BB&T 10-Q 2008
Washington, D.C. 20549
Quarterly Report Pursuant to Section 13 or 15(d)
For the quarterly period ended:
June 30, 2008
Commission file number: 1-10853
(Exact name of registrant as specified in its charter)
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 ¨
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.
At July 31, 2008, 549,489,664 shares of the registrant's common stock, $5 par value, were outstanding.
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Item 1. Financial Statements
BB&T CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
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BB&T CORPORATION AND SUBSIDIARIES
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NOTE 1. Basis of Presentation
In the opinion of management, the accompanying unaudited Consolidated Balance Sheets, Consolidated Statements of Income, Consolidated Statements of Changes in Shareholders Equity, and Consolidated Statements of Cash Flows of BB&T Corporation and subsidiaries (referred to herein as BB&T, the Corporation or the Company), present fairly, in all material respects, BB&Ts financial position at June 30, 2008 and December 31, 2007, BB&Ts results of operations for the three and six month periods ended June 30, 2008 and 2007, and BB&Ts changes in shareholders equity and cash flows for the six month periods ended June 30, 2008 and 2007. In the opinion of management, all adjustments necessary to fairly present the consolidated financial position and consolidated results of operations have been made. All adjustments during the first six months of 2008 and 2007 were of a normal recurring nature.
These consolidated financial statements and notes are presented in accordance with the instructions for Form 10-Q. The information contained in the financial statements and footnotes included in BB&Ts Annual Report on Form 10-K for the year ended December 31, 2007 should be referred to in connection with these unaudited interim consolidated financial statements.
Nature of Operations
BB&T is a financial holding company headquartered in Winston-Salem, North Carolina. BB&T conducts its operations primarily through its subsidiary, Branch Banking and Trust Company (Branch Bank), which has branches in North Carolina, South Carolina, Virginia, Maryland, Georgia, West Virginia, Tennessee, Kentucky, Florida, Alabama, Indiana and Washington, D.C. Branch Bank provides a wide range of banking services to individuals and businesses, and offers a variety of loans to businesses and consumers. Such loans are made primarily to individuals residing in the market areas described above or to businesses located within BB&Ts geographic footprint. Branch Bank also markets a wide range of deposit services to individuals and businesses. Branch Bank offers, either directly, or through its subsidiaries, lease financing to businesses and municipal governments; factoring; discount brokerage services, annuities and mutual funds; life insurance, property and casualty insurance, health insurance and commercial general liability insurance on an agency basis and through a wholesale insurance brokerage operation; insurance premium financing; permanent financing arrangements for commercial real estate; loan servicing for third-party investors; direct consumer finance loans to individuals; and trust services. The direct nonbank subsidiaries of BB&T provide a variety of financial services including automobile lending, equipment financing, full-service securities brokerage, payroll processing, asset management and capital markets services.
Principles of Consolidation
The consolidated financial statements of BB&T include the accounts of BB&T Corporation and those subsidiaries that are majority owned by BB&T and over which BB&T exercises control. In consolidation, all significant intercompany accounts and transactions are
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eliminated. The results of operations of companies acquired are included only from the dates of acquisition. All material wholly owned and majority owned subsidiaries are consolidated unless accounting principles generally accepted in the United States of America require otherwise.
BB&T evaluates variable interests in entities for which voting interests are not an effective means of identifying controlling financial interests. Variable interests are those in which the value of the interest changes with the fair value of the net assets of the entity exclusive of variable interests. If the results of the evaluation indicate the existence of a primary beneficiary and the entity does not effectively disperse risks among the parties involved, that primary beneficiary is required to consolidate the entity. Likewise, if the evaluation indicates that the requirements for consolidation are not met and the entity has previously been consolidated, then the entity would be deconsolidated.
BB&T has variable interests in certain entities that were not required to be consolidated, including affordable housing partnership interests, historic tax credit partnerships, other partnership interests and trusts that have issued capital securities.
BB&T accounts for unconsolidated partnership investments using the equity method of accounting. In addition to affordable housing partnerships, which represent the majority of unconsolidated investments in variable interest entities, BB&T also has investments and future funding commitments to venture capital and other entities. The maximum potential exposure to losses relative to investments in variable interest entities is generally limited to the sum of the outstanding balance, future funding commitments and any related loans to the entity. Loans to these entities are underwritten in substantially the same manner as are other loans and are generally secured.
BB&T has investments in certain entities for which BB&T does not have controlling interest. For these investments, the Company records its interest using the equity method with its portion of income or loss being recorded in other noninterest income in the Consolidated Statements of Income. BB&T periodically evaluates these investments for impairment.
In certain instances, amounts reported in prior periods consolidated financial statements have been reclassified to conform to the current presentation. Such reclassifications had no effect on previously reported shareholders equity or net income.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan and lease losses and the reserve for unfunded lending commitments, determination of fair value for financial instruments, valuation of goodwill,
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intangible assets and other purchase accounting related adjustments, benefit plan obligations and expenses, and tax assets, liabilities and expenses.
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements, (SFAS No. 157), which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 clarifies that fair value is the price that would be received to sell an asset or the price paid to transfer a liability in the principal or most advantageous market available to the entity in an orderly transaction between market participants on the measurement date. SFAS No. 157 is required to be applied whenever another financial accounting standard requires or permits an asset or liability to be measured at fair value. SFAS No. 157 does not expand the use of fair value to any new circumstances. BB&T adopted SFAS No. 157 effective January 1, 2008. The adoption of SFAS No. 157 was not material to the consolidated financial statements. Additional disclosures required by SFAS No. 157 are included in Note 12 to these consolidated financial statements.
In September 2006, the FASB reached a consensus on Emerging Issues Task Force (EITF) Issue 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements, (EITF Issue 06-4). In March 2007, the FASB reached a consensus on EITF Issue 06-10, Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements, (EITF Issue 06-10). Both of these standards require a company to recognize an obligation over an employees service period based upon the substantive agreement with the employee such as the promise to maintain a life insurance policy or provide a death benefit. BB&T adopted the provisions of these standards effective January 1, 2008. The adoption of these standards was not material to the consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial LiabilitiesIncluding an amendment of FASB Statement No. 115, (SFAS No. 159 or the Fair Value Option), which permits companies to choose to measure many financial instruments and certain other items at fair value, on an instrument-by-instrument basis. Once a company has elected to record eligible items at fair value, the decision is generally irrevocable. The objective of SFAS No. 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. BB&T adopted SFAS No. 159 effective January 1, 2008, and elected the Fair Value Option for certain loans held for sale originated after December 31, 2007. The adoption of SFAS No. 159 was not material to the consolidated financial statements. Additional disclosures required by SFAS No. 159 are included in Note 12 to these consolidated financial statements.
In November 2007, the Securities and Exchange Commission (SEC) Staff issued Staff Accounting Bulletin No. 109 Written Loan Commitments Recorded at Fair Value through Earnings, (SAB No. 109), which supersedes the guidance previously issued in SAB No. 105 Application of Accounting Principles to Loan Commitments (SAB No. 105). SAB No. 109 expresses the current view of the Staff that the expected net future cash flows related to the
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associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. The provisions of SAB No. 109 affect only the timing of mortgage banking income recognition and are effective for loan commitments as of January 1, 2008. The adoption of the provisions of SAB No. 109 was not material to BB&Ts consolidated results of operations.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations, (SFAS No. 141(R)). SFAS No. 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to disclose to investors and other users all of the information needed to evaluate and understand the nature and financial effect of the business combination. SFAS No. 141(R) is effective for BB&T for business combinations consummated after December 31, 2008.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statementsan amendment of ARB No. 51, (SFAS No. 160). SFAS No. 160 requires that a noncontrolling interest in a subsidiary be accounted for as equity in the consolidated statement of financial position and that net income include the amounts for both the parent and the noncontrolling interest, with a separate amount presented in the income statement for the noncontrolling interest share of net income. SFAS No. 160 also expands the disclosure requirements and provides guidance on how to account for changes in the ownership interest of a subsidiary. SFAS No. 160 is effective prospectively for BB&T on January 1, 2009, except for the presentation and disclosure provisions that will be applied retrospectively for all periods presented. Management does not expect the adoption of SFAS No. 160 to be material to the consolidated financial statements.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activitiesan amendment of SFAS No. 133, (SFAS No. 161). SFAS No. 161 requires that an entity provide enhanced disclosures related to derivative and hedging activities. SFAS No. 161 is effective for BB&T on January 1, 2009.
In April 2008, the FASB issued FASB Staff Position (FSP) No. 142-3, Determination of the Useful Life of Intangible Assets (FSP No. 142-3). FSP No. 142-3 amends the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized intangible assets under FASB SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142). The intent of FSP No. 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R). FSP No. 142-3 is effective for BB&T on January 1, 2009, and applies prospectively to intangible assets that are acquired individually or with a group of other assets in business combinations and asset acquisitions. The adoption of FSP No. 142-3 is not expected to have a material impact on BB&Ts consolidated financial statements.
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In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles, (SFAS No. 162). SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles. SFAS No. 162 is effective 60 days following the SECs approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. Management does not expect the adoption of the provisions of SFAS No. 162 to have any impact on the consolidated financial statements.
NOTE 2. Business Combinations and Intangible Assets
During the first six months of 2008, BB&T acquired six insurance agencies. Approximately $90 million in goodwill and $65 million of identifiable intangibles were recorded in connection with these transactions.
Goodwill and Other Intangible Assets
The changes in the carrying amount of goodwill attributable to each of BB&Ts operating segments for the six months ended June 30, 2008 are as follows:
The following table presents the gross carrying amounts and accumulated amortization for BB&Ts identifiable intangible assets subject to amortization at the dates presented:
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NOTE 3. Securities
The amortized cost and approximate fair values of securities available for sale were as follows:
The following tables reflect the gross unrealized losses and fair values of BB&Ts investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at the dates presented.
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On June 30, 2008, BB&T held certain investment securities having continuous unrealized loss positions for more than 12 months. As of June 30, 2008, the unrealized losses on these securities totaled $108 million. Substantially all of these losses were in mortgage-backed, municipal and corporate securities, all of which were investment grade. The unrealized losses are the result of changes in market interest rates rather than the credit quality of the issuers. At June 30, 2008, BB&T had the ability and intent to retain these securities for a period of time sufficient to recover all unrealized losses. Accordingly, BB&T did not recognize any other-than-temporary impairment in connection with these securities during the second quarter of 2008.
NOTE 4. Loans and Leases
The following table provides a breakdown of BB&Ts loan portfolio as of June 30, 2008 and December 31, 2007.
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An analysis of the allowance for credit losses for the six month periods ended June 30, 2008 and 2007 is presented in the following table:
The following table provides a summary of BB&Ts nonperforming and past due loans as of June 30, 2008 and December 31, 2007.
(1) Excludes mortgage loans guaranteed by GNMA that BB&T does not have the obligation to repurchase.
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NOTE 6. Contractual Obligations, Commitments, Contingent Liabilities, and Off-Balance Sheet Arrangements
BB&T utilizes a variety of financial instruments to meet the financing needs of clients and reduce exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees, and derivatives. BB&T also has commitments to fund certain affordable housing investments and contingent liabilities of certain sold loans.
Standby letters of credit and financial guarantees written are unconditional commitments issued by BB&T to guarantee the performance of a customer to a third party. These guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper issuance, bond financing and similar transactions. The credit risk involved in the issuance of these guarantees is essentially the same as that involved in extending loans to clients and as such, the instruments are collateralized when necessary. As of June 30, 2008 and December 31, 2007, BB&T had issued standby letters of credit totaling $4.4 billion and $3.4 billion, respectively. The carrying amount of the liability for such guarantees was $10 million and $5 million at June 30, 2008 and December 31, 2007, respectively.
A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. These instruments include interest-rate swaps, swaptions, caps, floors, collars, financial forward and futures contracts, when-issued securities, foreign exchange contracts and options written and purchased. BB&T uses derivatives primarily to manage risk related to securities, business loans, Federal Funds purchased, long-term debt, mortgage servicing rights, mortgage banking operations and certificates of deposit. BB&T also uses derivatives to facilitate transactions on behalf of its clients. BB&T held a variety of derivative financial instruments with notional values of $59.8 billion and $47.2 billion at June 30, 2008 and December 31, 2007, respectively. These instruments were in a net gain position of $156 million and $181 million at June 30, 2008 and December 31, 2007, respectively.
BB&T invests in certain affordable housing and historic building rehabilitation projects throughout its market area as a means of supporting local communities and receives tax credits related to these investments. BB&T typically acts as a limited partner in these investments and does not exert control over the operating or financial policies of the partnerships. Branch Bank typically provides financing during the construction and development of the properties; however, permanent financing is generally obtained from independent third parties upon completion of a project. BB&Ts outstanding commitments to fund affordable housing investments totaled $462 million and $444 million at June 30, 2008 and December 31, 2007, respectively. At June 30, 2008, BB&Ts maximum exposure to loss associated with these investments totaled $816 million.
In the ordinary course of business, BB&T indemnifies its officers and directors to the fullest extent permitted by law against liabilities arising from pending litigation. BB&T also issues standard representations and warranties in underwriting agreements, merger and acquisition agreements, loan sales, brokerage activities and other similar arrangements. Counterparties in many of these indemnification arrangements provide similar indemnifications
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to BB&T. Although these agreements often do not specify limitations, BB&T does not believe that any payments related to these guarantees would materially change the financial condition or results of operations of BB&T.
Merger and acquisition agreements of businesses other than financial institutions occasionally include additional incentives to the acquired entities to offset the loss of future cash flows previously received through ownership positions. Typically, these incentives are based on the acquired entitys contribution to BB&Ts earnings compared to agreed-upon amounts. When offered, these incentives are typically issued for terms of three to five years. Since certain provisions of these agreements do not specify dollar limitations, it is not possible to quantify the maximum exposure resulting from these agreements.
BB&T has sold certain mortgage-related loans that contain recourse provisions. These provisions generally require BB&T to reimburse the investor for a share of any loss that is incurred after the disposal of the property. At June 30, 2008, BB&T had $879 million of residential mortgage loans sold with recourse. In the event of nonperformance by the borrower, BB&T has maximum recourse exposure of approximately $771 million. In addition, BB&T has $2.1 billion in loans serviced for others that were covered by loss sharing agreements. BB&Ts maximum exposure to loss for these loans is approximately $696 million. The majority of these recourse obligations were acquired by BB&T during 2007 in connection with the acquisition of Collateral Real Estate Capital, LLC. Neither BB&T nor the predecessor has incurred any losses related to these recourse provisions.
BB&T has investments and future funding commitments to certain venture capital funds. As of June 30, 2008, BB&T had investments of $95 million, net of minority interest, related to these ventures and future funding commitments of $231 million. BB&Ts risk exposure relating to such commitments is generally limited to the amount of investments and future funding commitments made.
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NOTE 7. Benefit Plans
BB&T provides various benefit plans to substantially all employees, including employees of acquired entities. Employees of acquired entities generally participate in existing BB&T plans after consummation of the business combinations. The plans of acquired institutions are typically merged into the BB&T plans after consummation of the mergers, and, under these circumstances, credit is usually given to these employees for years of service at the acquired institution for vesting and eligibility purposes. Please refer to BB&Ts Annual Report on Form 10-K for the year ended December 31, 2007 for descriptions and disclosures about the various benefit plans offered by BB&T.
The following tables summarize the components of net periodic benefit cost recognized for BB&Ts pension plans for the three and six month periods ended June 30, 2008 and 2007, respectively:
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BB&Ts basic and diluted earnings per share amounts for the three and six month periods ended June 30, 2008 and 2007, respectively, were calculated as follows:
For the three months ended June 30, 2008 and 2007, the number of antidilutive awards was 33.2 million and 6.5 million shares, respectively. For the six months ended June 30, 2008 and 2007, the number of antidilutive awards was 32.4 million and 7.7 million shares, respectively.
NOTE 9. Comprehensive Income (Loss)
The balances in accumulated other comprehensive loss for the periods indicated are shown in the following tables:
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The following table reflects the components of total comprehensive income for the three and six month periods ended June 30, 2008 and 2007, respectively.
NOTE 10. Operating Segments
BB&Ts operations are divided into seven reportable business segments: the Banking Network, Residential Mortgage Banking, Sales Finance, Specialized Lending, Insurance Services, Financial Services and Treasury. These operating segments have been identified based on BB&Ts organizational structure. The segments require unique technology and marketing strategies and offer different products and services. While BB&T is managed as an integrated organization, individual executive managers are held accountable for the operations of these business segments.
BB&T emphasizes revenue growth by focusing on client service, sales effectiveness and relationship management. The segment results contained herein are presented based on internal management accounting policies that were designed to support these strategic objectives. Unlike financial accounting, there is no comprehensive authoritative body of guidance for management accounting equivalent to generally accepted accounting principles. The performance of the segments is not comparable with BB&Ts consolidated results or with similar information presented by any other financial institution. Additionally, because of the interrelationships of the various segments, the information presented is not indicative of how the segments would perform if they operated as independent entities.
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During the second quarter of 2008, the methodology for providing credit for client funding sources was reviewed and additional funds transfer pricing credits were provided. The adjustments made in the second quarter were retroactively applied to the beginning of the year. The amount of the adjustment that related to the first quarter of 2008 resulted in an increase in after-tax net income attributable to the Banking Network and Financial Services segments of approximately $21 million and $3 million, respectively, with a corresponding decrease of $24 million in the Treasury segment.
Please refer to BB&Ts Annual Report on Form 10-K for the year ended December 31, 2007, for a description of internal accounting policies and the basis of segmentation, including a description of the segments presented in the accompanying tables.
The following tables disclose selected financial information with respect to BB&Ts reportable business segments for the periods indicated:
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NOTE 11. Equity-Based Compensation Plans
BB&T has options, restricted shares of common stock and restricted share units outstanding from the following equity-based compensation plans: the 2004 Stock Incentive Plan (2004 Plan), the 1995 Omnibus Stock Incentive Plan, the Non-Employee Directors Stock Option Plan, and plans assumed from acquired entities. All plans generally allow for accelerated vesting of awards for holders who retire and have met all retirement eligibility requirements and in connection with certain other events. BB&Ts shareholders have approved all equity-based compensation plans with the exception of plans assumed from acquired companies. As of June 30, 2008, the 2004 Plan is the only plan that has awards available for future grants. Please refer to BB&Ts Annual Report on Form 10-K for the year ended December 31, 2007, for further disclosures related to equity-based awards issued by BB&T.
BB&T measures the fair value of each option award on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants awarded during the first six months of 2008.
BB&T measures the fair value of restricted shares based on the price of BB&Ts common stock on the grant date and the fair value of restricted share units based on the price of BB&Ts common stock on the grant date less the present value of expected dividends that are foregone during the vesting period.
The following table details the activity during the first six months of 2008 related to stock options awarded by BB&T:
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The following table details the activity during the first six months of 2008 related to restricted shares and restricted share units awarded by BB&T:
NOTE 12. Fair Value Measurements
BB&T adopted SFAS No. 157 effective January 1, 2008. SFAS No. 157, which provides a framework for measuring fair value, requires that an entity determine fair value based on the principal market for the asset or liability being measured. Upon adoption, BB&T changed its principal market for measuring the fair value of certain client derivative contracts. The impact of this change on the measurement of fair value for these contracts was $7 million, pre-tax, and was recorded as a decrease in other noninterest income effective January 1, 2008.
BB&T also adopted SFAS No. 159 effective January 1, 2008. SFAS No. 159 allows an entity the option to elect fair value for the initial and subsequent measurement of certain financial assets and liabilities on a contract-by-contract basis. This option is generally irrevocable. BB&T elected to adopt fair value for all commercial mortgage loans held for sale and prime residential mortgage loans held for sale originated after December 31, 2007. There was no impact to retained earnings as a result of the adoption of SFAS No. 159.
BB&T elected the Fair Value Option for the majority of new loans held for sale because they are hedged using derivatives and the historical accounting practice resulted in volatility in earnings. Under historical accounting practices, BB&T was required to account for the derivatives at fair value and the loans held for sale at lower of cost or market. This practice resulted in volatility in reported earnings during a declining interest-rate environment because the decline in the value of derivatives held were required to be marked down, but the increasing value of the loans held for sale could not be marked up. Under the Fair Value Option, BB&T will be permitted to record both the loans held for sale and the corresponding derivatives at the full fair value, which will eliminate the mismatch in reported earnings that was caused by the prior accounting practices. BB&T has not elected the Fair Value Option for a small portfolio of its loans held for sale because these loans are not exchanged in an active market and BB&T does not hedge these assets. Fair value for loans held for sale is primarily based on quoted market prices for securities backed by similar types of loans. Following the adoption of SFAS No. 159, direct loan origination fees and costs related to loans held for sale for which the Fair Value Option has been elected are no longer capitalized and recognized in earnings upon the sale of
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such loans, but rather are recorded as mortgage banking income in the case of the direct loan origination fees and primarily personnel expense in the case of the direct loan origination costs.
The following table details the fair value and unpaid principal balance of loans held for sale at June 30, 2008, that were elected to be carried at fair value.
Fair Value Measurements
SFAS No. 157 defines fair value as the exchange price that would be received on the measurement date to sell an asset or the price paid to transfer a liability in the principal or most advantageous market available to the entity in an orderly transaction between market participants. SFAS No. 157 also establishes a three level fair value hierarchy that describes the inputs that are used to measure assets and liabilities.
Level 1 asset and liability fair values are based on quoted prices in active markets for identical assets and liabilities. Level 1 assets and liabilities include certain equity securities and derivative contracts that are traded in an active market.
Level 2 asset and liability fair values are based on observable inputs that include: quoted market prices for similar assets or liabilities; quoted market prices that are not in an active market; or other inputs that are observable in the market and can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 2 assets and liabilities include fixed income securities and mortgage-backed securities that are held in the Corporations trading and available-for-sale portfolios, loans held for sale, certain derivative contracts and short-term borrowings.
Level 3 assets and liabilities are financial instruments whose value is calculated by the use of pricing models and/or discounted cash flow methodologies, as well as financial
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instruments for which the determination of fair value requires significant management judgment or estimation. These methodologies may result in a significant portion of the fair value being derived from unobservable data. Level 3 assets and liabilities include certain trading securities, mortgage servicing rights, venture capital investments and certain derivative contracts.
Assets and liabilities measured at fair value on a recurring basis, including financial instruments for which BB&T has elected the Fair Value Option are summarized below:
The tables below present a reconciliation for the three and six month periods ended June 30, 2008, for all Level 3 assets and liabilities that are measured at fair value on a recurring basis.
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The table below summarizes unrealized and realized gains and losses recorded in earnings for Level 3 assets and liabilities for the three month period ended June 30, 2008.
The realized and unrealized losses reported for mortgage servicing rights assets are composed of a positive valuation adjustment of $152 million less the realization of expected residential mortgage servicing rights cash flows of $21 million for the quarter ended June 30, 2008. BB&T uses various derivative financial instruments to mitigate the income statement effect of changes in fair value due to its quarterly valuation. During the three months ended June 30, 2008, the derivative instruments produced losses of $158 million, which offset the positive valuation adjustment recorded.
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The table below summarizes unrealized and realized gains and losses recorded in earnings for Level 3 assets and liabilities for the six month period ended June 30, 2008.
The realized and unrealized losses reported for mortgage servicing rights assets are composed of a positive valuation adjustment of $68 million less the realization of expected residential mortgage servicing rights cash flows of $44 million for the six months ended June 30, 2008. BB&T uses various derivative financial instruments to mitigate the income statement effect of changes in fair value due to its quarterly valuation. During the first six months of 2008, the derivative instruments produced losses of $76 million, which offset the positive valuation adjustment recorded.
Also, BB&T may be required, from time to time, to measure certain other financial assets at fair value on a nonrecurring basis. Assets measured at fair value on a nonrecurring basis in the first half of 2008 that were still held on the balance sheet at June 30, 2008 totaled $486 million. This amount consists of impaired loans that were classified as Level 3 assets. During the first six months of 2008, BB&T recorded $23 million in losses related to write-downs of these loans based on the appraised value of the underlying collateral.
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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q contains forward-looking statements with respect to the financial condition, results of operations and businesses of BB&T. These forward-looking statements involve certain risks and uncertainties and are based on the beliefs and assumptions of the management of BB&T and the information available to management at the time that these disclosures were prepared. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following:
BB&T and its subsidiaries and affiliates are subject to numerous examinations by federal and state banking regulators, as well as the SEC, the Financial Industry Regulatory Authority, and various state insurance and securities regulators. BB&T and its subsidiaries have from time to time received requests for information from regulatory authorities in various states, including state insurance commissions and state attorneys general, securities regulators and other regulatory authorities, concerning their business practices. Such requests are considered incidental to the normal conduct of business. Please refer to BB&Ts Annual Report on Form 10-K for the year ended December 31, 2007 for additional disclosures with respect to laws and regulations affecting the Companys businesses.
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On April 1, 2008, BB&T Bankcard Corporation was converted into a federally chartered thrift institution and renamed BB&T Financial, FSB (BB&T FSB). As a federally chartered thrift, BB&T FSB is subject to regulation, supervision and examination by the Office of Thrift Supervision. In connection with the charter conversion of BB&T FSB, Sheffield Financial, LLC and MidAmerica Gift Certificate Company, which were previously direct operating subsidiaries of the Corporation, became divisions or subsidiaries of BB&T FSB. In addition, Liberty Mortgage Corporation, formerly a subsidiary of Branch Bank, was reorganized as a subsidiary of BB&T FSB. These organizational structure changes were made to optimize the operating efficiency of these divisions or subsidiaries and have no impact on BB&Ts reportable segments.
Critical Accounting Policies
The accounting and reporting policies of BB&T Corporation and its subsidiaries are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. BB&Ts financial position and results of operations are affected by managements application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues and expenses. Different assumptions in the application of these policies could result in material changes in BB&Ts consolidated financial position and/or consolidated results of operations and related disclosures. The more critical accounting and reporting policies include BB&Ts accounting for the allowance for loan and lease losses and reserve for unfunded lending commitments, determining fair value of financial instruments, intangible assets and other purchase accounting related adjustments associated with mergers and acquisitions, costs and benefit obligations associated with BB&Ts pension and postretirement benefit plans, and income taxes. Understanding BB&Ts accounting policies is fundamental to understanding BB&Ts consolidated financial position and consolidated results of operations. Accordingly, BB&Ts significant accounting policies and changes in accounting principles are discussed in detail in Note 1 of the Notes to Consolidated Financial Statements in BB&Ts Annual Report on Form 10-K for the year ended December 31, 2007.
The following is a summary of BB&Ts critical accounting policies that are highly dependent on estimates, assumptions and judgments. These critical accounting policies are reviewed with BB&Ts Audit Committee on a periodic basis.
Allowance for Loan and Lease Losses and Reserve for Unfunded Lending Commitments
It is the policy of BB&T to maintain an allowance for loan and lease losses and a reserve for unfunded lending commitments that equals managements best estimate of probable credit losses that are inherent in the portfolio at the balance sheet date. Estimates for loan and lease losses are determined by analyzing historical loan and lease losses, current trends in delinquencies and charge-offs, changes in commercial loan risk grades, plans for problem loan and lease administration, the results of regulatory examinations, and changes in the size, composition and risk assessment of the loan and lease portfolio. Also included in managements estimates for loan and lease losses are considerations with respect to the impact of current economic events, the outcomes of which are uncertain. These events may include, but are not limited to, fluctuations in overall interest rates, political conditions, legislation that may directly or indirectly affect the banking industry and economic conditions affecting specific geographical
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areas and industries in which BB&T conducts business. The methodology used to determine an estimate for the reserve for unfunded lending commitments is inherently similar to the methodology utilized in calculating the allowance for loans and leases adjusted for factors specific to binding commitments, including the probability of funding and exposure at the time of funding.
Fair Value of Financial Instruments
A significant portion of BB&Ts assets and liabilities are financial instruments that are carried at fair value. This includes securities available for sale, trading securities, derivatives, certain loans held for sale, residential mortgage servicing rights, certain short-term borrowings and venture capital investments. At June 30, 2008, the percentage of total assets and total liabilities measured at fair value was 19.0% and less than 1%, respectively. The vast majority of assets and liabilities carried at fair value are based on either quoted market prices or market prices for similar instruments. At June 30, 2008, 3.1% of assets measured at fair value were based on significant unobservable inputs. This is less than 1% of BB&Ts total assets.
The fair values for available-for-sale and trading securities are generally based upon market prices or market prices for similar instruments. These values take into account recent market activity as well as other market observable data such as interest rate, spread and prepayment information. When market observable data is not available, which generally occurs due to the lack of liquidity for certain trading securities, the valuation of the security is subjective and may involve substantial judgment. As of June 30, 2008, BB&T had approximately $19 million of available-for-sale and trading securities, which is less than 1% of total assets, valued using unobservable inputs.
Mortgage Servicing Rights
BB&T has a significant mortgage loan servicing portfolio and related mortgage servicing rights. Mortgage servicing rights represent the present value of the future net servicing fees from servicing mortgage loans acquired or originated by BB&T. The methodology used to determine the fair value of mortgage servicing rights is subjective and requires the development of a number of assumptions, including anticipated prepayments of loan principal. The value of mortgage servicing rights is significantly affected by mortgage interest rates available in the marketplace, which influence mortgage loan prepayment speeds. In general, during periods of declining interest rates, the value of mortgage servicing rights declines due to increasing prepayments attributable to increased mortgage refinance activity. Conversely, during periods of rising interest rates, the value of servicing rights generally increases due to reduced refinance activity. BB&T has two classes of mortgage servicing rights for which it separately manages the economic risk: residential and commercial. Residential mortgage servicing rights are carried at fair value with changes in fair value recorded as a component of mortgage banking income each period. BB&T uses various derivative instruments to mitigate the income statement effect of changes in fair value, due to changes in valuation inputs and assumptions, of its residential mortgage servicing rights. Commercial mortgage servicing rights are carried at lower of cost or
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market and amortized over the estimated period that servicing income is expected to be received based on projections of the amount and timing of estimated future cash flows. The amount and timing of servicing asset amortization is updated based on actual results and updated projections.
Loans Held for Sale
BB&T originates certain mortgage loans to be sold to investors. The majority of these loans are carried at fair value based on the Fair Value Option. For these loans, the fair value is primarily based on quoted market prices for securities backed by similar types of loans. Changes in the fair value are recorded as a component of mortgage banking income while mortgage loan origination costs for loans held for sale for which the Corporation elected the Fair Value Option are recognized in noninterest expense when incurred. The changes in fair value of these assets are largely driven by changes in interest rates subsequent to loan funding and changes in the fair value of servicing associated with the mortgage loan held for sale. BB&T uses various derivative instruments to mitigate the income statement effect of changes in fair value of the underlying loans.
BB&T utilizes derivatives to manage various financial risks. The fair values of derivative financial instruments are determined based on quoted market prices, dealer quotes and internal pricing models that are primarily sensitive to market observable data. BB&T mitigates the credit risk by subjecting counterparties to credit reviews and approvals similar to those used in making loans and other extensions of credit. In addition, certain counterparties are required to provide collateral to BB&T when their unsecured loss positions exceed certain negotiated limits. The fair value of interest rate lock commitments, which are related to mortgage loan commitments, is based on quoted market prices adjusted for commitments that BB&T does not expect to fund and includes the value attributable to the net servicing fee.
Venture Capital Investments
BB&T has venture capital investments that are carried at fair value. Changes in the fair value of these investments are recorded in other noninterest income each period. In many cases there is no observable market value for these investments and therefore management must estimate the fair value based on a comparison of the operating performance of the company to multiples in the marketplace for similar entities. This analysis requires significant judgment and actual values in a sale could differ materially from those estimated. As of June 30, 2008, BB&T had $152 million of venture capital investments, which is less than 1% of total assets.
BB&Ts mergers and acquisitions are accounted for using the purchase method of accounting. Under the purchase method, BB&T is required to record the assets acquired, including identified intangible assets and liabilities assumed at their fair value, which often involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques, all of which are inherently subjective. The amortization of identified intangible assets is based upon the estimated economic
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benefits to be received, which is also subjective. These estimates also include the establishment of various accruals and allowances based on planned facility dispositions and employee severance considerations, among other acquisition-related items. In addition, purchase acquisitions typically result in goodwill, which is subject to ongoing periodic impairment tests based on the fair value of net assets acquired compared to the carrying value of goodwill. The major assumptions used in the impairment testing process include the estimated future cash flows of each business unit and discount rates. Discount rates are unique to each business unit and are based upon the cost of capital specific to the industry in which the business unit operates.
Pension and Postretirement Benefit Obligations
BB&T offers various pension plans and postretirement benefit plans to employees. The calculation of the obligations and related expenses under these plans requires the use of actuarial valuation methods and assumptions. Actuarial valuations and assumptions used in the determination of future values of plan assets and liabilities are subject to management judgment and may differ significantly if different assumptions are used.
The calculation of BB&Ts income tax provision is complex and requires the use of estimates and judgments. As part of the Companys analysis and implementation of business strategies, consideration is given to the tax laws and regulations that apply to the specific facts and circumstances for any tax position under evaluation. For tax positions that are uncertain in nature, management determines whether the tax position is more likely than not to be sustained upon examination. For tax positions that meet this threshold, management then estimates the amount of the tax benefit to recognize in the financial statements. Management closely monitors tax developments in order to evaluate the effect they may have on the Companys overall tax position and the estimates and judgments utilized in determining the income tax provision and records adjustments as necessary.
BB&Ts total assets at June 30, 2008 were $136.5 billion, an increase of $3.8 billion, or 2.9%, from December 31, 2007. The asset category that experienced the largest increase was loans and leases, including loans held for sale, which grew $4.0 billion, or 4.4%, during the first six months of 2008. In addition, securities available for sale increased $238 million, or 1.1%, compared to the balance at December 31, 2007.
Total deposits at June 30, 2008 were $88.2 billion, an increase of $1.4 billion, or 1.7%, from December 31, 2007. Long-term debt increased $1.9 billion, or 10.0%, and short-term borrowings increased $170 million, or 1.6%, during the first six months of 2008. Total shareholders equity increased $168 million compared to December 31, 2007.
Consolidated net income for the second quarter of 2008 totaled $428 million, a decrease of 6.6% compared to $458 million earned during the second quarter of 2007. On a diluted per share basis, earnings for the three months ended June 30, 2008 were $.78, compared to $.83 for
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the same period in 2007, a decrease of 6.0% . BB&Ts results of operations for the second quarter of 2008 produced an annualized return on average assets of 1.27% and an annualized return on average shareholders equity of 13.27% compared to prior year ratios of 1.47% and 15.18%, respectively.
Consolidated net income for the first six months of 2008 totaled $856 million, a decrease of 2.6% compared to $879 million earned during the first six months of 2007. On a diluted per share basis, earnings for the six months ended June 30, 2008 were $1.56, compared to $1.60 for the same period in 2007, a decrease of 2.5% . BB&Ts results of operations for the first six months of 2008 produced an annualized return on average assets of 1.28% and an annualized return on average shareholders equity of 13.29% compared to prior year ratios of 1.44% and 15.00%, respectively.
Included in the results of operations for the second quarter and first six months of 2008 were a number of notable items. During the second quarter of 2008, earnings benefited from $36 million in pretax gains on the early extinguishment of certain FHLB advances and a $47 million pretax gain from the sale of Visa, Inc. shares. The first six months of 2008 also included an additional increase in earnings of $47 million associated with the initial public offering of Visa, Inc., which was recorded in the first quarter of 2008, and included a $14 million reversal of a previously recorded liability. During the first six months of 2008, BB&T also recognized pretax securities gains of $53 million. The securities gains resulted from sales of available-for-sale securities, which allowed reinvestment at higher rates of return with no additional credit risk.
The second quarter and first six months of 2008 included $330 million and $553 million, respectively, in provision for credit losses. The provision for credit losses exceeded net charge-offs by $160 million for the second quarter and $258 million for the first six months of 2008, which resulted in an increase in the allowance for loan and lease losses as a percentage of loans and leases held for investment to 1.33% .
During the second quarter of 2008, BB&T continued to experience challenges resulting from the current credit cycle. These challenges resulted in additional credit deterioration during the quarter, which primarily related to residential real estate in Georgia, Florida and metro Washington, D.C. Management is working aggressively to deal with problem assets and continues to believe that BB&Ts credit issues are managea