Reserve Bank (FRB) stock held for debt and regulatory purposes, which totaled $85.9 million and $84.4 million at September 30, 2009 and December 31, 2008, respectively. Investment in FRB stock is based on the capital structure of the investing bank, and investment in FHLB stock is mainly tied to the level of borrowings from the FHLB. Non-marketable securities also include private equity investments, which amounted to $47.8 million and $55.4 million at September 30, 2009 and December 31, 2008, respectively.


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A summary of the available for sale investment securities by maturity groupings as of September 30, 2009 is shown below. The investment portfolio includes agency mortgage-backed securities, which are guaranteed by government-sponsored agencies such as the FHLMC, FNMA and GNMA, and non-agency mortgage-backed securities which have no guarantee but are collateralized by residential mortgages. Also included are certain other asset-backed securities, which are primarily collateralized by credit cards, automobiles, and commercial loans. These securities differ from traditional debt securities primarily in that they may have uncertain maturity dates and are priced based on estimated prepayment rates on the underlying collateral. The Company does not have exposure to subprime originated mortgage-backed or collateralized debt obligation instruments.
 
                 
   
    Amortized
    Fair
 
(Dollars in thousands)   Cost     Value  
   
 
U.S. government and federal agency obligations:
               
Within 1 year
  $ 700     $ 704  
After 1 but within 5 years
    99,270       100,912  
After 5 but within 10 years
    283,422       289,527  
 
 
Total U.S. government and federal agency obligations
    383,392       391,143  
 
 
Government-sponsored enterprise obligations:
               
Within 1 year
    16,825       17,240  
After 1 but within 5 years
    121,309       125,203  
 
 
Total government-sponsored enterprise obligations
    138,134       142,443  
 
 
State and municipal obligations:
               
Within 1 year
    109,521       110,968  
After 1 but within 5 years
    389,193       402,837  
After 5 but within 10 years
    173,662       178,733  
After 10 years
    272,967       275,869  
 
 
Total state and municipal obligations
    945,343       968,407  
 
 
Mortgage and asset-backed securities:
               
Agency mortgage-backed securities
    2,291,936       2,356,855  
Non-agency mortgage-backed securities
    690,701       627,584  
Other asset-backed securities
    1,329,999       1,348,197  
 
 
Total mortgage and asset-backed securities
    4,312,636       4,332,636  
 
 
Other debt securities:
               
After 1 but within 5 years
    172,592       186,500  
After 5 but within 10 years
    11,606       14,730  
 
 
Total other debt securities
    184,198       201,230  
 
 
Equity securities
    5,566       39,773  
 
 
Total available for sale investment securities
  $ 5,969,269     $ 6,075,632  
 
 
 
Included in U.S. government securities are $379.1 million, at fair value, of U.S. Treasury inflation-protected securities (TIPS), which were purchased during the current quarter. Interest paid on these securities increases with inflation and decreases with deflation, as measured by the Consumer Price Index. At maturity, the principal paid is the greater of an inflation-adjusted principal or the original principal. Included in state and municipal obligations are $170.1 million, at fair value, of auction rate securities (ARS), which were purchased from bank customers in the third quarter of 2008. These bonds are normally traded in a competitive bidding process at weekly/monthly auctions. These auctions have not performed since early 2008, and this market has not recovered. Interest is currently being paid at the maximum failed auction rates. Equity securities are primarily comprised of investments in common stock held by the holding company, Commerce Bancshares, Inc. (the Parent).


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For securities classified as available for sale, the following table shows the unrealized gains and losses (pre-tax) in accumulated other comprehensive income, by security type. Included in gross unrealized losses during 2009 are other-than-temporary impairment (OTTI) losses of $32.6 million relating to certain non-agency mortgage-backed securities, which represent the noncredit-related portion of the overall impairment amount.
 
                                 
   
          Gross
    Gross
       
    Amortized
    Unrealized
    Unrealized
       
(In thousands)   Cost     Gains     Losses     Fair Value  
   
 
September 30, 2009
                               
U.S. government and federal agency obligations
  $ 383,392     $ 7,751     $     $ 391,143  
Government-sponsored enterprise obligations
    138,134       4,309             142,443  
State and municipal obligations
    945,343       26,169       (3,105 )     968,407  
Mortgage and asset-backed securities:
                               
Agency mortgage-backed securities
    2,291,936       66,183       (1,264 )     2,356,855  
Non-agency mortgage-backed securities
    690,701       4,204       (67,321 )     627,584  
Other asset-backed securities
    1,329,999       20,044       (1,846 )     1,348,197  
 
 
Total mortgage and asset-backed securities
    4,312,636       90,431       (70,431 )     4,332,636  
 
 
Other debt securities
    184,198       17,032             201,230  
Equity securities
    5,566       34,207             39,773  
 
 
Total
  $ 5,969,269     $ 179,899     $ (73,536 )   $ 6,075,632  
 
 
December 31, 2008
                               
U.S. government and federal agency obligations
  $ 10,478     $ 1,116     $     $ 11,594  
Government-sponsored enterprise obligations
    135,825       6,132             141,957  
State and municipal obligations
    715,421       10,794       (6,463 )     719,752  
Mortgage and asset-backed securities:
                               
Agency mortgage-backed securities
    1,685,821       26,609       (1,026 )     1,711,404  
Non-agency mortgage-backed securities
    742,090       816       (122,427 )     620,479  
Other asset-backed securities
    275,641       113       (21,998 )     253,756  
 
 
Total mortgage and asset-backed securities
    2,703,552       27,538       (145,451 )     2,585,639  
 
 
Other debt securities
    116,527       5,404       (70 )     121,861  
Equity securities
    7,680       42,270             49,950  
 
 
Total
  $ 3,689,483     $ 93,254     $ (151,984 )   $ 3,630,753  
 
 
 
The Company’s impairment policy requires a review of all securities for which fair value is less than amortized cost. Special emphasis and analysis is placed on securities whose credit rating has fallen below A3/A-, whose fair values have fallen more than 20% below purchase price for an extended period of time, or have been identified based on management’s judgment. These securities are placed on a watch list, and for all such securities, detailed cash flow models are prepared which use inputs specific to each security. Inputs to these models include factors such as cash flow received, contractual payments required, and various other information related to the underlying collateral (including current delinquencies), collateral loss severity rates (including loan to values), expected delinquency rates, credit support from other tranches, and prepayment speeds. Stress tests are performed at varying levels of delinquency rates, prepayment speeds and loss severities in order to gauge probable ranges of credit loss. At September 30, 2009, the par value of securities on this watch list were $373.1 million.


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Prior to March 2009, the Company had not incurred OTTI on any of its debt securities. However, as of September 30, 2009, the Company had recorded OTTI on eight non-agency mortgage-backed securities, having an aggregate par value of $137.8 million. The credit portion of the impairment totaled $2.8 million and was recorded in current earnings. The noncredit-related portion of the impairment totaled $32.6 million on a pre-tax basis, and has been recognized in other comprehensive income. The Company does not intend to sell these securities and believes it is not more likely than not that it will be required to sell the securities before the recovery of their amortized cost.
 
The credit portion of the loss on these securities was based on the cash flows projected to be received over the estimated life of the securities, discounted to present value, and compared to the current amortized cost bases of the securities. Significant inputs to the cash flow models used to calculate the credit losses on these securities included the following:
 
     
 
Significant Inputs   Range
 
 
Prepayment CPR
  7% - 25%
Projected cumulative default
  9% - 34%
Credit support
  3% - 14%
Loss severity
  32% - 60%
 
 
 
The following table shows changes in the credit losses recorded in current earnings, for which a portion of an OTTI was recognized in other comprehensive income.
 
         
   
    For the
 
    Three Months
 
    Ended September 30
 
(In thousands)   2009  
   
 
Balance, June 30
  $ 1,347  
Credit losses on debt securities for which impairment was not previously recognized
    84  
Credit losses on debt securities for which impairment was previously recognized
    1,380  
 
 
Balance, September 30
  $ 2,811  
 
 
 
Additional OTTI on these and other securities may arise in future periods due to further deterioration in the general economy and national housing markets, which contribute to changing cash flows, loss severities and delinquency levels of the securities’ underlying collateral, which would negatively affect the Company’s financial results.


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Securities with unrealized losses recorded in accumulated other comprehensive income are shown in the table below, along with the length of the impairment period. The table includes the eight securities for which a portion of an other-than-temporary impairment has been recognized in other comprehensive income.
 
                                                 
   
    Less than 12 months     12 months or longer     Total  
          Unrealized
          Unrealized
          Unrealized
 
(In thousands)   Fair Value     Losses     Fair Value     Losses     Fair Value     Losses  
   
 
At September 30, 2009
                                               
State and municipal obligations
  $ 138,265     $ 3,077     $ 2,412     $ 28     $ 140,677     $ 3,105  
Mortgage and asset-backed securities:
                                               
Agency mortgage-backed securities
    179,843       1,263       84       1       179,927       1,264  
Non-agency mortgage-backed securities
    162,209       26,970       252,974       40,351       415,183       67,321  
Other asset-backed securities
    121,779       1,007       26,651       839       148,430       1,846  
 
 
Total mortgage and asset-backed securities
    463,831       29,240       279,709       41,191       743,540       70,431  
 
 
Total
  $ 602,096     $ 32,317     $ 282,121     $ 41,219     $ 884,217     $ 73,536  
 
 
 
                                                 
   
    Less than 12 months     12 months or longer     Total  
          Unrealized
          Unrealized
          Unrealized
 
(In thousands)   Fair Value     Losses     Fair Value     Losses     Fair Value     Losses  
   
 
At December 31, 2008
                                               
State and municipal obligations
  $ 175,770     $ 6,457     $ 369     $ 6     $ 176,139     $ 6,463  
Mortgage and asset-backed securities:
                                               
Agency mortgage-backed securities
    183,577       1,003       4,664       23       188,241       1,026  
Non-agency mortgage-backed securities
    412,002       95,153       176,013       27,274       588,015       122,427  
Other asset-backed securities
    216,187       16,696       22,514       5,302       238,701       21,998  
 
 
Total mortgage and asset-backed securities
    811,766       112,852       203,191       32,599       1,014,957       145,451  
 
 
Other debt securities
    2,691       70                   2,691       70  
 
 
Total
  $ 990,227     $ 119,379     $ 203,560     $ 32,605     $ 1,193,787     $ 151,984  
 
 
 
Out of the total available for sale portfolio, consisting of approximately 1,200 individual securities at September 30, 2009, 128 securities were temporarily impaired, of which 33 securities, or 4% of the portfolio value, have been in a loss position for 12 months or longer.
 
The unrealized losses on the Company’s investments, as shown in the preceding tables, are largely contained in the portfolio of non-agency mortgage-backed securities. These securities are not guaranteed by an outside agency and are dependent on payments received from the underlying mortgage collateral. While virtually all of these securities, at purchase date, were comprised of senior tranches and were highly rated by various rating agencies, the adverse housing market, liquidity pressures and overall economic climate has resulted in low fair values for these securities. Also, as mentioned above, the Company maintains a watch list comprised mostly of these securities, and has recorded OTTI losses on eight of these securities. The Company continues to closely monitor the performance of these securities. State and municipal obligations and agency mortgage-backed securities have smaller unrealized losses due to the nature of the bonds and the guarantee provided to agency mortgage-backed securities, while the fair values of other asset-backed securities have been depressed to some degree by the current economic recession and its impact to the consumer. Most of the ARS held by the Company, which are included in state and municipal obligations, have Moody’s credit ratings of A3 or higher and Fitch ratings of A or higher.
 
The Company does not intend to sell these investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity.


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The following table presents proceeds from sales of securities and the components of investment securities gains and losses which have been recognized in earnings.
 
                 
   
    For the Nine
 
    Months Ended
 
    September 30  
(In thousands)   2009     2008  
   
 
Proceeds from sales of available for sale securities
  $ 26,877     $ 105,961  
Proceeds from sales/redemption of non-marketable securities
    5,308       22,196  
 
 
Total proceeds
  $ 32,185     $ 128,157  
 
 
Available for sale:
               
Gains realized on sales
  $ 82     $ 462  
Losses realized on sales
    (41 )     (888 )
Other-than-temporary impairment recognized
    (2,811 )     (1,939 )
Non-marketable:
               
Gains realized on sales/redemption
    1,087       22,196  
Losses realized on sales
    (170 )      
Fair value adjustments, net
    (4,017 )     5,649  
 
 
Investment securities gains (losses), net
  $ (5,870 )   $ 25,480  
 
 
 
At September 30, 2009, securities carried at $3.2 billion were pledged to secure public fund deposits, securities sold under agreements to repurchase, trust funds, and borrowing capacity at the Federal Reserve Bank. Securities pledged under agreements pursuant to which the collateral may be sold or re-pledged by the secured parties approximated $538.4 million, while securities pledged under agreements pursuant to which the secured parties may not sell or re-pledge the collateral approximated $2.7 billion at September 30, 2009.
 
5.  Goodwill and Other Intangible Assets
 
The following table presents information about the Company’s intangible assets which have estimable useful lives.
 
                                                                 
   
    September 30, 2009     December 31, 2008  
    Gross
                      Gross
                   
    Carrying
    Accumulated
    Valuation
    Net
    Carrying
    Accumulated
    Valuation
    Net
 
(In thousands)   Amount     Amortization     Allowance     Amount     Amount     Amortization     Allowance     Amount  
   
 
Amortizable intangible assets:
                                                               
Core deposit premium
  $ 25,720     $ (12,130 )   $     $ 13,590     $ 25,720     $ (9,324 )   $     $ 16,396  
Mortgage servicing rights
    2,801       (1,123 )     (208 )     1,470       1,816       (871 )     (150 )     795  
 
 
Total
  $ 28,521     $ (13,253 )   $ (208 )   $ 15,060     $ 27,536     $ (10,195 )   $ (150 )   $ 17,191  
 
 
 
Aggregate amortization expense on intangible assets was $1.0 million and $1.1 million, respectively, for the three month periods ended September 30, 2009 and 2008, and $3.1 million and $3.3 million for the nine month periods ended September 30, 2009 and 2008, respectively. The following table shows the estimated annual amortization expense for the next five fiscal years. This expense is based on existing asset balances and the interest rate environment as of September 30, 2009. The Company’s actual amortization expense in any given period may be different from the estimated amounts depending upon the acquisition of intangible assets, changes in mortgage interest rates, prepayment rates and other market conditions.
 
         
   
(In thousands)      
   
 
2009
  $ 3,980  
2010
    3,423  
2011
    2,867  
2012
    2,348  
2013
    1,845  
 
 


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Changes in the carrying amount of goodwill and net other intangible assets for the nine month period ended September 30, 2009 is as follows.
 
                         
   
                Mortgage
 
          Core Deposit
    Servicing
 
(In thousands)   Goodwill     Premium     Rights  
   
 
Balance at January 1, 2009
  $ 125,585     $ 16,396     $ 795  
Originations
                985  
Amortization
          (2,806 )     (252 )
Impairment
                (58 )
 
 
Balance at September 30, 2009
  $ 125,585     $ 13,590     $ 1,470  
 
 
 
Goodwill allocated to the Company’s operating segments at September 30, 2009 and December 31, 2008 is shown below.
 
         
   
(In thousands)      
   
 
Consumer segment
  $ 67,765  
Commercial segment
    57,074  
Money Management segment
    746  
 
 
Total goodwill
  $ 125,585  
 
 
 
6.  Guarantees
 
The Company, as a provider of financial services, routinely issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company generally to guarantee the payment or performance obligation of a customer to a third party. While these represent a potential outlay by the Company, a significant amount of the commitments may expire without being drawn upon. The Company has recourse against the customer for any amount it is required to pay to a third party under a standby letter of credit. The letters of credit are subject to the same credit policies, underwriting standards and approval process as loans made by the Company. Most of the standby letters of credit are secured and in the event of nonperformance by the customers, the Company has rights to the underlying collateral, which could include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities.
 
Upon issuance of standby letters of credit, the Company recognizes a liability for the fair value of the obligation undertaken, which is estimated to be equivalent to the amount of fees received from the customer over the life of the agreement. At September 30, 2009 that net liability was $3.1 million, which will be accreted into income over the remaining life of the respective commitments. The contractual amount of these letters of credit, which represents the maximum potential future payments guaranteed by the Company, was $412.7 million at September 30, 2009.
 
The Company guarantees payments to holders of certain trust preferred securities issued by two wholly owned grantor trusts. At September 30, 2009, the Company had a recorded liability of $14.0 million in principal and accrued interest to date, representing amounts owed to the security holders. Preferred securities issued by Breckenridge Capital Trust I, amounting to $4.0 million, are due in 2030 and may be redeemed beginning in 2010. These securities have a 10.875% interest rate throughout their term. Securities issued by West Pointe Statutory Trust I amounted to $10.0 million, which the Company intends to redeem in December 2009. These securities have a variable interest rate, which was 2.55% at September 30, 2009. The maximum potential future payments guaranteed by the Company on the Breckenridge issue, which includes future interest and principal payments through maturity, was estimated to be approximately $12.9 million at September 30, 2009.
 
The Company periodically enters into risk participation agreements (RPAs) as a guarantor to other financial institutions, in order to mitigate those institutions’ credit risk associated with interest rate swaps with third parties. The RPA stipulates that, in the event of default by the third party on the interest rate swap,


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the Company will reimburse a portion of the loss borne by the financial institution. These interest rate swaps are normally collateralized (generally with real property, inventories and equipment) by the third party, which limits the credit risk associated with the Company’s RPAs. The third parties usually have other borrowing relationships with the Company. The Company monitors overall borrower collateral, and at September 30, 2009, believes sufficient collateral is available to cover potential swap losses. The Company receives a fee from the institution at the inception of the contract, which is recorded as a liability representing the fair value of the RPA. Any future changes in fair value, including those due to a change in the third party’s creditworthiness, are recorded in current earnings. The terms of the RPAs, which correspond to the terms of the underlying swaps, range from 5 to 10 years. At September 30, 2009, the liability recorded for guarantor RPAs was $250 thousand, and the notional amount of the underlying swaps was $34.6 million. The maximum potential future payment guaranteed by the Company cannot be readily estimated, but is dependent upon the fair value of the interest rate swaps at the time of default. If an event of default on all contracts had occurred at September 30, 2009, the Company would have been required to make payments of approximately $3.1 million.
 
At September 30, 2009 the Company had recorded a liability of $8.8 million representing its obligation to share certain estimated litigation costs of Visa, Inc. (Visa). This obligation resulted from revisions in October 2007 to Visa’s by-laws affecting all member banks, as part of an overall reorganization in which the member banks indemnified Visa on certain covered litigation. The covered litigation related mainly to American Express and Discover suits, which are now settled, and other interchange litigation, which has not yet been settled. As part of the reorganization, Visa held an initial public offering in March 2008. An escrow account was established in conjunction with the offering, and is being used to fund actual litigation settlements as they occur. The escrow account was funded initially with proceeds from the offering, and subsequently with contributions by Visa. The Company’s indemnification obligation is periodically adjusted to reflect changes in estimates of litigation costs, and is reduced as funding occurs in the escrow account. The Company currently anticipates that its proportional share of eventual escrow funding will more than offset its liability related to the Visa litigation.
 
7.  Pension
 
The amount of net pension cost (income) is as follows:
 
                                 
   
    For the
    For the
 
    Three Months
    Nine Months
 
    Ended September 30     Ended September 30  
(In thousands)   2009     2008     2009     2008  
   
 
Service cost – benefits earned during the period
  $ 12     $ 263     $ 548     $ 769  
Interest cost on projected benefit obligation
    1,378       1,337       4,104       3,925  
Expected return on plan assets
    (1,395 )     (2,124 )     (4,592 )     (6,124 )
Amortization of unrecognized net loss
    832             2,182        
 
 
Net periodic pension cost (income)
  $ 827     $ (524 )   $ 2,242     $ (1,430 )
 
 
 
Substantially all benefits under the Company’s defined benefit pension plan were frozen effective January 1, 2005. During the first nine months of 2009, the Company made no funding contributions to its defined benefit pension plan, and made minimal funding contributions to a supplemental executive retirement plan (the CERP), which carries no segregated assets. The Company has no plans to make any further contributions, other than those related to the CERP, during the remainder of 2009. The Company recognized expense for the defined benefit pension plan for the first nine months of 2009 compared to income in prior periods. This occurred because of lower fair values of plan assets at the measurement date, a decline in the anticipated rate of return on plan assets in 2009, and amortization of prior year differences between actual and anticipated returns on plan assets. The Company expects to recognize additional expense during the remainder of 2009.
 
New guidance for pension accounting required measurement of plan assets and benefit obligations as of fiscal year end, beginning in 2008. Accordingly, the Company changed its 2008 measurement date from September 30 to December 31. It recorded an adjustment to reflect this change on December 31, 2008, which reduced the accrued benefit liability and increased retained earnings by $561 thousand on a pre-tax basis.


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8.  Common Stock
 
Presented below is a summary of the components used to calculate basic and diluted earnings per share. On January 1, 2009, the Company adopted new accounting guidance which requires application of the two-class method of computing earnings per share. Under this guidance, unvested share-based awards that contain nonforfeitable rights to dividends are considered securities which participate in undistributed earnings with common stock. The two-class method requires the calculation of separate earnings per share amounts for the unvested share-based awards and for common stock. Earnings per share attributable to common stock is shown in the table below. Prior period earnings per share data has been retroactively adjusted to conform to the pronouncement. Unvested share-based awards are further discussed in Note 13 below.
 
                                 
   
    For the Three
    For the Nine
 
    Months Ended
    Months Ended
 
    September 30     September 30  
(In thousands, except per share data)   2009     2008     2009     2008  
   
 
Basic earnings per common share:
                               
Net income attributable to Commerce Bancshares, Inc. 
  $ 51,649     $ 24,673     $ 119,453     $ 144,819  
Less earnings allocated to unvested restricted stockholders
    224       71       526       460  
 
 
Net income available to common stockholders
  $ 51,425     $ 24,602     $ 118,927     $ 144,359  
 
 
Distributed earnings
  $ 18,880     $ 17,963     $ 55,483     $ 53,832  
Undistributed earnings
  $ 32,545     $ 6,639     $ 63,444     $ 90,527  
 
 
Weighted average common shares outstanding
    78,257       75,456       76,806       75,357  
 
 
Distributed earnings per share
  $ .24     $ .24     $ .72     $ .72  
Undistributed earnings per share
    .42       .09       .83       1.20  
 
 
Basic earnings per common share
  $ .66     $ .33     $ 1.55     $ 1.92  
 
 
Diluted earnings per common share:
                               
Net income attributable to Commerce Bancshares, Inc. 
  $ 51,649     $ 24,673     $ 119,453     $ 144,819  
Less earnings allocated to unvested restricted stockholders
    224       71       525       458  
 
 
Net income available to common stockholders
  $ 51,425     $ 24,602     $ 118,928     $ 144,361  
 
 
Distributed earnings
  $ 18,880     $ 17,962     $ 55,483     $ 53,831  
Undistributed earnings
  $ 32,545     $ 6,640     $ 63,445     $ 90,530  
 
 
Weighted average common shares outstanding
    78,257       75,456       76,806       75,357  
Net effect of the assumed exercise of stock-based awards – based on the treasury stock method using the average market price for the respective periods
    306       609       290       619  
 
 
Weighted average diluted common shares outstanding
    78,563       76,065       77,096       75,976  
 
 
Distributed earnings per share
  $ .24     $ .24     $ .72     $ .71  
Undistributed earnings per share
    .42       .08       .82       1.19  
 
 
Diluted earnings per common share
  $ .66     $ .32     $ 1.54     $ 1.90  
 
 
 
On February 27, 2009, the Company initiated an at-the-market offering of its common stock, which was terminated on July 31, 2009. Pursuant to this offering, the Company issued a total of 2,894,773 shares for gross proceeds of $100.0 million, which were used for general corporate purposes.


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9.  Other Comprehensive Income (Loss)
 
The Company adopted new accounting guidance on other-than-temporary impairment on debt securities in March 2009. Under this guidance, credit-related losses on debt securities with other-than-temporary impairment are recorded in current earnings, while the noncredit-related portion of the overall loss in fair value is recorded in other comprehensive income (loss). The Company recorded other-than-temporary impairments on certain debt securities during the first nine months of 2009. Changes in the noncredit-related loss in fair value of these securities, after other-than-temporary impairment (OTTI) was initially recognized, are shown separately in the table below.
 
The Company’s other components of other comprehensive income (loss) consist of the unrealized holding gains and losses on available for sale investment securities for which OTTI has not been recorded (and also includes holding gains and losses on certain securities prior to the recognition of OTTI), and the amortization of accumulated pension loss which has been recognized in net periodic benefit cost.
 
                                 
   
    For the Three
    For the Nine
 
    Months Ended
    Months Ended
 
    September 30     September 30  
(In thousands)   2009     2008     2009     2008  
   
 
Available for sale debt securities for which OTTI has been recognized:
                               
Unrealized holding gains subsequent to initial OTTI recognition
  $ 9,407     $     $ 11,788     $  
Income tax expense
    3,574             4,479        
 
 
Net unrealized gains
    5,833             7,309        
 
 
Other available for sale investment securities:
                               
Unrealized holding gains (losses)
    78,321       (32,819 )     153,345       (52,131 )
Reclassification adjustment for (gains) losses included in net income
    23       1       (41 )     2,366  
 
 
Net unrealized gains (losses) on securities
    78,344       (32,818 )     153,304       (49,765 )
Income tax expense (benefit)
    29,771       (12,469 )     58,256       (18,909 )
 
 
Net unrealized gains (losses)
    48,573       (20,349 )     95,048       (30,856 )
 
 
Prepaid pension cost:
                               
Amortization of accumulated pension loss
    832             2,182        
Income tax expense
    307             807        
 
 
Pension loss amortization
    525             1,375        
 
 
Other comprehensive income (loss)
  $ 54,931     $ (20,349 )   $ 103,732     $ (30,856 )
 
 
 
At September 30, 2009, accumulated other comprehensive income was $47.0 million, net of tax. It was comprised of $20.4 million in unrealized holding losses on available for sale debt securities for which OTTI has been recorded, $86.4 million in unrealized holding gains on other available for sale securities, and $18.9 million in accumulated pension loss.
 
10.  Segments
 
The Company segregates financial information for use in assessing its performance and allocating resources among three reportable business segments: Commercial, Consumer and Money Management. The Consumer segment includes the consumer portion of the retail branch network (loans, deposits, and other personal banking services), indirect and other consumer financing, consumer debit and credit bank cards, and student lending. The Commercial segment provides corporate lending (including the Small Business Banking product line within the branch network), leasing, international services, and business, government deposit, and related commercial cash management services, as well as Merchant and Commercial bank card products. The Money Management segment provides traditional trust and estate tax planning, advisory and discretionary investment management, as well as brokerage services, and the Private Banking product portfolio.


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As products or business units grow or diminish, or processing channels are refined, or as periodic changes in organizational structure are made, management may decide that associated business activities should also be rearranged between reportable segments. In the first quarter of 2009, selected business units were realigned between reportable segments so that brokerage services and Private Banking accounts were moved from Consumer to Money Management, while portions of indirect lending were moved from Commercial to the Consumer segment. The figures presented below for 2008 have been revised to incorporate these changes in order to provide comparable data.
 
The following table presents selected financial information by segment and reconciliations of combined segment totals to consolidated totals. There were no material intersegment revenues among the three segments. Management periodically makes changes to methods of assigning costs and income to its business segments to better reflect operating results. If appropriate, these changes are reflected in prior year information presented below.
 
                                                 
   
                Money
    Segment
    Other/
    Consolidated
 
(In thousands)   Consumer     Commercial     Management     Totals     Elimination     Totals  
   
 
Three Months Ended September 30, 2009:
                                               
Net interest income
  $ 87,976     $ 65,803     $ 10,767     $ 164,546     $ (1,007 )   $ 163,539  
Provision for loan losses
    (19,835 )     (11,086 )     76       (30,845 )     (4,516 )     (35,361 )
Non-interest income
    42,729       30,334       28,233       101,296       839       102,135  
Investment securities losses, net
                            (945 )     (945 )
Non-interest expense
    (74,748 )     (47,190 )     (26,403 )     (148,341 )     (6,148 )     (154,489 )
 
 
Income before income taxes
  $ 36,122     $ 37,861     $ 12,673     $ 86,656     $ (11,777 )   $ 74,879  
 
 
Three Months Ended September 30, 2008:
                                               
Net interest income
  $ 81,358     $ 51,065     $ 8,828     $ 141,251     $ 10,313     $ 151,564  
Provision for loan losses
    (14,946 )     (3,540 )     (152 )     (18,638 )     (10,929 )     (29,567 )
Non-interest income
    41,025       26,737       27,904       95,666       (73 )     95,593  
Investment securities gains, net
                            1,149       1,149  
Non-interest expense
    (72,361 )     (45,552 )     (57,934 )     (175,847 )     (8,599 )     (184,446 )
 
 
Income before income taxes
  $ 35,076     $ 28,710     $ (21,354 )   $ 42,432     $ (8,139 )   $ 34,293  
 
 
Nine Months Ended September 30, 2009:
                                               
Net interest income
  $ 262,721     $ 186,275     $ 31,415     $ 480,411     $ (9,412 )   $ 470,999  
Provision for loan losses
    (62,255 )     (39,348 )     (199 )     (101,802 )     (17,893 )     (119,695 )
Non-interest income
    118,879       84,047       87,110       290,036       3,092       293,128  
Investment securities losses, net
                            (5,870 )     (5,870 )
Non-interest expense
    (227,704 )     (143,737 )     (80,284 )     (451,725 )     (15,661 )     (467,386 )
 
 
Income before income taxes
  $ 91,641     $ 87,237     $ 38,042     $ 216,920     $ (45,744 )   $ 171,176  
 
 
Nine Months Ended September 30, 2008:
                                               
Net interest income
  $ 241,790     $ 150,540     $ 26,945     $ 419,275     $ 17,175     $ 436,450  
Provision for loan losses
    (39,235 )     (5,883 )     (167 )     (45,285 )     (22,282 )     (67,567 )
Non-interest income
    117,352       80,216       85,747       283,315       7,171       290,486  
Investment securities gains, net
                            25,480       25,480  
Non-interest expense
    (214,132 )     (135,539 )     (106,864 )     (456,535 )     (15,157 )     (471,692 )
 
 
Income before income taxes
  $ 105,775     $ 89,334     $ 5,661     $ 200,770     $ 12,387     $ 213,157  
 
 
 
The information presented above was derived from the internal profitability reporting system used by management to monitor and manage the financial performance of the Company. This information is based on internal management accounting policies, which have been developed to reflect the underlying economics of the businesses. The policies address the methodologies applied in connection with funds transfer pricing and assignment of overhead costs among segments. Funds transfer pricing was used in the determination of net


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interest income by assigning a standard cost (credit) for funds used (provided) by assets and liabilities based on their maturity, prepayment and/or repricing characteristics.
 
The segment activity, as shown above, includes both direct and allocated items. Amounts in the “Other/Elimination” column include activity not related to the segments, such as that relating to administrative functions, the investment securities portfolio, and the effect of certain expense allocations to the segments. The provision for loan losses in this category contains the difference between loan charge-offs and recoveries assigned directly to the segments and the recorded provision for loan loss expense. Included in this category’s net interest income are earnings of the investment portfolio, which are not allocated to a segment. Investment securities gains and non-interest expense for this category included stock redemption gains (occurring in 2008) and litigation accrual adjustments (occurring in both years) related to the bank subsidiary’s membership in Visa.
 
The performance measurement of the business segments is based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. The information is also not necessarily indicative of the segments’ financial condition and results of operations if they were independent entities.
 
11.  Derivative Instruments
 
The notional amounts of the Company’s derivative instruments are shown in the table below. These contractual amounts, along with other terms of the derivative, are used to determine amounts to be exchanged between counterparties, and are not a measure of loss exposure. The largest group of notional amounts relate to interest rate swaps, which are discussed in more detail below. Through its International Department, the Company enters into foreign exchange contracts consisting mainly of contracts to purchase or deliver foreign currencies for customers at specific future dates. Also, mortgage loan commitments and forward sales contracts result from the Company’s mortgage banking operation, in which fixed rate personal real estate loans are originated and sold to other institutions. The Company also contracts with other financial institutions, as a guarantor or beneficiary, to share credit risk associated with certain interest rate swaps. The Company’s risks and responsibilities as guarantor are further discussed in Note 6 on Guarantees.
 
                 
   
    September 30
    December 31
 
(In thousands)   2009     2008  
   
 
Interest rate swaps
  $ 509,997     $ 492,111  
Interest rate caps
    16,236        
Credit risk participation agreements
    56,379       47,750  
Foreign exchange contracts:
               
Forward contracts
    21,982       6,226  
Option contracts
    3,400       3,300  
Mortgage loan commitments
    12,279       23,784  
Mortgage loan forward sale contracts
    22,213       26,996  
 
 
Total notional amount
  $ 642,486     $ 600,167  
 
 


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The Company’s interest rate risk management strategy includes the ability to modify the repricing characteristics of certain assets and liabilities so that changes in interest rate do not adversely affect the net interest margin and cash flows. Interest rate swaps are used on a limited basis as part of this strategy. At September 30, 2009, the Company had entered into three interest rate swaps with a notional amount of $17.2 million, which are designated as fair value hedges of certain fixed rate loans. Gains and losses on these derivative instruments, as well as the offsetting loss or gain on the hedged loans attributable to the hedged risk, are recognized in current earnings. These gains and losses are reported in interest and fees on loans in the accompanying statements of income. The table below shows gains and losses related to fair value hedges.
 
                                 
   
    For the Three Months Ended
    For the Nine Months Ended
 
    September 30     September 30  
(In thousands)   2009     2008     2009     2008  
   
 
Gain (loss) on interest rate swaps
  $ (191 )   $ (215 )   $ 442     $ (196 )
Gain (loss) on loans
    182       214       (443 )     193  
 
 
Amount of hedge ineffectiveness
  $ (9 )   $ (1 )   $ (1 )   $ (3 )
 
 
 
The Company’s other derivative instruments are accounted for as free-standing derivatives, and changes in their fair value are recorded in current earnings. These instruments include interest rate swap contracts sold to customers who wish to modify their interest rate sensitivity. These swaps are offset by matching contracts purchased by the Company from other financial institutions. Because of the matching terms of the offsetting contracts, in addition to collateral provisions which mitigate the impact of non-performance risk, changes in fair value subsequent to initial recognition have a minimal effect on earnings. The notional amount of these types of swaps at September 30, 2009 was $492.8 million. The Company is party to master netting arrangements with its institutional counterparties; however, the effect of offsetting assets and liabilities under these arrangements is not significant. Collateral exchanges typically involve marketable securities. The Company’s interest rate swap arrangements with other financial institutions contain contingent features relating to debt ratings or capitalization levels. Under these provisions, if the Company’s debt rating falls below investment grade or if the Company ceases to be “well-capitalized” under risk-based capital guidelines, certain counterparties can require immediate and ongoing collateralization on interest rate swaps in net liability positions, or in certain circumstances, can require instant settlement of the contracts. The aggregate fair value of interest rate swap contracts with credit risk-related contingent features that were in a liability position on September 30, 2009 was $18.9 million, for which the Company had posted collateral of $14.5 million. If the credit risk-related contingent features relating to collateral were triggered on September 30, 2009, the Company would be required to post an additional $4.9 million of collateral to certain counterparties. If other credit-related settlement features were also triggered at September 30, 2009, a cash disbursement of $1.2 million, in addition to collateral posted, would be required.
 
The banking customer counterparties are engaged in a variety of businesses, including real estate, building materials, communications, consumer products, and manufacturing. The manufacturing group is the largest, with a combined notional amount of 36.9% of the total customer swap portfolio. If this group of manufacturing counterparties failed to perform, and if the underlying collateral proved to be of no value, the Company would incur a loss of $5.6 million, based on amounts at September 30, 2009.
 
Effective January 1, 2008, the Company adopted new accounting guidance which modified the accounting for initial recognition of fair value for certain interest rate swap contracts held by the Company. Former accounting guidance precluded immediate recognition in earnings of an unrealized gain or loss, measured as the difference between the transaction price and fair value of these instruments at initial recognition. Under the new guidance, the immediate recognition of a gain or loss is appropriate under certain circumstances and, in accordance with transition provisions, the Company increased equity by $903 thousand on January 1, 2008 to reflect interest rate swaps at fair value.


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The fair values of the Company’s derivative instruments are shown in the table below. Information about the valuation methods used to measure fair value is provided in Note 14 on Fair Value Measurements.
 
                                         
   
    Asset Derivatives     Liability Derivatives  
        Sept. 30
    Dec. 31
        Sept. 30
    Dec. 31
 
        2009     2008         2009     2008  
                     
    Balance
              Balance
           
    Sheet
              Sheet
           
(In thousands)   Location   Fair Value     Location   Fair Value  
   
 
Derivatives designated as hedging instruments:
                                       
Interest rate swaps
  Other assets   $ 39     $     Other liabilities   $ (1,024 )   $ (1,413 )
 
 
Total derivatives designated as hedging instruments
      $ 39     $         $ (1,024 )   $ (1,413 )
 
 
Derivatives not designated as hedging instruments:
                                       
Interest rate swaps
  Other assets   $ 19,319     $ 25,274     Other liabilities   $ (19,194 )   $ (25,155 )
Interest rate caps
  Other assets     216           Other liabilities     (221 )      
Credit risk participation agreements
  Other assets     148       117     Other liabilities     (250 )     (178 )
Foreign exchange contracts:
                                       
Forward contracts
  Other assets     342       207     Other liabilities     (490 )     (217 )
Option contracts
  Other assets     1       18     Other liabilities     (1 )     (18 )
Mortgage loan commitments
  Other assets     201       198     Other liabilities     (3 )     (6 )
Mortgage loan forward sale
                                       
contracts
  Other assets     2       21     Other liabilities     (125 )     (88 )
 
 
Total derivatives not designated as hedging instruments
      $ 20,229     $ 25,835         $ (20,284 )   $ (25,662 )
 
 
Total derivatives
      $ 20,268     $ 25,835         $ (21,308 )   $ (27,075 )
 
 
 
The effects of derivative instruments on the consolidated statements of income are shown in the table below.
 
                                     
   
    Location of Gain or (Loss)
  Amount of Gain or (Loss)
 
    Recognized in Income on
  Recognized in Income on
 
    Derivative   Derivative  
       
        For the Three
    For the Nine
 
        Months Ended
    Months Ended
 
        September 30     September 30  
(In thousands)       2009     2008     2009     2008  
   
 
Derivatives in fair value hedging relationships:
                                   
Interest rate swaps
  Interest and fees on loans   $ (191 )   $ (215 )   $ 442     $ (196 )
 
 
Total
      $ (191 )   $ (215 )   $ 442     $ (196 )
 
 
Derivatives not designated as hedging instruments:
                                   
Interest rate swaps
  Other non-interest income   $ 226     $ 778     $ 350     $ 1,180  
Interest rate caps
  Other non-interest income     1             6        
Credit risk participation agreements
  Other non-interest income     4       4       13       17  
Foreign exchange contracts:
                                   
Forward contracts
  Other non-interest income     (127 )     (57 )     (139 )     60  
Option contracts
  Other non-interest income                        
Mortgage loan commitments
  Loan fees and sales     84       16       7       47  
Mortgage loan forward sale contracts
  Loan fees and sales     (412 )     (146 )     (56 )     (3 )
 
 
Total
      $ (224 )   $ 595     $ 181     $ 1,301  
 
 


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12.  Income Taxes
 
For the third quarter of 2009, income tax expense amounted to $23.4 million compared to $9.5 million in the third quarter of 2008. The effective income tax rate for the Company, including the effect of non-controlling interest, was 31.2% in the current quarter compared to 27.9% in the same quarter last year. For the nine months ended September 30, 2009 and 2008, income tax expense amounted to $52.3 million and $67.3 million, resulting in effective income tax rates of 30.4% and 31.7%, respectively. Effective tax rates were higher in the third quarter of 2009 compared to the third quarter of 2008 due to changes in the mix of taxable and non-taxable income on higher pre-tax income. However, effective tax rates were lower in the nine months ended September 30, 2009 compared to same period in 2008 due to changes in the mix of taxable and non-taxable income on lower pre-tax income.
 
13.  Stock-Based Compensation
 
Stock-based compensation expense that has been charged against income was $1.7 million and $1.6 million in the three months ended September 30, 2009 and 2008, respectively, and $4.9 million in each of the nine months ended September 30, 2009 and 2008. In previous years, the Company has issued such compensation in the form of nonvested stock awards, stock appreciation rights (SARs) and stock options. During the first nine months of 2009, stock-based compensation was issued primarily in the form of nonvested stock awards.
 
The 2009 stock awards generally vest in 5 to 7 years and contain restrictions as to transferability, sale, pledging, or assigning, among others, prior to the end of the vesting period. Dividend and voting rights are conferred upon grant. A summary of the status of the Company’s nonvested share awards, as of September 30, 2009, and changes during the nine month period then ended is presented below.
 
                 
   
          Weighted
 
          Average
 
          Grant Date
 
    Shares     Fair Value  
   
 
Nonvested at January 1, 2009
    227,986     $ 41.81  
Granted
    168,774       35.70  
Vested
    (48,031 )     39.99  
Forfeited
    (4,190 )     40.89  
 
 
Nonvested at September 30, 2009
    344,539     $ 39.07  
 
 
 
SARs and stock options are granted with an exercise price equal to the market price of the Company’s stock at the date of grant and have 10-year contractual terms. SARs vest on a graded basis over 4 years of continuous service. All SARs must be settled in stock under provisions of the plan. Stock options, which were granted in 2005 and previous years, vest on a graded basis over 3 years of continuous service. In determining compensation cost, the Black-Scholes option-pricing model is used to estimate the fair value of SARs and options on date of grant. The table below shows the fair values of SARs granted during the first nine months of 2009 and 2008, including the model assumptions for those grants.
 
                 
   
    Nine Months
 
    Ended September 30  
    2009     2008  
   
 
Weighted per share average fair value at grant date
  $ 7.38     $ 8.27  
Assumptions:
               
Dividend yield
    2.7 %     2.3 %
Volatility
    21.0 %     18.4 %
Risk-free interest rate
    3.2 %     3.5 %
Expected term
    7.3 years       7.2 years  
 
 


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A summary of option activity during the first nine months of 2009 is presented below.
 
                                 
   
                Weighted
       
          Weighted
    Average
       
          Average
    Remaining
    Aggregate
 
          Exercise
    Contractual
    Intrinsic
 
(Dollars in thousands, except per share data)   Shares     Price     Term     Value  
   
 
Outstanding at January 1, 2009
    2,395,333     $ 32.05                  
Granted
                           
Forfeited
                           
Expired
    (2,914 )     39.13                  
Exercised
    (87,805 )     22.88                  
 
 
Outstanding at September 30, 2009
    2,304,614     $ 32.39       3.4 years     $ 12,943  
 
 
 
A summary of SAR activity during the first nine months of 2009 is presented below.
 
                                 
   
                Weighted
       
          Weighted
    Average
       
          Average
    Remaining
    Aggregate
 
          Exercise
    Contractual
    Intrinsic
 
(Dollars in thousands, except per share data)   Shares     Price     Term     Value  
   
 
Outstanding at January 1, 2009
    1,600,228     $ 43.83                  
Granted
    5,000       38.06                  
Forfeited
    (4,049 )     42.73                  
Expired
    (3,690 )     43.93                  
Exercised
                           
 
 
Outstanding at September 30, 2009
    1,597,489     $ 43.80       7.4 years     $ 2  
 
 
 
14.   Fair Value Measurements
 
The Company uses fair value measurements to record fair value adjustments to certain financial and nonfinancial assets and liabilities and to determine fair value disclosures. Various financial instruments such as available for sale and trading securities, certain non-marketable securities relating to private equity activities, and derivatives are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets and liabilities on a nonrecurring basis, such as loans held for sale, mortgage servicing rights and certain other investment securities. These nonrecurring fair value adjustments typically involve lower of cost or fair value accounting, or write-downs of individual assets.
 
Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Depending on the nature of the asset or liability, the Company uses various valuation techniques and assumptions when estimating fair value. For accounting disclosure purposes, a three-level valuation hierarchy of fair value measurements has been established. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:
 
  •  Level 1 – inputs to the valuation methodology are quoted prices for identical assets or liabilities in active markets.
 
  •  Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, and inputs that are observable for the assets or liabilities, either directly or indirectly (such as interest rates, yield curves, and prepayment speeds).


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  •  Level 3 – inputs to the valuation methodology are unobservable and significant to the fair value. These may be internally developed, using the Company’s best information and assumptions that a market participant would consider.
 
When determining the fair value measurements for assets and liabilities required or permitted to be recorded or disclosed at fair value, the Company considers the principal or most advantageous market in which it would transact and considers assumptions that market participants would use when pricing the asset or liability. When possible, the Company looks to active and observable markets to price identical assets or liabilities. When identical assets and liabilities are not traded in active markets, the Company looks to market observable data for similar assets and liabilities. Nevertheless, certain assets and liabilities are not actively traded in observable markets and the Company must use alternative valuation techniques to derive an estimated fair value measurement. The Company adopted new guidance in March 2009 for estimating fair values for securities where the market volume and level of activity have significantly decreased. The application of the new guidance did not result in a change in valuation technique or related inputs.
 
Valuation methods for instruments measured at fair value on a recurring basis
 
Following is a description of the Company’s valuation methodologies used for instruments measured at fair value on a recurring basis:
 
Available for sale investment securities
 
For available for sale securities, changes in fair value, including that portion of other-than-temporary impairment unrelated to credit loss, are recorded in other comprehensive income. As mentioned in Note 4 on Investment Securities, the Company records the credit-related portion of other-than-temporary impairment in current earnings. This portfolio comprises the majority of the assets which the Company records at fair value. Most of the portfolio, which includes government-sponsored enterprise, mortgage-backed and asset-backed securities, are priced utilizing industry-standard models that consider various assumptions, including time value, yield curves, volatility factors, prepayment speeds, default rates, loss severity, current market and contractual prices for the underlying financial instruments, as well as other relevant economic measures. Substantially all of these assumptions are observable in the marketplace, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace. These measurements are classified as Level 2 in the fair value hierarchy. Where quoted prices are available in an active market, the measurements are classified as Level 1. Most of the Level 1 measurements apply to common stock and U.S. Treasury obligations.
 
Valuation methods and inputs, by major security type:
 
  •  U.S. government and federal agency obligations
These securities are valued using live data from active market makers and inter-dealer brokers.
 
  •  Government-sponsored enterprise obligations
Government-sponsored enterprise obligations are evaluated using cash flow valuation models. Inputs used are live market data, cash settlements, Treasury market yields, and floating rate indices such as LIBOR, CMT, and Prime.
 
  •  State and municipal obligations, excluding auction rate securities
A yield curve is generated and applied to bond sectors, and individual bond valuations are extrapolated. Inputs used to generate the yield curve are bellwether issue levels, established trading spreads between similar issuers or credits, historical trading spreads over widely accepted market benchmarks, new issue scales, and verified bid information. Bid information is verified by corroborating the data against external sources such as broker-dealers, trustees/paying agents, issuers, or non-affiliated bondholders.
 
  •  Mortgage and asset-backed securities
All mortgage-backed securities (agency and non-agency) and other asset-backed securities are valued at the tranche level. For each tranche valuation, the process generates predicted cash flows for the


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  tranche and determines a benchmark yield. The final price is determined by inputting the predicted cash flows into a model that will determine principal and interest payments along with an average life. The yield from the model is used to discount the predicted cash flows to generate an evaluated price. Inputs for the model include a swap curve or a Treasury benchmark curve, as well as a spread that is generated based on average life, type, volatility, ratings, collateral and collateral performance.
 
  •  Other debt securities
Other debt securities are valued using active markets and inter-dealer brokers as well as bullet spread scales and option adjusted spreads. The spreads and models use yield curves, terms and conditions of the bonds, and any special features (i.e., call or put options, redemption features, etc.).
 
  •  Equity securities
Equity securities are priced using the market prices for each security from the major stock exchanges or other electronic quotation systems.
 
At September 30, 2009, the Company held certain auction rate securities (ARS) in its available for sale portfolio, totaling $170.1 million. Nearly all of these securities were purchased from customers during the third quarter of 2008. The auction process by which the ARS are normally priced has failed since the first quarter of 2008, and the fair value of these securities cannot be based on observable market prices due to the illiquidity in the market. The fair values of the ARS are currently estimated using a discounted cash flows analysis. The analysis compares the present value of cash flows based on mandatory rates paid under failing auctions with the present value of estimated cash flows for similar securities, after adjustment for liquidity premium and nonperformance risk. The cash flows were projected over an estimated market recovery period, or in some cases, a shorter period if refinancing by specific issuers is expected. The discount rate was based on the published Treasury rate for the period commensurate with the estimated holding period. In developing the inputs, discussions were held with traders, both internal and external to the Company, who are familiar with the ARS markets. Because many of the inputs significant to the measurement are not observable, these measurements are classified as Level 3 measurements.
 
Trading securities
 
The securities in the Company’s trading portfolio are priced by averaging several broker quotes for identical instruments, and are classified as Level 2 measurements.
 
Private equity investments
 
These securities are held by the Company’s venture capital subsidiaries and are included in non-marketable investment securities in the consolidated balance sheets. Valuation of these nonpublic investments requires significant management judgment due to the absence of quoted market prices. Each quarter, valuations are performed utilizing available market data and other factors. Market data includes published trading multiples for private equity investments of similar size. The multiples are considered in conjunction with current operating performance, future expectations, financing and sales transactions, and other investment-specific issues. The Company applies its valuation methodology consistently from period to period, and believes that its methodology is similar to that used by other market participants. These fair value measurements are classified as Level 3.
 
Derivatives
 
The Company’s derivative instruments include interest rate swaps, foreign exchange forward contracts, commitments and sales contracts related to personal mortgage loan origination activity, and certain credit risk guarantee agreements. When appropriate, the impact of credit standing as well as any potential credit enhancements, such as collateral, has been considered in the fair value measurement.
 
  •  Valuations for interest rate swaps are derived from proprietary models whose significant inputs are readily observable market parameters, primarily yield curves. The results of the models are constantly validated through comparison to active trading in the marketplace. These fair value measurements are classified as Level 2.


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  •  Fair value measurements for foreign exchange contracts are derived from a model whose primary inputs are quotations from global market makers, and are classified as Level 2.
 
  •  The fair values of mortgage loan commitments and forward sales contracts on the associated loans are based on quoted prices for similar loans in the secondary market. However, these prices are adjusted by a factor which considers the likelihood that a commitment will ultimately result in a closed loan. This estimate is based on the Company’s historical data and its judgment about future economic trends. Based on the unobservable nature of this adjustment, these measurements are classified as Level 3.
 
  •  The Company’s contracts related to credit risk guarantees are valued under an internally developed methodology which uses significant unobservable inputs and assumptions about the creditworthiness of the counterparty to the guaranteed interest rate swap contract. Consequently, these measurements are classified as Level 3.
 
Assets held in trust
 
Assets held in an outside trust for the Company’s deferred compensation plan consist of investments in mutual funds. The fair value measurements are based on quoted prices in active markets and classified as Level 1. The Company has recorded an asset representing the total investment amount. The Company has also recorded a corresponding nonfinancial liability, representing the Company’s liability to the plan participants.
 
The table below presents the September 30, 2009 carrying values of assets and liabilities measured at fair value on a recurring basis.
 
                                 
   
          Fair Value Measurements Using  
          Quoted
             
          Prices in
             
          Active
             
          Markets
    Significant
       
          for
    Other
    Significant
 
          Identical
    Observable
    Unobservable
 
          Assets
    Inputs
    Inputs
 
(In thousands)   9/30/09     (Level 1)     (Level 2)     (Level 3)  
   
 
Assets:
                               
Available for sale securities:
                               
U.S. government and federal agency obligations
  $ 391,143     $ 391,143     $     $  
Government-sponsored enterprise obligations
    142,443             142,443        
State and municipal obligations
    968,407             798,343       170,064  
Agency mortgage-backed securities
    2,356,855             2,356,855        
Non-agency mortgage-backed securities
    627,584             627,584        
Other asset-backed securities
    1,348,197             1,348,197        
Other debt securities
    201,230             201,230        
Equity securities
    39,773       23,895       15,878        
Trading securities
    9,242             9,242        
Private equity investments
    42,800                   42,800  
Derivatives
    20,268             19,917       351  
Assets held in trust
    3,240       3,240              
 
 
Total assets
    6,151,182       418,278       5,519,689       213,215  
 
 
Liabilities:
                               
Derivatives
    21,308             20,930       378  
 
 
Total liabilities
  $ 21,308     $     $ 20,930     $ 378  
 
 


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The changes in Level 3 assets and liabilities measured at fair value on a recurring basis are summarized as follows:
 
                                 
   
    Fair Value Measurements Using
 
    Significant Unobservable Inputs
 
    (Level 3)  
    State and
    Private
             
    Municipal
    Equity
             
(In thousands)   Obligations     Investments     Derivatives     Total  
   
 
For the three months ended September 30, 2009:
                               
 
 
Balance at June 30, 2009
  $ 170,263     $ 43,020     $ 247     $ 213,530  
Total gains or losses (realized /unrealized):
                               
Included in earnings
          (339 )     (324 )     (663 )
Included in other comprehensive income
    1,198                   1,198  
Purchases, issuances, and settlements, net
    (1,397 )     119       50       (1,228 )
 
 
Balance at September 30, 2009
  $ 170,064     $ 42,800     $ (27 )   $ 212,837  
 
 
Total gains or losses for the three months included in earnings attributable to the change in unrealized gains or losses relating to assets still held at September 30, 2009
  $     $ (339 )   $ 79     $ (260 )
 
 
For the nine months ended September 30, 2009:
                               
 
 
Balance at January 1, 2009
  $ 167,996     $ 49,494     $ 64     $ 217,554  
Total gains or losses (realized/unrealized):
                               
Included in earnings
          (3,216 )     (36 )     (3,252 )
Included in other comprehensive income
    3,751                   3,751  
Purchases, issuances, and settlements, net
    (1,683 )     (3,478 )     (55 )     (5,216 )
 
 
Balance at September 30, 2009
  $ 170,064     $ 42,800     $ (27 )   $ 212,837  
 
 
Total gains or losses for the nine months included in earnings attributable to the change in unrealized gains or losses relating to assets still held at September 30, 2009
  $     $ (3,216 )   $ 88     $ (3,128 )
 
 
 
Gains and losses on the Level 3 assets and liabilities in the table above are reported in the following income categories:
 
                                 
   
                Investment
       
                Securities
       
          Other Non-
    Gains
       
    Loan Fees
    Interest
    (Losses),
       
(In thousands)   and Sales     Income     Net     Total  
   
 
For the three months ended September 30, 2009:
                               
 
 
Total gains or losses included in earnings
  $ (328 )   $ 4     $ (339 )   $ (663 )
 
 
Change in unrealized gains or losses relating to assets still held at September 30, 2009
  $ 75     $ 4     $ (339 )   $ (260 )
 
 
For the nine months ended September 30, 2009:
                               
 
 
Total gains or losses included in earnings
  $ (49 )   $ 13     $ (3,216 )   $ (3,252 )
 
 
Change in unrealized gains or losses relating to assets still held at September 30, 2009
  $ 75     $ 13     $ (3,216 )   $ (3,128 )
 
 


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Valuation methods for instruments measured at fair value on a nonrecurring basis
 
Following is a description of the Company’s valuation methodologies used for other financial instruments measured at fair value on a nonrecurring basis.
 
Collateral dependent impaired loans
 
While the overall loan portfolio is not carried at fair value, adjustments are recorded on certain loans to reflect partial write-downs that are based on the value of the underlying collateral. In determining the value of real estate collateral, the Company relies on external appraisals and assessment of property values by its internal staff. In the case of non-real estate collateral, reliance is placed on a variety of sources, including external estimates of value and judgments based on the experience and expertise of internal specialists. Because many of these inputs are not observable, the measurements are classified as Level 3. The carrying value of these impaired loans was $50.7 million at September 30, 2009, and charge-offs of $30.8 million related to these loans were recorded during the first nine months of 2009.
 
Loans held for sale
 
Loans held for sale are carried at the lower of cost or fair value. The portfolio consists primarily of student loans, and to a lesser extent, residential real estate loans. The Company’s student loans are contracted for sale with the Federal Department of Education and various investors in the secondary market. Since 2008, the secondary market for student loans has been disrupted by liquidity concerns. Consequently, several investors are currently unable to consistently purchase loans under existing contractual terms. Loans under contract to these investors, in addition to other investors whose future liquidity is of concern, have been identified for evaluation. Such loans are carried at $134.9 million at September 30, 2009. They were evaluated using a fair value measurement method based on a discounted cash flows analysis, which was classified as Level 3. Previously recorded impairment losses of $3.1 million were reversed during the first nine months of 2009, as certain of the related loans were sold in accordance with their contract terms. The measurement of fair value for the remaining student loans is based on the specific prices mandated in the underlying sale contracts, the estimated exit price, and is classified as Level 2. Fair value measurements on mortgage loans held for sale are based on quoted market prices for similar loans in the secondary market and are classified as Level 2.
 
Private equity investments and restricted stock
 
These assets are included in non-marketable investment securities in the consolidated balance sheets. They include private equity investments held by the Parent company which are carried at cost, reduced by other-than-temporary impairment. These investments are periodically evaluated for impairment based on their estimated fair value. The valuation methodology is described above under the recurring measurements for “Private equity investments”. Also included is stock issued by the Federal Reserve Bank and FHLB which is held by the bank subsidiary as required for regulatory purposes. Generally, there are restrictions on the sale and/or liquidation of these investments, and they are carried at cost. Fair value measurements for these securities are classified as Level 3.
 
Mortgage servicing rights
 
The Company initially measures its mortgage servicing rights at fair value, and amortizes them over the period of estimated net servicing income. They are periodically assessed for impairment based on fair value at the reporting date. Mortgage servicing rights do not trade in an active market with readily observable prices. Accordingly, the fair value is estimated based on a valuation model which calculates the present value of estimated future net servicing income. The model incorporates assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, market discount rates, cost to service, float earnings rates, and other ancillary income, including late fees. The fair value measurements are classified as Level 3.


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Goodwill and core deposit premium
 
Valuation of goodwill to determine impairment is performed on an annual basis, or more frequently if there is an event or circumstance that would indicate impairment may have occurred. The process involves calculations to determine the fair value of each reporting unit on a stand-alone basis. A combination of formulas using current market multiples, based on recent sales of financial institutions within the Company’s geographic marketplace, is used to estimate the fair value of each reporting unit. That fair value is compared to the carrying amount of the reporting unit, including its recorded goodwill. Impairment is considered to have occurred if the fair value of the reporting unit is lower than the carrying amount of the reporting unit.
 
Core deposit premiums are recognized at the time a portfolio of deposits is acquired, using valuation techniques which calculate the present value of the estimated net cost savings attributable to the core deposit base, relative to alternative costs of funds and tax benefits, if applicable, over the expected remaining economic life of the depositors. Subsequent evaluations are made when facts or circumstances indicate potential impairment may have occurred. The Company uses estimates of discounted future cash flows, comparisons with alternative sources for deposits, consideration of income potential generated in other product lines by current customers, geographic parameters, and other demographics to estimate a current fair value of a specific deposit base. If the calculated fair value is less than the carrying value, impairment is considered to have occurred.
 
Foreclosed assets
 
Foreclosed assets consist of loan collateral which has been repossessed through foreclosure. This collateral is comprised of commercial and residential real estate and other non-real estate property, including auto, recreational and marine vehicles. Foreclosed assets are recorded as held for sale initially at the lower of the loan balance or fair value of the collateral less estimated selling costs. Subsequent to foreclosure, valuations are updated periodically, and the assets may be marked down further, reflecting a new cost basis. Fair value measurements may be based upon appraisals or third-party price opinions and, accordingly, those measurements are classified as Level 2. Other fair value measurements may be based on internally developed pricing methods, and those measurements are classified as Level 3.
 
For assets measured at fair value on a nonrecurring basis during the first nine months of 2009, and still held as of September 30, 2009, the following table provides the adjustments to fair value recognized that period, the level of valuation assumptions used to determine each adjustment, and the carrying value of the related individual assets or portfolios at September 30, 2009.
 
                                         
   
          Fair Value Measurements Using        
          Quoted
                   
          Prices in
                   
          Active
                   
          Markets
    Significant
             
          for
    Other
    Significant
       
          Identical
    Observable
    Unobservable
       
          Assets
    Inputs
    Inputs
    Total Gains
 
(In thousands)   9/30/09     (Level 1)     (Level 2)     (Level 3)     (Losses)  
   
 
Loans
  $ 50,706     $     $     $ 50,706     $ (30,756 )
Private equity investments
    2,250                   2,250       (800 )
Mortgage servicing rights
    1,470                   1,470       (58 )
Foreclosed assets
    2,296             2,296             (457 )
 
 


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15.   Fair Value of Financial Instruments
 
The carrying amounts and estimated fair values of financial instruments held by the Company, in addition to a discussion of the methods used and assumptions made in computing those estimates, are set forth below.
 
Loans
 
The fair values of loans are estimated by discounting the expected future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures.
 
Investment Securities
 
A detailed description of the fair value measurement of the debt and equity instruments in the available for sale and trading sections of the investment security portfolio is provided in Note 14 on Fair Value Measurements. In general, these fair values are based on prices obtained from stock exchanges, pricing models, or bid quotations received from securities dealers. Fair values are estimated for those investments for which a market source is not readily available.
 
A schedule of investment securities by category and maturity is provided in Note 4 on Investment Securities. Fair value estimates are based on the value of one unit without regard to any premium or discount that may result from concentrations of ownership, possible tax ramifications or estimated transaction costs.
 
Federal Funds Sold and Securities Purchased under Agreements to Resell, Interest Earning Deposits With Banks and Cash and Due From Banks
 
The carrying amounts of federal funds sold and securities purchased under agreements to resell, interest earning deposits with banks, and cash and due from banks approximate fair value. Federal funds sold and securities purchased under agreements to resell generally mature in 90 days or less.
 
Accrued Interest Receivable/Payable
 
The carrying amounts of accrued interest receivable and accrued interest payable approximate their fair values because of the relatively short time period between the accrual period and the expected receipt or payment due date.
 
Derivative Instruments
 
A detailed description of the fair value measurement of derivative instruments is provided in Note 14 on Fair Value Measurements. Fair values are generally estimated using observable market prices or pricing models.
 
Deposits
 
The fair value of deposits with no stated maturity is equal to the amount payable on demand. Such deposits include savings and interest and non-interest bearing demand deposits. These fair value estimates do not recognize any benefit the Company receives as a result of being able to administer, or control, the pricing of these accounts. The fair value of certificates of deposit is based on the discounted value of cash flows, taking early withdrawal optionality into account. Discount rates are based on the Company’s approximate cost of obtaining similar maturity funding in the market.


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Borrowings
 
The fair value of short-term borrowings such as federal funds purchased, securities sold under agreements to repurchase, and borrowings under the Federal Reserve’s Term Auction Facility, which mature or reprice within 90 days, approximates their carrying value. The fair value of long-term debt is estimated by discounting contractual maturities using an estimate of the current market rate for similar instruments.
 
The estimated fair values of the Company’s financial instruments are as follows:
 
                 
   
    September 30, 2009  
    Carrying
    Estimated
 
(In thousands)   Amount     Fair Value  
   
 
Financial Assets
               
Loans, including held for sale
  $ 10,600,603     $ 10,824,042  
Available for sale investment securities
    6,075,632       6,075,632  
Trading securities
    9,242       9,242  
Non-marketable securities
    133,732       133,732  
Federal funds sold and securities purchased under agreements to resell
    12,620       12,620  
Accrued interest receivable
    76,070       76,070  
Derivative instruments
    20,268       20,268  
Cash and due from banks
    342,949       342,949  
Interest earning deposits with banks
    118,745       118,745  
 
 
Financial Liabilities
               
Non-interest bearing demand deposits
  $ 1,512,529     $ 1,512,529  
Savings, interest checking and money market deposits
    8,678,985       8,678,985  
Time open and C.D.’s
    3,649,281       3,695,108  
Federal funds purchased and securities sold under agreements to repurchase
    1,130,193       1,129,725  
Other borrowings
    821,941       857,075  
Accrued interest payable
    28,557       28,557  
Derivative instruments
    21,308       21,308  
 
 
 
Off-Balance Sheet Financial Instruments
 
The fair value of letters of credit and commitments to extend credit is based on the fees currently charged to enter into similar agreements. The aggregate of these fees is not material.
 
Limitations
 
Fair value estimates are made at a specific point in time based on relevant market information. They do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for many of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, risk characteristics and economic conditions. These estimates are subjective, involve uncertainties and cannot be determined with precision. Changes in assumptions could significantly affect the estimates.


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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes and with the statistical information and financial data appearing in this report as well as the Company’s 2008 Annual Report on Form 10-K. Results of operations for the three and nine month periods ended September 30, 2009 are not necessarily indicative of results to be attained for any other period.
 
Forward Looking Information
 
This report may contain “forward-looking statements” that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of the Company. This could cause results or performance to differ materially from those expressed in the forward-looking statements. Words such as “expects”, “anticipates”, “believes”, “estimates”, variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements. Readers should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed throughout this report. Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. Such possible events or factors include: changes in economic conditions in the Company’s market area, changes in policies by regulatory agencies, governmental legislation and regulation, fluctuations in interest rates, changes in liquidity requirements, demand for loans in the Company’s market area, and competition with other entities that offer financial services.
 
Critical Accounting Policies
 
The Company’s consolidated financial statements are prepared based on the application of certain accounting policies, some of which require numerous estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations which may significantly affect the Company’s reported results and financial position for the current period or future periods. The use of estimates, assumptions, and judgments are necessary when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Current economic conditions may require the use of additional estimates, and some estimates may be subject to a greater degree of uncertainty due to the current instability of the economy. The Company has identified several policies as being critical because they require management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for loan losses, the valuation of investment securities, and accounting for income taxes.
 
Allowance for Loan Losses
 
The Company performs periodic and systematic detailed reviews of its loan portfolio to assess overall collectability. The level of the allowance for loan losses reflects the Company’s estimate of the losses inherent in the loan portfolio at any point in time. While these estimates are based on substantive methods for determining allowance requirements, actual outcomes may differ significantly from estimated results, especially when determining allowances for business, lease, construction and business real estate loans. These loans are normally larger and more complex, and their collection rates are harder to predict. Personal loans, including personal mortgage, credit card and consumer loans, are individually smaller and perform in a more homogenous manner, making loss estimates more predictable. Further discussion of the


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methodologies used in establishing the allowance is provided in the Provision and Allowance for Loan Losses section of this discussion.
 
Valuation of Investment Securities
 
The Company carries its investment securities at fair value, and employs valuation techniques which utilize observable inputs when those inputs are available. These observable inputs reflect assumptions market participants would use in pricing the security, developed based on market data obtained from sources independent of the Company. When such information is not available, the Company employs valuation techniques which utilize unobservable inputs, or those which reflect the Company’s own assumptions about market participants, based on the best information available in the circumstances. These valuation methods typically involve cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, estimates, or other inputs to the valuation techniques could have a material impact on the Company’s future financial condition and results of operations. Assets and liabilities carried at fair value inherently result in more financial statement volatility. Under the fair value measurement hierarchy, fair value measurements are classified as Level 1 (quoted prices), Level 2 (based on observable inputs) or Level 3 (based on unobservable, internally-derived inputs), as discussed in more detail in Note 14 to the consolidated financial statements. Most of the available for sale investment portfolio is priced utilizing industry-standard models that consider various assumptions which are observable in the marketplace, or can be derived from observable data. Such securities totaled approximately $5.5 billion, or 90.4% of the available for sale portfolio at September 30, 2009, and were classified as Level 2 measurements. The Company also holds $170.1 million in auction rate securities. These were classified as Level 3 measurements, as no market currently exists for these securities, and fair values were derived from internally generated cash flow valuation models which used unobservable inputs which were significant to the overall measurement.
 
Changes in the fair value of available for sale securities, excluding credit losses relating to other-than-temporary impairment, are reported in other comprehensive income. The Company periodically evaluates the available for sale portfolio for other-than-temporary impairment. Evaluation for other-than-temporary impairment is based on the Company’s intent to sell the security and whether it is likely that it will be required to sell the security before the anticipated recovery of its amortized cost basis. If either of these conditions is met, the entire loss (the amount by which the amortized cost exceeds the fair value) must be recognized in current earnings. If neither condition is met, but the Company does not expect to recover the amortized cost basis, the Company must determine whether a credit loss has occurred. This credit loss is the amount by which the amortized cost basis exceeds the present value of cash flows expected to be collected from the security. The credit loss, if any, must be recognized in current earnings, while the remainder of the loss, related to all other factors, is recognized in other comprehensive income.
 
The estimation of whether a credit loss exists and the period over which the security is expected to recover requires significant judgment. The Company must consider available information about the collectability of the security, including information about past events, current conditions, and reasonable forecasts, which includes payment structure, prepayment speeds, expected defaults, and collateral values. Changes in these factors could result in additional impairment, recorded in current earnings, in future periods.
 
In 2009, non-agency guaranteed mortgage-backed securities with a par value of $137.8 million were identified as other than temporarily impaired. The credit-related impairment loss on these securities amounted to $2.8 million, which was recorded in the consolidated income statement in investment securities gains (losses), net. The noncredit-related loss on these securities, which was recorded in other comprehensive income, was $32.6 million on a pre-tax basis.
 
The Company, through its direct holdings and its Small Business Investment subsidiaries, has numerous private equity investments, categorized as non-marketable securities in the accompanying consolidated balance sheets. These investments are reported at fair value, and totaled $47.8 million at September 30, 2009. Changes in fair value are reflected in current earnings, and reported in investment securities gains (losses), net in the consolidated income statements. Because there is no observable market data for these securities, their fair values are internally developed using available information and


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management’s judgment and are classified as Level 3 measurements. Although management believes its estimates of fair value reasonably reflect the fair value of these securities, key assumptions regarding the projected financial performance of these companies, the evaluation of the investee company’s management team, and other economic and market factors may affect the amounts that will ultimately be realized from these investments.
 
Accounting for Income Taxes
 
Accrued income taxes represent the net amount of current income taxes which are expected to be paid attributable to operations as of the balance sheet date. Deferred income taxes represent the expected future tax consequences of events that have been recognized in the financial statements or income tax returns. Current and deferred income taxes are reported as either a component of other assets or other liabilities in the consolidated balance sheets, depending on whether the balances are assets or liabilities. Judgment is required in applying generally accepted accounting principles in accounting for income taxes. The Company regularly monitors taxing authorities for changes in laws and regulations and their interpretations by the judicial systems. The aforementioned changes, and changes that may result from the resolution of income tax examinations by federal and state taxing authorities, may impact the estimate of accrued income taxes and could materially impact the Company’s financial position and results of operations.
 
Selected Financial Data
                                 
   
    Three Months Ended
    Nine Months Ended
 
    September 30     September 30  
    2009     2008     2009     2008  
   
 
Per Share Data
                               
Net income per common share – basic
  $ .66     $ .33     $ 1.55     $ 1.92  
Net income per common share – diluted
    .66       .32       1.54       1.90  
Cash dividends
    .240       .238       .720       .714  
Book value
                    23.45       21.16  
Market price
                    37.24       44.19  
Selected Ratios
                               
(Based on average balance sheets)
                               
Loans to deposits(1)
    77.40 %     93.29 %     81.96 %     92.46 %
Non-interest bearing deposits to total deposits
    6.33       5.49       6.12       5.44  
Equity to loans(1)
    16.62       14.26       15.01       14.14  
Equity to deposits
    12.86       13.30       12.30       13.07  
Equity to total assets
    10.13       9.88       9.64       9.75  
Return on total assets
    1.16       .60       .91       1.18  
Return on total equity
    11.49       6.06       9.49       12.14  
(Based on end-of-period data)
                               
Non-interest income to revenue(2)
    38.44       38.68       38.36       39.96  
Efficiency ratio(3)
    57.75       74.20       60.76       64.43  
Tier I risk-based capital ratio
                    12.77       10.65  
Total risk-based capital ratio
                    14.14       11.94  
Tangible equity to assets ratio(4)
                    9.60       8.66  
Tier I leverage ratio
                    9.65       9.11  
 
 
 
(1) Includes loans held for sale.
(2) Revenue includes net interest income and non-interest income.
(3) The efficiency ratio is calculated as non-interest expense (excluding intangibles amortization) as a percent of revenue.
(4) The tangible equity ratio is calculated as stockholders’ equity reduced by goodwill and other intangible assets (excluding mortgage servicing rights) divided by total assets reduced by goodwill and other intangible assets (excluding mortgage servicing rights).


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Results of Operations
 
Summary
                                                 
   
    Three Months Ended
    Nine Months Ended
 
    September 30     September 30  
(Dollars in thousands)   2009     2008     % Change     2009     2008     % Change  
   
 
Net interest income
  $ 163,539     $ 151,564       7.9 %   $ 470,999     $ 436,450       7.9 %
Provision for loan losses
    (35,361 )     (29,567 )     19.6       (119,695 )     (67,567 )     77.2  
Non-interest income
    102,135       95,593       6.8       293,128       290,486       .9  
Investment securities gains (losses), net
    (945 )     1,149       N.M.       (5,870 )     25,480       N.M.  
Non-interest expense
    (154,489 )     (184,446 )     (16.2 )     (467,386 )     (471,692 )     (.9 )
Income taxes
    (23,415 )     (9,534 )     145.6       (52,264 )     (67,320 )     (22.4 )
Non-controlling interest (expense) income
    185       (86 )     N.M.       541       (1,018 )     N.M.  
 
 
Net income
  $ 51,649     $ 24,673       109.3 %   $ 119,453     $ 144,819       (17.5 )%
 
 
 
For the quarter ended September 30, 2009, net income amounted to $51.6 million, an increase of $27.0 million, or 109.3%, over the third quarter of the previous year. For the current quarter, the annualized return on average assets was 1.16%, the annualized return on average equity was 11.49%, and the efficiency ratio was 57.75%. Diluted earnings per share was $.66, an increase of 106.3% over $.32 per share in the third quarter of 2008. Compared to the third quarter of last year, net interest income increased $12.0 million, or 7.9%, resulting from an increase in investment securities balances and lower rates paid on deposits, partly offset by lower loan balances and lower yields on earning assets. Additionally, non-interest income increased $6.5 million, or 6.8%, partly because of a $5.3 million increase in loan fees and sales income, mainly in gains on student loan sales. The provision for loan losses was $35.4 million in the current quarter, a $5.8 million increase over the third quarter of last year. Non-interest expense declined by $30.0 million, or 16.2%, largely due to a $33.0 million loss related to the purchase of auction rate securities in the third quarter of 2008. The loss on auction rate securities lowered diluted earnings per share in the third quarter of 2008 by $.27.
 
Net income for the first nine months of 2009 was $119.5 million, a $25.4 million, or 17.5%, decrease from the first nine months of 2008. For the first nine months of 2009, the annualized return on average assets was .91%, the annualized return on average equity was 9.49%, and the efficiency ratio was 60.76%. Diluted earnings per share was $1.54, a decrease of 18.9% from $1.90 per share during the first nine months of 2008. Compared to the first nine months of 2008, net interest income increased $34.5 million, or 7.9%. Non-interest income rose $2.6 million due to increases in loan fees and sales, bond trading income, and bank card fees. Investment securities gains declined $31.4 million due to a $22.2 million gain on the redemption of Visa, Inc. common stock in the first quarter of 2008. The provision for loan losses totaled $119.7 million for the first nine months of 2009, representing an increase of $52.1 million over the same period in 2008. Non-interest expense declined by $4.3 million, largely due to the absence of the $33.3 million loss related to the purchase of auction rate securities in the third quarter of 2008, partly offset by increases of $20.4 million in FDIC insurance expense and $10.3 million in salaries and benefits expense in 2009.
 
The Company continually evaluates the profitability of its network of bank branches throughout its markets. As a result of this evaluation process, the Company may periodically sell the assets and liabilities of certain branches, or may sell the premises of specific banking facilities. In February 2009, the Company sold its branch in Lakin, Kansas. In this transaction, the Company sold the bank facility and certain deposits of approximately $4.7 million, and recorded a pre-tax gain of $644 thousand. In May 2008, the Company sold its banking branch, including the facility, in Independence, Kansas. In this transaction, approximately $23.3 million in loans, $85.0 million in deposits, and various other assets and liabilities were sold, and the Company recorded a pre-tax gain of $6.9 million.


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Net Interest Income
 
The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates. Changes not solely due to volume or rate changes are allocated to rate.
 
Analysis of Changes in Net Interest Income
                                                 
   
    Three Months Ended
    Nine Months Ended
 
    September 30, 2009 vs. 2008     September 30, 2009 vs. 2008  
    Change due to           Change due to        
    Average
    Average
          Average
    Average
       
(In thousands)   Volume     Rate     Total     Volume     Rate     Total  
   
 
Interest income, fully taxable equivalent basis:
                                               
Loans
  $ (11,415 )   $ (11,659 )   $ (23,074 )   $ (16,210 )   $ (58,197 )   $ (74,407 )
Loans held for sale
    (630 )     (1,699 )     (2,329 )     3,093       (7,567 )     (4,474 )
Investment securities:
                                               
U.S. government and federal agency securities
    3,037       404       3,441       904       (204 )     700  
State and municipal obligations
    2,819       (939 )     1,880       10,907       (2,777 )     8,130  
Mortgage and asset-backed securities
    19,212       (5,404 )     13,808       38,641       (7,147 )     31,494  
Other securities
    2,332       (947 )     1,385       1,200       1,129       2,329  
 
 
Total interest on investment securities
    27,400       (6,886 )     20,514       51,652       (8,999 )     42,653  
 
 
Federal funds sold and securities purchased under agreements to resell
    (1,953 )     (120 )     (2,073 )     (6,769 )     (819 )     (7,588 )
Interest earning deposits with banks
    120             120       622             622  
 
 
Total interest income
    13,522       (20,364 )     (6,842 )     32,388       (75,582 )     (43,194 )
 
 
Interest expense:
                                               
Deposits:
                                               
Savings
    26       (179 )     (153 )     92       (599 )     (507 )
Interest checking and money market
    951       (7,905 )     (6,954 )     2,741       (28,277 )     (25,536 )
Time open & C.D.’s of less than $100,000
    604       (3,247 )     (2,643 )     (2,188 )     (16,890 )     (19,078 )
Time open & C.D.’s of $100,000 and over
    1,942       (5,053 )     (3,111 )     10,806       (23,888 )     (13,082 )
 
 
Total interest on deposits
    3,523       (16,384 )     (12,861 )     11,451       (69,654 )     (58,203 )
 
 
Federal funds purchased and securities sold under agreements to repurchase
    (1,817 )     (2,784 )     (4,601 )     (8,645 )     (11,511 )     (20,156 )
Other borrowings
    (2,295 )     (35 )     (2,330 )     797       (2,695 )     (1,898 )
 
 
Total interest expense
    (589 )     (19,203 )     (19,792 )     3,603       (83,860 )     (80,257 )
 
 
Net interest income, fully taxable equivalent basis
  $ 14,111     $ (1,161 )   $ 12,950     $ 28,785     $ 8,278     $ 37,063  
 
 
 
Net interest income for the third quarter of 2009 was $163.5 million, a $12.0 million, or 7.9%, increase over the third quarter of 2008. The increase in net interest income was primarily the result of lower rates paid on interest bearing deposits and higher average balances of investment securities, partly offset by lower loan yields coupled with lower average loan balances. The Company’s net interest rate margin was 4.02% in the third quarter of 2009, compared to 4.04% in the third quarter of 2008.
 
Interest income, on a tax equivalent basis (T/E), decreased $6.8 million, or 3.2%, in the third quarter of 2009 compared to the same quarter in 2008. Interest income on loans (T/E) declined $23.1 million, or 14.2%,


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as the result of a 57 basis point decrease in rates earned on the loan portfolio coupled with a decrease in average loan balances of 5.1%. Average rates earned on business loans in the third quarter of 2009 decreased 93 basis points from the same quarter in 2008, resulting in a $7.2 million decrease in interest income. Average quarterly rates earned on business real estate loans decreased 76 basis points resulting in a decline in interest income of $4.0 million. Contributing to the income reduction in the current quarter compared to the same quarter in 2008 was a decrease in the average balances of business loans of $454.8 million, or 13.1%, which reflected lower line of credit usage, lower demand, and pay-downs by business loan customers. Average business real estate loans declined $177.6 million, or 7.6%, as a result of continued uncertain economic conditions in the real estate markets and lower overall demand. Also, quarterly average consumer loan balances decreased $293.2 million, or 17.1%, reducing interest income by $5.2 million compared to the same quarter in 2008. Partially offsetting these reductions to interest income were an increase of $1.8 million earned on consumer credit card loans, primarily due to a 184 basis point increase in rates earned, and an increase of $2.0 million earned on student loans, which were acquired in the fourth quarter of 2008. During the third quarter of 2009, interest income on investment securities (T/E) increased $20.5 million, as average balances increased $2.1 billion, or 60.6%, with most of the growth in mortgage and asset-backed securities. In addition, average balances of U.S. government and federal agencies increased due to the purchase of $369.9 million of U.S. Treasury inflation-protected securities (TIPS) during the quarter. The inflation-adjusted income earned on the TIPS during the current quarter amounted to $2.4 million. However, these effects were partially offset by an overall decrease of 48 basis points in average rates earned on the total portfolio, compared to the third quarter of 2008. Interest income on overnight investments in federal funds sold and securities purchased under agreements to resell decreased $2.1 million, primarily due to a decrease in average balances of $388.3 million coupled with a decline of 135 basis points in rates earned. The average tax equivalent yield on total interest earning assets was 4.93% in the third quarter of 2009 compared to 5.55% in the third quarter of 2008.
 
Interest expense in the third quarter of 2009 decreased $19.8 million, or 34.2%, compared to the third quarter of 2008, primarily due to a $12.9 million decrease in interest expense incurred on interest bearing deposits, coupled with a $4.6 million decrease in interest expense incurred on federal funds purchased and securities sold under agreements to repurchase. The decrease in expense incurred on interest bearing deposits resulted from a 57 basis point decrease in average rates paid, offset slightly by a $1.5 billion, or 12.9%, increase in average balances. Average rates paid on interest checking and money market accounts decreased 42 basis points, while average balances increased $1.2 billion, or 15.4%, resulting in a net decrease in interest expense of $7.0 million. Additionally, interest expense incurred on certificates of deposit decreased $5.8 million as a result of an 83 basis point decline in average rates paid, partly offset by a $297.1 million increase in average balances. Interest expense on federal funds purchased and securities sold under agreements to repurchase decreased $4.6 million compared to the third quarter of 2008 as a result of a decrease in average balances of $430.3 million, or 31.5%, coupled with a 123 basis point decrease in average rates paid. Interest expense on other borrowings decreased $2.3 million, or 23.3%, primarily due to lower average balances of FHLB advances coupled with a decline in average borrowings under the Federal Reserve’s Term Auction Facility (TAF). The overall average rate incurred on all interest bearing liabilities decreased to 1.02% in the third quarter of 2009 compared to 1.65% in the third quarter of 2008.
 
Net interest income for the first nine months of 2009 was $471.0 million compared to $436.5 million for the same period in 2008, an increase of $34.5 million, or 7.9%. For the first nine months of 2009, the net yield on total interest earning assets on a tax equivalent basis was 3.92% compared to the net yield of 3.93% in the first nine months of 2008. Lower rates paid on interest bearing liabilities, coupled with growth in average balances of investment securities, contributed to higher net interest income, which was partially offset by lower average rates earned on loans and declines in average loan balances.
 
For the first nine months of 2009, total interest income (T/E) decreased $43.2 million, or 6.6%, from the same period in 2008, mainly due to lower interest earned on loans coupled with lower average loan balances, partially offset by higher interest earned on investment securities. The average rate earned on the loan portfolio for the first nine months of 2009 decreased 84 basis points, lowering interest income by $58.2 million compared to 2008, while average loan balances decreased $146.8 million, lowering interest income by $16.2 million. Additionally, interest income was reduced by $9.0 million compared to the first nine


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months of 2008 due to a 27 basis point decline in average rates earned on investment securities. These effects were partly offset by a $1.4 billion, or 39.8%, increase in average balances of investment securities, resulting in an increase in interest income of $51.7 million compared to the first nine months of 2008. Beginning October 1, 2008, amounts held with the Federal Reserve Bank began earning interest, which contributed $622 thousand to interest income in the first nine months of 2009, most of which was earned in the first quarter of 2009.
 
Total interest expense decreased $80.3 million, or 39.4%, in the first nine months of 2009 compared to the same period in the prior year. Interest expense on deposits decreased $58.2 million compared to the first nine months of 2008, mainly due to a 79 basis point decrease in average rates paid, slightly offset by an increase of $1.3 billion, or 11.5%, in average interest bearing deposit balances. Additionally, interest expense incurred on federal funds purchased and securities sold under agreements to repurchase decreased $20.2 million during the first nine months of 2009 compared to the same period in 2008 as a result of a $506.7 million decline in average balances and a 169 basis point decrease in average rates paid. For the first nine months of 2009, the overall tax equivalent yield on earning assets declined 79 basis points to 4.92%, while the overall cost of interest bearing liabilities decreased 83 basis points to 1.12%.
 
Summaries of average assets and liabilities and the corresponding average rates earned/paid appear on the last page of this discussion.
 
Non-Interest Income
 
                                                 
   
    Three Months
    Nine Months
 
    Ended September 30     Ended September 30  
(Dollars in thousands)   2009     2008     % Change     2009     2008     % Change  
   
 
Deposit account charges and other fees
  $ 27,750     $ 27,854       (.4 )%   $ 80,277     $ 83,189       (3.5 )%
Bank card transaction fees
    31,279       29,317       6.7       88,552       85,019       4.2  
Trust fees
    19,258       20,518       (6.1 )     57,486       60,917       (5.6 )
Bond trading income
    4,834       2,604       85.6       16,381       9,951       64.6  
Consumer brokerage services
    3,045       3,439       (11.5 )     9,566       10,259       (6.8 )
Loan fees and sales
    6,851       1,594       329.8       13,545       4,884       177.3  
Other
    9,118       10,267       (11.2 )     27,321       36,267       (24.7 )
 
 
Total non-interest income
  $ 102,135     $ 95,593       6.8 %   $ 293,128     $ 290,486       .9 %
 
 
Non-interest income as a % of total revenue*
    38.4 %     38.7 %             38.4 %     40.0 %        
 
 
* Total revenue includes net interest income and non-interest income.
 
For the third quarter of 2009, total non-interest income amounted to $102.1 million, an increase of $6.5 million, or 6.8%, compared with $95.6 million in the same quarter last year. This increase was due to growth in bank card fees, bond trading income and loan fees and sales revenue, while trust fees declined from the prior period. Deposit account fees for the quarter declined $104 thousand, or .4%, from the third quarter of last year as a result of a 9.7% decline in overdraft fee income, but partly offset by growth in cash management fees, which were up 26.5% over the previous year. Bank card fees increased $2.0 million, or 6.7%, over the same period last year, primarily due to continued growth in transaction fees earned on corporate cards and debit cards, which grew by 26.4% and 3.1%, respectively, but continued to be negatively impacted by lower retail sales affecting both merchant and credit card fees. Trust fees for the quarter decreased $1.3 million, or 6.1%, from the same quarter last year and reflected the impact that lower markets have had on trust asset values and the effects of low rates on money market assets held in trust. Bond trading income for the current quarter totaled $4.8 million, an increase of $2.2 million, or 85.6%, due to higher sales of fixed income securities to correspondent banks and corporate customers. Consumer brokerage services revenue decreased by $394 thousand, or 11.5%, mainly due to lower sales and commissions on fixed annuity and insurance products. Loan fees and sales revenue increased $5.3 million as a result of the sale of $221.1 million in student


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loans during the current quarter, which resulted in a pre-tax gain of $4.4 million. Other non-interest income for the current quarter decreased $1.1 million, or 11.2%, from the same quarter last year. This decrease was mainly due to declines in cash sweep commissions, fees on interest rate swap sales, and equipment rental income, partly offset by an increase in tax credit sale income.
 
Non-interest income for the nine months ended September 30, 2009 was $293.1 million, compared to $290.5 million in the first nine months of 2008, resulting in a $2.6 million, or .9%, increase. Deposit account fees declined $2.9 million, or 3.5%, as a result of lower overdraft fee revenue, which fell $5.1 million, or 9.5%, while cash management fees were higher by $2.7 million, or 11.7%, over the prior year. Bank card fees rose $3.5 million, or 4.2% overall, due to increases of 21.7% and 2.6%, respectively, in corporate and debit card transaction fees. Trust fees decreased $3.4 million, or 5.6%, mainly in institutional and corporate fees. Bond trading income rose $6.4 million due to increased sales activity, while consumer brokerage income declined $693 thousand. Loan fees and sales increased by $8.7 million, as gains on student loans sales increased $6.3 million and mortgage banking revenue grew $1.3 million, due to refinancing activity. The decrease in other non-interest income of $8.9 million in the first nine months of 2009 compared to 2008 was mainly due to a gain of $6.9 million recorded in the second quarter of 2008 on the sale of a banking branch in Kansas, mentioned previously. Other declines were reported in cash sweep commissions, equipment rental income and interest rate swap sales. Additionally, an impairment charge of $1.1 million was recorded in 2008 on an office building held for sale, which formerly housed the Company’s check processing operations.
 
Investment Securities Gains (Losses), Net
 
Net gains and losses on investment securities recognized in earnings during the three and nine month periods ended September 30, 2009 and 2008 are shown in the table below. Net securities losses were $945 thousand and $5.9 million in the three and nine month periods ended September 30, 2009, respectively. Included in these losses were credit-related impairment losses of $1.5 million and $2.8 million for the three and nine month periods, respectively, on certain non-agency mortgage-backed securities identified as other than temporarily impaired. The total noncredit-related loss on these securities, which was recorded in other comprehensive income, was $32.6 million. The combined par value of these securities was $137.8 million at September 30, 2009. Also shown below are net gains and losses relating to non-marketable private equity investments, which are primarily held by the Parent and its majority-owned venture capital subsidiaries. These include fair value adjustments, in addition to gains and losses realized upon disposition. The portion of this activity attributable to minority interests is reported as non-controlling interest in the consolidated income statement and resulted in income of $865 thousand during the first nine months of 2009 and expense of $660 thousand during the same period last year. Most of the net gain in the first nine months of 2008 resulted from the redemption of Visa, Inc. (Visa) common stock, amounting to $22.2 million.
 
                                 
   
    Three Months
    Nine Months
 
    Ended September 30     Ended September 30  
(In thousands)   2009     2008     2009     2008  
   
 
Available for sale:
                               
Preferred equity securities
  $     $     $     $ (3,504 )
Common stock
          (1 )           (1 )
Other bonds
    (1,487 )           (2,770 )     1,139  
Non-marketable:
                               
Private equity investments
    542       1,150       (3,100 )     5,650  
Visa Class B stock
                      22,196  
 
 
Total investment securities gains (losses), net
  $ (945 )   $ 1,149     $ (5,870 )   $ 25,480  
 
 


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Non-Interest Expense
 
                                                 
   
    Three Months
    Nine Months
 
    Ended September 30     Ended September 30  
(Dollars in thousands)   2009     2008     % Change     2009     2008     % Change  
   
 
Salaries and employee benefits
  $ 87,267     $ 83,766       4.2 %   $ 260,299     $ 250,023       4.1 %
Net occupancy
    11,752       11,861       (.9 )     34,652       34,735       (.2 )
Equipment
    6,306       6,122       3.0       18,883       18,273       3.3  
Supplies and communication
    8,061       9,276       (13.1 )     24,994       26,545       (5.8 )
Data processing and software
    15,500       14,229       8.9       44,854       41,951       6.9  
Marketing
    4,846       4,926       (1.6 )     14,099       15,660       (10.0 )
Deposit insurance
    4,833       510       847.6       21,908       1,535       N.M.  
Indemnification obligation
    (2,496 )     2,879       N.M.       (2,496 )     (5,929 )     57.9  
Loss on purchase of auction rate securities
          32,967       (100.0 )           33,266       (100.0 )
Other
    18,420       17,910       2.8       50,193       55,633       (9.8 )
 
 
Total non-interest expense
  $ 154,489     $ 184,446       (16.2 )%   $ 467,386     $ 471,692       (.9 )%
 
 
 
Non-interest expense for the third quarter of 2009 amounted to $154.5 million, a decrease of $30.0 million, or 16.2%, compared with $184.4 million recorded in the third quarter of last year. Much of the decline was due to a $33.0 million loss on the purchase of auction rate securities from the Company’s customers in the third quarter of 2008, which did not recur in 2009. The securities were purchased at par value from the customers, and this loss represented the amount by which par value exceeded estimated fair value on the purchase date. Excluding this loss, non-interest expense would have increased $3.0 million, or 2.0%, in the third quarter of 2009 over the same period in 2008. This increase includes a $4.3 million rise in FDIC insurance costs over the same quarter last year. Compared with the third quarter of last year, salaries and benefits expense increased $3.5 million, or 4.2%, resulting mainly from higher medical and pension costs, coupled with increased incentives paid on certain Capital Markets activities. Occupancy costs decreased $109 thousand, or .9%, from the same quarter last year, while equipment expense increased $184 thousand, or 3.0%. Supplies and communication expense declined $1.2 million, or 13.1%, mainly due to lower courier service costs and data network expense. Marketing expense was slightly lower than in the previous year, while data processing and software costs increased $1.3 million, or 8.9%, mainly as a result of higher costs for several new software and servicing systems put in place this year. Included in non-interest expense in the current quarter was a reduction of $2.5 million in an indemnification obligation relating to Visa litigation, compared to net charges of $2.9 million related to this obligation in the third quarter of 2008. Other non-interest expense increased $510 thousand, or 2.8%, over the same quarter last year primarily as a result of higher professional fees, loan collection expense and impairment charges on foreclosed property, in addition to lower deferrals of loan origination costs. These effects were partly offset by lower travel and entertainment expense.
 
For the first nine months of 2009, non-interest expense decreased $4.3 million, or .9%, compared to the same period in the previous year. As mentioned above, the previous period included a loss of $33.3 million related to the purchase of auction rate securities. During the first nine months of 2009, salaries and benefits expense grew $10.3 million, or 4.1%, due to merit increases and higher pension and medical costs. Full-time equivalent employees totaled 5,148 and 5,202 at September 30, 2009 and 2008, respectively. Occupancy expense decreased slightly, while equipment expense increased $610 thousand, or 3.3%, mainly due to higher data processing equipment depreciation expense. Supplies and communication expense decreased $1.6 million, or 5.8%, as a result of lower courier service and supplies expense, partly offset by higher data network expense. Data processing and software costs grew $2.9 million, or 6.9%, due to several new software and servicing systems. Marketing expense decreased $1.6 million, or 10.0%. FDIC deposit insurance increased $20.4 million due to higher insurance rates assessed, which included costs for a special assessment of $8.0 million in the second quarter of 2009. As mentioned above, a reduction of $2.5 million in Visa indemnification costs was recorded in the first nine months of 2009, compared to a net reduction of $5.9 million during the same period in 2008. These reductions to the Company’s indemnification obligation were recorded as additional funds were


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contributed by Visa to its litigation escrow account. Other non-interest expense decreased $5.4 million, or 9.8%, partly due to declines in travel and entertainment expense and impairment charges on foreclosed property. Other decreases occurred in leased asset depreciation expense and recruiting expense, which were partly offset by a decline in loan origination cost deferrals.
 
Costs for FDIC deposit insurance have risen substantially in the first nine months of 2009. The Company expects this trend to continue as the banking industry is assessed higher costs to replenish the FDIC insurance fund, which has been depleted by the recent high levels of bank failures across the country. The Company expects to incur total annual expense of approximately $27 million during 2009 as a result of normal deposit premiums and special assessments, which would be higher than 2008 expense by $25 million. The FDIC is currently proposing to require insured institutions to prepay their quarterly risk-based assessments for the fourth quarter of 2009 and subsequent years 2010 through 2012. Under the proposal, a cash payment by the Company would be required on December 30, 2009. The amount of the payment would be recorded as an asset and reduced each quarter as the Company’s regular quarterly assessments come due and are expensed. Under the proposed terms, the Company expects to pay approximately $70 million on December 30, 2009.
 
Provision and Allowance for Loan Losses
 
                                         
   
          Nine Months Ended
 
    Three Months Ended     September 30  
    Sept. 30
    June 30
    Sept. 30
             
(In thousands)   2009     2009     2008     2009     2008  
   
 
Provision for loan losses
  $ 35,361     $ 41,166     $ 29,567     $ 119,695     $ 67,567  
 
 
Net loan charge-offs (recoveries):
                                       
Business
    4,626       2,378       1,775       10,846       2,315  
Real estate-construction and land
    4,463       10,373       1,217       24,062       2,194  
Real estate-business
    1,253       1,033       257       3,062       1,198  
Consumer credit card
    12,577       13,214       8,314       36,554       22,842  
Consumer
    6,522       8,476       6,060       24,331       14,546  
Home equity
    233       96       208       629       338  
Student
    2       2             4        
Real estate-personal
    797       215       182       1,557       356  
Overdrafts
    423       246       721       803       1,333  
 
 
Total net loan charge-offs
  $ 30,896     $ 36,033     $ 18,734     $ 101,848     $ 45,122  
 
 
 
                                         
   
          Nine Months Ended
 
    Three Months Ended     September 30  
    Sept. 30
    June 30
    Sept. 30
             
    2009     2009     2008     2009     2008  
   
 
Annualized net loan charge-offs*:
                                       
Business
    .61 %     .29 %     .20 %     .45 %     .09 %
Real estate-construction and land
    2.53       5.54       .69       4.26       .42  
Real estate-business
    .23       .19       .04       .19       .07  
Consumer credit card
    6.85       7.60       4.19       6.79       3.92  
Consumer
    1.82       2.27       1.40       2.17       1.16  
Home equity
    .19       .08       .17       .17       .10  
Real estate-personal
    .20       .05       .05       .13       .03  
Overdrafts
    14.87       11.47       23.17       11.38       14.37  
 
 
Total annualized net loan charge-offs
    1.17 %     1.33 %     .68 %     1.26 %     .55 %
 
 
* as a percentage of average loans (excluding loans held for sale)


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The Company has an established process to determine the amount of the allowance for loan losses, which assesses the risks and losses inherent in its portfolio. This process provides an allowance consisting of a specific allowance component based on certain individually evaluated loans and a general component based on estimates of reserves needed for pools of loans with similar risk characteristics.
 
Loans subject to individual evaluation are defined by the Company as impaired, and generally consist of business, construction, business real estate and personal real estate loans on non-accrual status. These loans are evaluated individually for the impairment of repayment potential and collateral adequacy, and in conjunction with current economic conditions and loss experience, allowances are estimated. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic factors, loan risk ratings and industry concentrations.
 
In using this process and the information available, management must consider various assumptions and exercise considerable judgment to determine the overall level of the allowance for loan losses. Because of these subjective factors, actual outcomes of inherent losses can differ from original estimates. The process of determining adequate levels of the allowance for loan losses is subject to regular review by the Company’s Credit Administration personnel and outside regulators.
 
Net loan charge-offs for the third quarter of 2009 amounted to $30.9 million, compared with $36.0 million in the prior quarter and $18.7 million in the third quarter of last year. The decrease in net charge-offs in the third quarter of 2009 compared to the previous quarter was mainly due to a $5.9 million decline in construction and land loan losses, coupled with lower consumer banking losses of $2.0 million and lower consumer credit card losses. Net loan charge-offs on business loans increased by $2.2 million over the previous quarter. During the third quarter of 2009, net loan charge-offs on construction and land loans totaled $4.5 million, compared to $10.4 million in the previous quarter and $1.2 million in the third quarter of 2008. Consumer credit card net charge-offs totaled $12.6 million during the third quarter of 2009 compared to $13.2 million in the previous quarter and $8.3 million in the third quarter of 2008. Consumer loan net charge-offs totaled $6.5 million in the current quarter compared to $8.5 million in the previous quarter and $6.1 million in the third quarter of 2008. Included in the consumer net charge-offs were marine and recreational vehicle loan losses of $4.6 million in the third quarter of 2009, $5.7 million in the second quarter of 2009 and $3.8 million in the third quarter of 2008. Combined net loan charge-offs for business, business real estate, and construction loans totaled $10.3 million in the current quarter, compared to $13.8 million in each of the first and second quarters of 2009.
 
The ratio of annualized total net loan charge-offs to total average loans was 1.17%, compared to 1.33% in the previous quarter and .68% in the third quarter of last year. For the third quarter of 2009, annualized net charge-offs on average construction and land loans were 2.53% compared with 5.54% in the previous quarter and .69% in the same period last year. Additionally, annualized net charge-offs on average consumer credit card loans were 6.85% in the current quarter, compared with 7.60% in the previous quarter and 4.19% in the same period last year. Consumer loan annualized net charge-offs for the quarter amounted to 1.82% of average consumer loans, compared to 2.27% in the previous quarter and 1.40% in the same quarter last year.
 
The provision for loan losses for the third quarter of 2009 totaled $35.4 million, which was a $5.8 million decrease compared to the previous quarter and a $5.8 million increase compared to the third quarter of 2008. The amount of the provision in each quarter was determined by management’s review and analysis of the adequacy of the allowance for loan losses, involving all the activities and factors described above regarding that process. The provision in the current quarter was influenced by higher incurred losses within the loan portfolio and an increase in classified loans (mainly non-accrual loans) stemming from increasing risk in the broader economy, but partly offset by lower overall loan balances.
 
Net charge-offs during the first nine months of 2009 were $101.8 million compared to $45.1 million in the same period of 2008. The increase occurred because of higher losses in most loan categories. The provision for loan losses was $119.7 million in the first nine months of 2009 compared to $67.6 million in the same period in 2008. The provision for loan losses in the first nine months exceeded net loan charge-offs in the same period by $17.8 million, which resulted in a corresponding increase in the allowance for loan losses.


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The allowance for loan losses at September 30, 2009 amounted to $190.5 million, or 1.85% of total loans (excluding loans held for sale) compared to $172.6 million, or 1.53%, at December 31, 2008 and $156.0 million, or 1.42%, at September 30, 2008. The increase in the allowance compared to previous periods resulted primarily from provisions exceeding net charge-offs. Higher levels of consumer credit card losses, coupled with growth in the watch list were the main reasons for the increase in the balance of the allowance for loan losses. At September 30, 2009, the allowance for loan loss balances was 157% of total non-accrual loans. The Company considers the allowance for loan losses adequate to cover losses inherent in the loan portfolio at September 30, 2009.
 
Risk Elements of Loan Portfolio
 
The following table presents non-performing assets and loans which are past due 90 days and still accruing interest. Non-performing assets include non-accruing loans and foreclosed real estate. Loans are placed on non-accrual status when management does not expect to collect payments consistent with acceptable and agreed upon terms of repayment. Loans that are 90 days past due as to principal and/or interest payments are generally placed on non-accrual, unless they are both well-secured and in the process of collection, or they are consumer loans that are exempt under regulatory rules from being classified as non-accrual.
 
                         
   
    September 30
    June 30
    December 31
 
(Dollars in thousands)   2009     2009     2008  
   
 
Non-accrual loans:
                       
Business
  $ 24,067     $ 18,369     $ 4,007  
Real estate – construction and land
    67,395       75,579       48,871  
Real estate – business
    19,917       20,948       13,137  
Real estate – personal
    10,232       7,634       6,794  
Consumer
    87       118       87  
 
 
Total non-accrual loans
    121,698       122,648       72,896  
 
 
Foreclosed real estate
    7,535       9,039       6,181  
 
 
Total non-performing assets
  $ 129,233     $ 131,687     $ 79,077  
 
 
Non-performing assets as a percentage of total loans
    1.26 %     1.23 %     .70 %
Non-performing assets as a percentage of total assets
    .72 %     .74 %     .45 %
 
 
Loans past due 90 days and still accruing interest:
                       
Business
  $ 3,873     $ 1,534     $ 1,459  
Real estate – construction and land
    1,775       138       466  
Real estate – business
    2,380             1,472  
Real estate – personal
    4,233       4,964       4,717  
Consumer
    1,991       1,422       3,478  
Home equity
    871       535       440  
Student
    15,622       16,652       14,018  
Consumer credit card
    14,869       14,723       13,914  
 
 
Total loans past due 90 days and still accruing interest
  $ 45,614     $ 39,968     $ 39,964  
 
 
 
Non-accrual loans, which are also considered impaired, totaled $121.7 million at September 30, 2009, and increased $48.8 million over amounts recorded at December 31, 2008. The increase over December 31, 2008 occurred mainly in business non-accrual loans, which increased $20.1 million, and in construction and land real estate non-accrual loans, which increased $18.5 million. These increases reflected weakening of the general economic environment and deterioration in the market conditions of the construction industry during 2009. The total non-accrual loan balance at September 30, 2009 was relatively flat compared with the


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balance at the previous quarter end, with some improvement in construction and land real estate non-accrual loans but higher levels in business loans and personal real estate loans. At September 30, 2009, non-accrual loans were comprised mainly of construction and land real estate loans (55.4%), business loans (19.8%) and business real estate loans (16.4%). At September 30, 2009, foreclosed real estate totaled $7.5 million, an increase of $1.4 million over the balance at December 31, 2008, but a decline of $1.5 million from June 30, 2009.
 
Loans whose terms have been modified in a troubled debt restructuring are generally placed on non-accrual status until a six-month payment history is sustained. Non-accrual loan balances at September 30, 2009 included $333 thousand of such loans.
 
Total loans past due 90 days or more and still accruing interest amounted to $45.6 million as of September 30, 2009, which included $15.3 million in guaranteed student loans that the Company intends to hold to maturity. The balance of loans 90 days past due or more increased $5.7 million at September 30, 2009 compared to the balance at December 31, 2008, and increased $5.6 million compared to the June 30, 2009 balance. The increase during the current quarter occurred mainly in business, business real estate, and construction and land loan delinquencies.
 
In addition to non-accrual loans, the Company also has identified loans for which management has concerns about the ability of the borrowers to meet existing repayment terms, which are shown in the table below. They are primarily classified as substandard under the Company’s internal rating system. The loans are generally secured by either real estate or other borrower assets, reducing the potential for loss should they become non-performing. Although these loans are generally identified as potential problem loans, they may never become non-performing. Most of the $73.5 million increase during the current quarter occurred in business real estate loans, construction and land loans, and business loans (including lease and floorplan loans).
 
                         
   
    September 30
    June 30
    December 31
 
(In thousands)   2009     2009     2008  
   
 
Potential problem loans:
                       
Business
  $ 101,480     $ 84,870     $ 125,618  
Real estate – construction and land
    135,318       120,409       135,324  
Real estate – business
    109,220       69,199       41,821  
Real estate – personal
    15,196       13,639       13,642  
Consumer
    1,822       1,696       2,208  
Home equity
    871       536       440  
Consumer credit card
    15,648       15,684       14,666  
 
 
Total potential problem loans
  $ 379,555     $ 306,033     $ 333,719  
 
 
 
Within the total loan portfolio, certain sectors are considered at higher risk due to their contractual features and collateral values that could increase credit exposure in the present economic environment. Additional information about the major types of loans in these categories and their risk features is provided as follows.


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Real Estate – Construction and Land Loans
 
The Company’s portfolio of construction loans, as shown in the table below, amounted to 6.7% of total loans outstanding at September 30, 2009.
 
                                 
   
    September 30
          December 31
       
(In thousands)   2009     % of Total     2008     % of Total  
   
 
Residential land and land development
  $ 181,882       26.5 %   $ 246,335       29.4 %
Residential construction
    127,964       18.6       141,405       16.9  
Commercial land and land development
    130,227       18.9       139,726       16.7  
Commercial construction
    247,755       36.0       309,903       37.0  
 
 
Total real estate – construction and land loans
  $ 687,828       100.0 %   $ 837,369       100.0 %
 
 
 
Real Estate – Business Loans
 
Total business real estate loans were $2.2 billion at September 30, 2009 and comprised 21.0% of the Company’s total loan portfolio. These loans include properties such as manufacturing and warehouse buildings, small office and medical buildings, churches, hotels and motels, shopping centers, and other commercial properties. Approximately 53% of these loans were for owner-occupied real estate properties, which present lower risk profiles.
 
                 
   
    September 30
       
(In thousands)   2009     % of Total  
   
 
Owner-occupied
  $ 1,134,297       52.5 %
Industrial
    124,117       5.8  
Office
    227,659       10.5  
Retail
&