BOK Financial 10-K 2011
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2010
For the transition period from _____________ to ______________
Commission File No. 0-19341
BOK FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12 (b) of the Act: None
Securities registered pursuant to Section 12 (g) of the Act:
Common stock, $0.00006 par value
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15 (d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, 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 x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
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 definitions of “larger accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
The aggregate market value of the registrant’s common stock (“Common Stock”) held by non-affiliates is approximately $1.2 billion (based on the June 30, 2010 closing price of Common Stock of $47.47 per share). As of January 31, 2011, there were 68,274,150 shares of Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Part III incorporates certain information by reference from the Registrant’s Proxy Statement for the 2011 Annual Meeting of Shareholders.
BOK FINANCIAL CORPORATION
ANNUAL REPORT ON FORM 10-K
ITEM 1. BUSINESS
Developments relating to individual aspects of the business of BOK Financial Corporation (“BOK Financial” or “the Company”) are described below. Additional discussion of the Company’s activities during the current year appears within Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Description of Business
BOK Financial is a financial holding company incorporated in the state of Oklahoma in 1990 whose activities are limited by the Bank Holding Company Act of 1956 (“BHCA”), as amended by the Financial Services Modernization Act or Gramm-Leach-Bliley Act. BOK Financial offers full service banking in Oklahoma, Texas, New Mexico, Northwest Arkansas, Colorado, Arizona, and Kansas/Missouri.
On October 6, 2010, the Office of the Comptroller of the Currency (“OCC”) approved the affiliated merger of the Company’s wholly-owned subsidiary banks, Bank of Texas, N.A., Bank of Albuquerque, N.A., Bank of Arkansas, N.A., Colorado State Bank and Trust, N.A., Bank of Arizona, N.A., and Bank of Kansas City, N.A. into Bank of Oklahoma, N.A. (“the Banks”). The resulting subsidiary bank is named BOKF, NA. The Company effected the merger on January 1, 2011. The Banks will continue to operate as distinct geographical regions using the trade names of the former charters. The merger will allow us to more efficiently utilize capital of the Banks. Other subsidiaries of BOK Financial include BOSC, Inc., a broker/dealer that engages in retail and institutional securities sales and municipal bond underwriting. Other non-bank subsidiary operations do not have a significant effect on the Company’s financial statements.
Our overall strategic objective is to emphasize growth in long-term value by building on our leadership position in Oklahoma through expansion into other high-growth markets in contiguous states. We operate primarily in the metropolitan areas of Tulsa and Oklahoma City, Oklahoma; Dallas, Fort Worth and Houston, Texas; Albuquerque, New Mexico; Denver, Colorado; Phoenix, Arizona, and Kansas City, Kansas/Missouri. Our acquisition strategy targets quality organizations that have demonstrated solid growth in their business lines. We provide additional growth opportunities by hiring talent to enhance competitiveness, adding locations and broadening product offerings. Our operating philosophy embraces local decision-making in each of our geographic markets while adhering to common Company standards. We also consider acquisitions of distressed financial institutions in our existing markets when attractive opportunities become available.
Our primary focus is to provide a comprehensive range of nationally competitive financial products and services in a personalized and responsive manner. Products and services include loans and deposits, cash management services, fiduciary services, mortgage banking and brokerage and trading services to middle-market businesses, financial institutions and consumers. Commercial banking represents a significant part of our business. Our credit culture emphasizes building relationships by making high quality loans and providing a full range of financial products and services to our customers. Our energy financing expertise enables us to offer commodity derivatives for customers to use in their risk management and positioning. Our diversified base of revenue sources is designed to generate returns in a range of economic situations. Historically, fees and commissions provide 40 to 45% of our total revenue. Approximately 42% of our revenue came from fees and commission in 2010.
BOK Financial’s corporate headquarters is located at Bank of Oklahoma Tower, P.O. Box 2300, Tulsa, Oklahoma 74192.
The Company’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports are available on the Company’s website at www.bokf.com as soon as reasonably practicable after the Company electronically files such material with or furnishes it to the Securities and Exchange Commission.
BOK Financial operates three principal lines of business: commercial banking, consumer banking and wealth management. Commercial banking includes lending, treasury and cash management services and customer risk management products for small businesses, middle market and larger commercial customers. Commercial banking also includes the TransFund electronic funds network. Consumer banking includes retail lending and deposit services and all mortgage banking activities. Wealth management provides fiduciary services, brokerage and trading, private bank services and investment advisory services in all markets. Discussion of these principal lines of business appears within the Lines of Business section of “Management's Discussion and Analysis of Financial Condition and Results of Operations” and within Note 17 of the Company’s Notes to Consolidated Financial Statements, both of which appear elsewhere herein.
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BOK Financial and its operating segments face competition from other banks, thrifts, credit unions and other non-bank financial institutions, such as investment banking firms, investment advisory firms, brokerage firms, investment companies, government agencies, mortgage brokers and insurance companies. The Company competes largely on the basis of customer services, interest rates on loans and deposits, lending limits and customer convenience. Some operating segments face competition from institutions that are not as closely regulated as banks, and therefore are not limited by the same capital requirements and other restrictions. All market share information presented below is based upon share of deposits in specified areas according to SNL DataSource as of December 31, 2010.
We are the largest financial institution in the state of Oklahoma with 12% of the state’s total deposits. The Tulsa and Oklahoma City areas have 28% and 9% of the market share, respectively. We compete with two banks that have operations nationwide and have greater access to funds at lower costs, higher lending limits, and greater access to technology resources and also compete with regional and locally-owned banks in both the Tulsa and Oklahoma City areas, as well as in every other community in which we do business throughout the state.
Bank of Texas competes against numerous financial institutions, including some of the largest in the United States, and has a market share of approximately 2% in the Dallas, Fort Worth area and 1% in the Houston area. Bank of Albuquerque has a number four market share position with 10% of deposits in the Albuquerque area and competes with two large national banks, some regional banks and several locally-owned smaller community banks. Colorado State Bank and Trust has a market share of approximately 2% in the Denver area. Bank of Arizona operates as a community bank with locations in Phoenix, Mesa and Scottsdale. Bank of Arkansas serves Benton and Washington counties in Arkansas, and Bank of Kansas City serves the Kansas City, Kansas/Missouri market. The Company’s ability to expand into additional states remains subject to various federal and state laws.
As of December 31, 2010, BOK Financial and its subsidiaries employed 4,432 full-time equivalent employees. None of the Company’s employees are represented by collective bargaining agreements. Management considers its employee relations to be good.
Supervision and Regulation
BOK Financial and its subsidiaries are subject to extensive regulations under federal and state laws. These regulations are designed to protect depositors, the Bank Insurance Fund and the banking system as a whole and not necessarily to protect shareholders and creditors. As detailed below, these regulations may restrict the Company’s ability to diversify, to acquire other institutions and to pay dividends on its capital stock. They also may require the Company to provide financial support to its subsidiaries and maintain certain capital balances.
On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“the Dodd-Frank Act”) was signed into law, giving federal banking agencies authority to increase the minimum deposit ratio, increase regulatory capital requirements, impose additional rules and regulations over consumer financial products and services and limit the amount of interchange fee that may be charged in an electronic debit transaction. In addition, the Dodd-Frank Act makes permanent the $250,000 limit for federal deposit insurance and provides unlimited federal deposit insurance until January 1, 2013 for non-interest bearing demand deposit accounts. It also repeals prohibitions on payment of interest on demand deposits, which could impact how interest is paid on business transaction and other accounts. We continue to assess the potential impact of the complex provisions that the Dodd-Frank Act will have in the coming months or years. The effect of this legislation on fee income and operating expenses could be significant but cannot be accurately quantified at this time.
The following information summarizes certain existing laws and regulations that affect the Company’s operations. It does not discuss all provisions of these laws and regulations and it does not summarize all laws and regulations that affect the Company presently or in the future.
As a financial holding company, BOK Financial is regulated under the BHCA and is subject to regular inspection, examination and supervision by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). Under the BHCA, BOK Financial files quarterly reports and other information with the Federal Reserve Board.
The Banks are organized as a national banking association under the National Banking Act, and are subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (the “OCC”), the Federal Deposit Insurance Corporation (the “FDIC”), the Federal Reserve Board and other federal and state regulatory agencies. The OCC has primary supervisory responsibility for national banks and must approve certain corporate or structural changes, including changes in capitalization, payment of dividends, change of place of business, and establishment of a branch or operating subsidiary. The OCC performs its functions through national bank examiners who provide the OCC with information
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concerning the soundness of a national bank, the quality of management and directors, and compliance with applicable regulations. The National Banking Act authorizes the OCC to examine every national bank as often as necessary.
A financial holding company, and the companies under its control, are permitted to engage in activities considered “financial in nature” as defined by the Gramm-Leach-Bliley Act and Federal Reserve Board interpretations, and therefore may engage in a broader range of activities than permitted for bank holding companies and their subsidiaries. Activities that are “financial in nature” include securities underwriting and dealing, insurance underwriting, operating a mortgage company, credit card company or factoring company, performing certain data processing operations, servicing loans and other extensions of credit, providing investment and financial advice, owning and operating savings and loan associations, and leasing personal property on a full pay-out, non-operating basis. In order for a financial holding company to commence any new activity permitted by the BHCA, each insured depository institution subsidiary of the financial holding company must have received a rating of at least satisfactory in its most recent examination under the Community Reinvestment Act. A financial holding company is required to notify the Federal Reserve Board within thirty days of engaging in new activities determined to be “financial in nature.” BOK Financial is engaged in some of these activities and has notified the Federal Reserve Board.
The BHCA requires the Federal Reserve Board’s prior approval for the direct or indirect acquisition of more than five percent of any class of voting stock of any non-affiliated bank. Under the Federal Bank Merger Act, the prior approval of the OCC is required for a national bank to merge with another bank or purchase the assets or assume the deposits of another bank. In reviewing applications seeking approval of merger and acquisition transactions, the bank regulatory authorities consider, among other things, the competitive effect and public benefits of the transactions, the capital position of the combined organization, the applicant’s performance record under the Community Reinvestment Act and fair housing laws and the effectiveness of the subject organizations in combating money laundering activities.
A financial holding company and its subsidiaries are prohibited under the BHCA from engaging in certain tie-in arrangements in connection with the provision of any credit, property or services. Thus, a subsidiary of a financial holding company may not extend credit, lease or sell property, furnish any services or fix or vary the consideration for these activities on the condition that (1) the customer obtain or provide additional credit, property or services from or to the financial holding company or any subsidiary thereof, or (2) the customer may not obtain some other credit, property or services from a competitor, except to the extent reasonable conditions are imposed to insure the soundness of credit extended.
The Banks and other non-bank subsidiaries are also subject to other federal and state laws and regulations. For example, BOSC, Inc., the Company’s broker/dealer subsidiary that engages in retail and institutional securities sales and municipal bond underwriting, is regulated by the Securities and Exchange Commission, the Financial Industry Regulatory Authority (FINRA), the Federal Reserve Board, and state securities regulators. As another example, Bank of Arkansas is subject to certain consumer-protection laws incorporated in the Arkansas Constitution, which, among other restrictions, limit the maximum interest rate on general loans to five percent above the Federal Reserve Discount Rate and limit the rate on consumer loans to the lower of five percent above the discount rate or seventeen percent.
Capital Adequacy and Prompt Corrective Action
The Federal Reserve Board, the OCC and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to United States banking organizations to ensure capital adequacy based upon the risk levels of assets and off-balance sheet financial instruments. In addition, these regulatory agencies may from time to time require that a banking organization maintain capital above the minimum levels, whether because of its financial condition or actual or anticipated growth. Capital adequacy guidelines and prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators regarding components, risk weighting and other factors.
The Federal Reserve Board risk-based guidelines define a three-tier capital framework. Core capital (Tier 1) includes common shareholders’ equity and qualifying preferred stock, less goodwill, most intangible assets and other adjustments. Supplementary capital (Tier 2) consists of preferred stock not qualifying as Tier 1 capital, qualifying mandatory convertible debt securities, limited amounts of subordinated debt, other qualifying term debt and allowances for credit losses, subject to limitations. Market risk capital (Tier 3) includes qualifying unsecured subordinated debt. Assets and off-balance sheet exposures are assigned to one of four categories of risk-weights, based primarily upon relative credit risk. Risk-based capital ratios are calculated by dividing Tier 1 and total capital by risk-weighted assets. For a depository institution to be considered well capitalized under the regulatory framework for prompt corrective action, the institution’s Tier 1 and total capital ratios must be at least 6% and 10% on a risk-adjusted basis, respectively. As of December 31, 2010, BOK Financial’s Tier 1 and total capital ratios under these guidelines were 12.69% and 16.20%, respectively.
The leverage ratio is determined by dividing Tier 1 capital by adjusted average total assets. Banking organizations are required to maintain a ratio of at least 5% to be classified as well capitalized. BOK Financial’s leverage ratio at December 31, 2010 was 8.74%.
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The Federal Deposit Insurance Corporation Improvement Act of 1991 (the “FDICIA”), among other things, identifies five capital categories for insured depository institutions from well capitalized to critically undercapitalized and requires the respective federal regulatory agencies to implement systems for prompt corrective action for institutions failing to meet minimum capital requirements within such categories. FDICIA imposes progressively more restrictive covenants on operations, management and capital distributions, depending upon the category in which an institution is classified.
Substantially all of the deposits held by the Banks are insured up to applicable limits by the Deposit Insurance Fund (“DIF”) of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank’s capital level and supervisory rating (“CAMELS rating”). The risk matrix includes four risk categories, distinguished by capital levels and supervisory ratings. For large Risk Category 1 institutions (generally those with assets in excess of $10 billion) that have long-term debt issuer ratings, including Bank of Oklahoma, assessment rates are determined from weighted-average CAMELS component ratings and long-term debt issuer ratings. The minimum annualized assessment rate for large institutions is 12 basis points per $100 of deposits and the maximum annualized assessment rate for large institutions is 50 basis points per $100 of deposits. Quarterly assessment rates for large institutions in Risk Category 1 may vary within this range depending upon changes in CAMELS component ratings and long-term debt issuer ratings.
Subsequent to December 31, 2010, the FDIC released a final rule to implement provisions of the Dodd-Frank Act that affect deposit insurance assessments. Among other things, the Dodd-Frank Act raised the minimum designated reserve ratio from 1.15% to 1.35% of estimated insured deposits, removed the upper limit of the designated reserve ratio, required that the designated reserve ratio reach 1.35% by September 30, 2020, and required that the FDIC offset the effect of increasing the minimum designated reserve ratio on depository institutions with total assets of less than $10 billion. The Dodd-Frank Act also required that the FDIC redefine the assessment base to average consolidated assets minus average tangible equity. The final rule becomes effective April 1, 2011. We do not expect the change to have a significant effect on our current deposit insurance assessment.
In response to an increase in bank failures, the board of directors of the FDIC approved a special assessment during 2009. This assessment was calculated as 5 basis points times each insured depository institution’s assets minus Tier 1 capital as of June 30, 2009. Collectively, the Banks paid $12 million of special assessment charges.
On November 12, 2009 the board of directors of the FDIC voted to require insured institutions to prepay over three years of estimated insurance assessments on December 30, 2009 in order to strengthen the cash position of the DIF. As of December 31, 2009 and each quarter thereafter, the regular quarterly assessment will be applied against the prepaid assessment until the asset is exhausted. Any prepaid assessment not exhausted as of June 30, 2013 will be returned. Collectively, the Banks prepaid $78 million of deposit insurance assessments. As of December 31, 2010, $57 million of prepaid deposit insurance assessments are included in Other assets on the Consolidated Balance Sheet of the Company.
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In addition, the Banks are assessed a charge based on deposit balances by the Financing Corporation (“FICO”). The FICO is a mixed-ownership government corporation established by the Competitive Equality Banking Act of 1987 whose sole purpose was to function as a financing vehicle for the now defunct Federal Savings & Loan Insurance Corporation.
The primary source of liquidity for BOK Financial is dividends from the Banks, which are limited by various banking regulations to net profits, as defined, for the year plus retained profits for the preceding two years and further restricted by minimum capital requirements. In consideration of our bank charter consolidation, Bank of Oklahoma, N.A. declared and paid a dividend of $175 million to BOK Financial Corporation for general corporate purposes. Subsequent to the consolidation of the existing bank charters into BOKF, NA, based on the most restrictive limitations as well as management’s internal capital policy, BOKF, NA had excess regulatory capital and could declare up to $82 million of dividends without regulatory approval as of January 1, 2011. This amount is not necessarily indicative of amounts that may be available to be paid in future periods.
Source of Strength Doctrine
According to Federal Reserve Board policy, bank holding companies are expected to act as a source of financial strength to each subsidiary bank and to commit resources to support each such subsidiary. This support may be required at times when a bank holding company may not be able to provide such support. Similarly, under the cross-guarantee provisions of the Federal Deposit Insurance Act, in the event of a loss suffered by the FDIC as a result of default of a banking subsidiary or related to FDIC assistance provided to a subsidiary in danger of default, the other Banks may be assessed for the FDIC’s loss, subject to certain exceptions.
Governmental Policies and Economic Factors
The operations of BOK Financial and its subsidiaries are affected by legislative changes and by the policies of various regulatory authorities and, in particular, the credit policies of the Federal Reserve Board. An important function of the Federal Reserve Board is to regulate the national supply of bank credit to moderate recessions and curb inflation. Among the instruments of monetary policy used by the Federal Reserve Board to implement its objectives are: open-market operations in U.S. Government securities, changes in the discount rate and federal funds rate on bank borrowings, and changes in reserve requirements on bank deposits. The effect of future changes in such policies on the business and earnings of BOK Financial and its subsidiaries is uncertain.
In response to the significant recession in business activity which began in 2007, the U.S. government enacted various programs and continues to enact programs to stimulate the economy. These programs include the Trouble Assets Relief Program (“TARP”), which provided capital to eligible financial institutions and other sectors of the domestic economy, and the Temporary Liquidity Guarantee Program, which expanded insurance coverage to a larger amount of deposit account balances and other qualifying debt issued by eligible financial institutions. In addition, the government recently enacted economic stimulus legislation, which increases government spending and reduces certain taxes. In 2010, the Federal Reserve announced its intention to purchase up to $600 billion of U.S. government securities to further stimulate the economy. The short-term effectiveness and long-term impact of these programs on the economy in general and on BOK Financial Corporation in particular are uncertain.
The Company elected not to participate in the TARP Capital Purchase Program as we believed that our capital sources were sufficient to support organic growth, acquisitions within our current market areas, cash dividends on our common stock and periodic stock repurchases.
BOK Financial does not engage in operations in foreign countries, nor does it lend to foreign governments.
ITEM 1A. RISK FACTORS
The United States economy experienced a significant recession from 2007 to 2009. Business activity across a wide range of industries and geographic regions decreased and unemployment increased significantly. The financial services industry and capital markets have been adversely affected by significant declines in asset values, rising delinquencies and defaults, and restricted liquidity. Numerous financial institutions failed or required a significant amount of government assistance due to credit losses and liquidity shortages. The rate of economic recovery has been slow, unemployment has been persistently high and the national housing market remains depressed overall. The Federal Reserve Board continues to take steps to promote more robust economic growth including maintaining historically low federal funds rate for an extended period of time. High unemployment levels and protracted economic recovery could adversely affect our credit quality, financial condition and results of operations.
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Adverse factors could impact BOK Financial's ability to implement its operating strategy.
Although BOK Financial has developed an operating strategy which it expects to result in continuing improved financial performance, BOK Financial cannot assure that it will be successful in fulfilling this strategy or that this operating strategy will be successful. Achieving success is dependent upon a number of factors, many of which are beyond BOK Financial's direct control. Factors that may adversely affect BOK Financial's ability to implement its operating strategy include:
Adverse regional economic developments could negatively affect BOK Financial's business.
A substantial majority of BOK Financial loans are generated in Oklahoma and other markets in the southwest region. As a result, poor economic conditions in Oklahoma or other markets in the southwest region may cause BOK Financial to incur losses associated with higher default rates and decreased collateral values in BOK Financial's loan portfolio. A regional economic downturn could also adversely affect revenue from brokerage and trading activities, mortgage loan originations and other sources of fee-based revenue.
Adverse economic factors affecting particular industries could have a negative effect on BOK Financial customers and their ability to make payments to BOK Financial.
Certain industry-specific economic factors also affect BOK Financial. For example, a portion of BOK Financial's total loan portfolio is comprised of loans to borrowers in the energy industry, which is historically a cyclical industry. Low commodity prices may adversely affect that industry and, consequently, may affect BOK Financial's business negatively. The effect of volatility in commodity prices on our customer derivatives portfolio could adversely affect our liquidity and regulatory capital. In addition, BOK Financial's loan portfolio includes commercial real estate loans. A downturn in the real estate industry in general or in certain segments of the commercial real estate industry in Oklahoma and the southwest region could also have an adverse effect on BOK Financial's operations.
Fluctuations in interest rates could adversely affect BOK Financial's business.
BOK Financial's business is highly sensitive to:
A significant increase in market interest rates, or the perception that an increase may occur, could adversely affect both BOK Financial's ability to originate new loans and BOK Financial's ability to grow. Conversely, a decrease in interest rates could result in acceleration in the payment of loans, including loans underlying BOK Financial's holdings of mortgage-backed securities and termination of BOK Financial's mortgage servicing rights. In addition, changes in market interest rates, changes in the relationships between short-term and long-term market interest rates or changes in the relationships between different interest rate indices, could affect the interest rates charged on interest-earning assets differently than the interest rates paid on interest-bearing liabilities. This difference could result in an increase in interest expense relative to interest income. An increase in market interest rates also could adversely affect the ability of BOK Financial's floating-rate borrowers to meet their higher payment obligations. If this occurred, it could cause an increase in nonperforming assets and net charge-offs, which could adversely affect BOK Financial's business.
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BOK Financial's substantial holdings of mortgage-backed securities and mortgage servicing rights could adversely affect BOK Financial's business.
BOK Financial has invested a substantial amount of its holdings in mortgage-backed securities, which are investment interests in pools of mortgages. Mortgage-backed securities are highly sensitive to changes in interest rates. BOK Financial mitigates this risk somewhat by investing principally in shorter duration mortgage products, which are less sensitive to changes in interest rates. A significant decrease in interest rates could lead mortgage holders to refinance the mortgages constituting the pool backing the securities, subjecting BOK Financial to a risk of prepayment and decreased return on investment due to subsequent reinvestment at lower interest rates. A significant decrease in interest rates could also accelerate premium amortization. Conversely, a significant increase in interest rates could cause mortgage holders to extend the term over which they repay their loans, which delays the Company’s opportunity to reinvest funds at higher rates.
In an effort to promote a stronger pace of economic recovery and ensure inflation, over time, is at a level consistent with its mandate, the Federal Reserve Board has announced it will continue its policy of reinvesting principal payments from its security holdings in longer-term Treasury securities which may result in rising interest rates and lower fair values of our residential mortgage-backed securities.
Mortgage-backed securities are also subject to credit risk from delinquency or default of the underlying loans. BOK Financial mitigates this risk somewhat by investing in securities issued by U.S. government agencies. Principal and interest payments on the loans underlying these securities are guaranteed by these agencies. Credit risk on mortgage-backed securities originated by private issuers is mitigated somewhat by investing in senior tranches with additional collateral support.
In addition, as part of BOK Financial's mortgage banking business, BOK Financial has substantial holdings of mortgage servicing rights. The value of these rights is also very sensitive to changes in interest rates. Falling interest rates tend to increase loan prepayments, which may lead to cancellation of the related servicing rights. BOK Financial's investments and dealings in mortgage-related products increase the risk that falling interest rates could adversely affect BOK Financial's business. BOK Financial attempts to manage this risk by maintaining an active hedging program for its mortgage servicing rights. BOK Financial's hedging program has only been partially successful in recent years. The value of mortgage servicing rights may also decrease due to rising delinquency or default of the loans serviced. This risk is mitigated somewhat by adherence to underwriting standards on loans originated for sale.
Market disruptions could impact BOK Financial’s funding sources.
BOK Financial’s subsidiary banks rely on other financial institutions and the Federal Home Loan Banks of Topeka and Dallas as a significant source of funds. Our ability to fund loans, manage our interest rate risk and meet other obligations depends on funds borrowed from these sources. The inability to borrow funds at market interest rates could have a material adverse effect on our operations.
Substantial competition could adversely affect BOK Financial.
Banking is a competitive business. BOK Financial competes actively for loan, deposit and other financial services business in Oklahoma, as well as in BOK Financial's other markets. BOK Financial's competitors include a large number of small and large local and national banks, savings and loan associations, credit unions, trust companies, broker-dealers and underwriters, as well as many financial and nonfinancial firms that offer services similar to BOK Financial's. Large national financial institutions have entered the Oklahoma market. These institutions have substantial capital, technology and marketing resources. Such large financial institutions may have greater access to capital at a lower cost than BOK Financial does, which may adversely affect BOK Financial's ability to compete effectively.
BOK Financial has expanded into markets outside of Oklahoma, where it competes with a large number of financial institutions that have an established customer base and greater market share than BOK Financial. BOK Financial may not be able to continue to compete successfully in these markets outside of Oklahoma. With respect to some of its services, BOK Financial competes with non-bank companies that are not subject to regulation. The absence of regulatory requirements may give non-banks a competitive advantage.
Banking regulations could adversely affect BOK Financial.
BOK Financial and its subsidiaries are extensively regulated under both federal and state law. In particular, BOK Financial is subject to the Bank Holding Company Act of 1956, the National Bank Act and the Dodd-Frank Act. These regulations are primarily for the benefit and protection of BOK Financial's customers and not for the benefit of BOK Financial's investors. In the past, BOK Financial's business has been materially affected by these regulations. For example, regulations limit BOK Financial's business to banking and related businesses, and they limit the location of BOK Financial's branches and offices, as well as the amount of deposits that it can hold in a particular state. These regulations may limit BOK Financial's ability to grow and expand into new markets and businesses.
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Additionally, under the Community Reinvestment Act, BOK Financial is required to provide services in traditionally underserved areas. BOK Financial's ability to make acquisitions and engage in new business may be limited by these requirements.
The Federal Deposit Insurance Corporation Improvement Act of 1991 and the Bank Holding Company Act of 1956, and various regulations of regulatory authorities, require us to maintain specified capital ratios. Any failure to maintain required capital ratios would limit the growth potential of BOK Financial's business.
Under a long-standing policy of the Board of Governors of the Federal Reserve System, a bank holding company is expected to act as a source of financial strength for its subsidiary banks. As a result of that policy, BOK Financial may be required to commit financial and other resources to its subsidiary banks in circumstances where we might not otherwise do so.
The trend toward increasingly extensive regulation is likely to continue and become more costly in the future. Laws, regulations or policies currently affecting BOK Financial and its subsidiaries may change at any time. Regulatory authorities may also change their interpretation of these statutes and regulations. Therefore, BOK Financial's business may be adversely affected by any future changes in laws, regulations, policies or interpretations. For example, effective July 1, 2010, the Company recently implemented changes mandated by federal regulations concerning overdraft charges that significantly impacted our fee revenue in the second half of 2010.
The implementation of the Dodd-Frank Act will affect BOK Financial’s business including interchange revenue, mortgage banking, consumer products and higher capital standards. Among the rules pending for mortgage banking are uniform lending and servicing standards, consumer protection measures and several reforms affecting loan originators. A cap on interchange revenue has also been proposed. The Bureau of Consumer Financial Protection will have authority over banks greater than $10 billion in assets and may implement additional consumer protection standards. BOK Financial will be affected by other aspects of the Dodd-Frank Act including new capital rules and revised deposit insurance assessments. Provisions of the Dodd-Frank Act may also make portions of our customer hedging programs uneconomical to continue.
Statutory restrictions on subsidiary dividends and other distributions and debts of BOK Financial's subsidiaries could limit amounts BOK Financial's subsidiaries may pay to BOK Financial.
BOK Financial is a financial holding company, and a substantial portion of BOK Financial's cash flow typically comes from dividends that BOK Financial's bank and nonbank subsidiaries pay to BOK Financial. Various statutory provisions restrict the amount of dividends BOK Financial's subsidiaries can pay to BOK Financial without regulatory approval. Management also developed, and the BOK Financial board of directors approved, an internal capital policy that is more restrictive than the regulatory capital standards. In addition, if any of BOK Financial's subsidiaries liquidates, that subsidiary's creditors will be entitled to receive distributions from the assets of that subsidiary to satisfy their claims against it before BOK Financial, as a holder of an equity interest in the subsidiary, will be entitled to receive any of the assets of the subsidiary. If, however, BOK Financial is a creditor of the subsidiary with recognized claims against it, BOK Financial will be in the same position as other creditors.
Although publicly traded, BOK Financial's common stock has substantially less liquidity than the average trading market for a stock quoted on the NASDAQ National Market System.
A relatively small fraction of BOK Financial's outstanding common stock is actively traded. The risks of low liquidity include increased volatility of the price of BOK Financial's common stock. Low liquidity may also limit holders of BOK Financial's common stock in their ability to sell or transfer BOK Financial's shares at the price, time and quantity desired.
BOK Financial's principal shareholder controls a majority of BOK Financial's common stock.
Mr. George B. Kaiser owns a majority of the outstanding shares of BOK Financial's common stock. Mr. Kaiser is able to elect all of BOK Financial's directors and effectively control the vote on all matters submitted to a vote of BOK Financial's common shareholders. Mr. Kaiser's ability to prevent an unsolicited bid for BOK Financial or any other change in control could have an adverse effect on the market price for BOK Financial's common stock. A substantial majority of BOK Financial's directors are not officers or employees of BOK Financial or any of its affiliates. However, because of Mr. Kaiser's control over the election of BOK Financial's directors, he could change the composition of BOK Financial's Board of Directors so that it would not have a majority of outside directors.
Possible future sales of shares by BOK Financial's principal shareholder could adversely affect the market price of BOK Financial's common stock.
Mr. Kaiser has the right to sell shares of BOK Financial's common stock in compliance with the federal securities laws at any time, or from time to time. The federal securities laws will be the only restrictions on Mr. Kaiser's ability to sell. Because of his current control of BOK Financial, Mr. Kaiser could sell large amounts of his shares of BOK Financial's common stock by causing BOK Financial to file a registration statement that would allow him to sell shares more easily. In
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addition, Mr. Kaiser could sell his shares of BOK Financial's common stock without registration under Rule 144 of the Securities Act. Although BOK Financial can make no predictions as to the effect, if any, that such sales would have on the market price of BOK Financial's common stock, sales of substantial amounts of BOK Financial's common stock, or the perception that such sales could occur, could adversely affect market prices. If Mr. Kaiser sells or transfers his shares of BOK Financial's common stock as a block, another person or entity could become BOK Financial's controlling shareholder.
ITEM 1B. UNRESOLVED STAFF COMMENTS
ITEM 2. PROPERTIES
BOK Financial and its subsidiaries own and lease improved real estate that is carried at $265 million, net of depreciation and amortization. The Company’s principal offices are located in leased premises in the Bank of Oklahoma Tower in Tulsa, Oklahoma. Banking offices are primarily located in Tulsa and Oklahoma City, Oklahoma; Dallas, Fort Worth and Houston, Texas; Albuquerque, New Mexico; Denver, Colorado; Phoenix, Arizona; and Kansas City, Kansas/Missouri. Primary operations facilities are located in Tulsa and Oklahoma City, Oklahoma; Dallas, Texas and Albuquerque, New Mexico. The Company’s facilities are suitable for their respective uses and present needs.
The information set forth in Notes 5 and 14 of the Company’s Notes to Consolidated Financial Statements, which appear elsewhere herein, provides further discussion related to properties.
ITEM 3. LEGAL PROCEEDINGS
The information set forth in Note 14 of the Company’s Notes to Consolidated Financial Statements, which appear elsewhere herein, provides discussion related to legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders, through the solicitation of proxies or otherwise, during the three months ended December 31, 2010.
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ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
BOK Financial’s $0.00006 par value common stock is traded on the NASDAQ Stock Market under the symbol BOKF. As of January 31, 2011, common shareholders of record numbered 901 with 68,274,150 shares outstanding.
The highest and lowest closing bid price for shares and cash dividends per share of BOK Financial common stock follows:
Shareholder Return Performance Graph
Set forth below is a line graph comparing the change in cumulative shareholder return of the NASDAQ Index, the NASDAQ Bank Index, and the KBW 50 Bank Index for the period commencing December 31, 2005 and ending December 31, 2010.*
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The following table provides information with respect to purchases made by or on behalf of the Company or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of the Company’s common stock during the three months ended December 31, 2010.
1 On April 26, 2005, the Company’s board of directors authorized the Company to repurchase up to two million shares of the Company’s common stock. As of December 31, 2010, the Company had repurchased 784,073 shares under this plan.
2 The Company routinely repurchases mature shares from employees to cover the exercise price and taxes in connection with employee stock option exercises.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data is set forth within Table 1 of Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Dollars in thousands except per share data)
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Management’s Assessment of Operations and Financial Condition
The following discussion is management’s analysis to assist in the understanding and evaluation of the financial condition and results of operations BOK Financial Corporation (“BOK Financial” or “the Company”). This discussion should be read in conjunction with the consolidated financial statements and footnotes and selected financial data presented elsewhere in this report.
From 2007 to 2009 the United States experienced a severe recession, characterized by substantial market volatility and lack of available liquidity. The effects of the recession continued to impact the economy in 2010, primarily characterized by slow economic growth and persistently high national unemployment rates. In response, the U.S. government continued to provide significant liquidity and other intervening measures to support economic recovery based on evidence of subdued inflation. Lending activity remained slow in light of the economic uncertainty and interest rates remained at historic lows throughout the year. Low national mortgage rates during much of the year sustained a high level of mortgage lending activity and increased prepayments of our mortgage-backed securities. Cash flows from these securities were reinvested at current rates.
BOK Financial’s net income for 2010 totaled $246.8 million or $3.61 per diluted share compared to $200.6 million or $2.96 per diluted share compared to 2009, up 23% over 2009 on diversified fee income growth and improving credit quality. Net income was up 15% over last year, excluding a $6.5 million or $0.10 per diluted share day-one gain from the purchase of the rights to service $4.2 billion of residential mortgage loans on favorable terms in 2010 and a $7.7 million or $0.11 per share special assessment by the Federal Deposits Insurance Corporation (“FDIC”) in 2009.
Highlights of 2010 included:
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Net income for the fourth quarter of 2010 totaled $58.8 million or $0.86 per diluted share compared with $42.8 million or $0.63 per diluted share in 2009.
Highlights of the fourth quarter of 2010 included:
Critical Accounting Policies & Estimates
The Consolidated Financial Statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”). The Company’s accounting policies are more fully described in Note 1 of the Consolidated Financial Statements. Management makes significant assumptions and estimates in the preparation of the Consolidated Financial Statements and accompanying notes in conformity with GAAP that may be highly subjective, complex and subject to variability. Actual results could differ significantly from these assumptions and estimates. The following discussion addresses the most critical areas where these assumptions and estimates could affect the financial condition, results of operations and cash flows of the Company. These critical accounting policies and estimates have been discussed with the appropriate committees of the Board of Directors.
Allowances for Loan Losses and Off-Balance Sheet Credit Losses
Allowances for loan losses and off-balance sheet credit losses are assessed by management based on an ongoing quarterly evaluation of the probable estimated losses inherent in the portfolio and probable estimated losses on unused commitments to provide financing. A consistent, well-documented methodology has been developed and is applied by an independent Credit Administration department to assure consistency across the Company. The allowance for loan losses includes allowances assigned to specific impaired loans and commitments that have not yet been charged down to amounts we expect to recover, general allowances for unimpaired loans that are based on migration factors and nonspecific allowances that are based on analysis of general economic risk concentration and related factors. Additional details regarding the policies utilized in the development of the allowances for loan losses and off-balance sheet credit losses are included in Notes 1 and 4 to the Consolidated Financial Statements. There have been no material changes in the approach or techniques utilized in developing the allowances for loan losses or off-balance sheet credit losses during 2010.
Loans are considered impaired when it is probable that we will not collect all amounts due according to the contractual terms of the loan agreements. This is substantially the same criteria utilized to determine whether a loan should be placed on nonaccrual status. Generally, all nonaccruing commercial and commercial real estate loans are impaired. Impaired loans are charged-off when the loan balance or a portion of the loan balance is no longer supported by the paying capacity of the borrower determined through a quarterly evaluation of available cash resources and collateral value. Specific allowances for impairment are determined for loans that have not yet been charged down to amounts we expect to recover through evaluation of estimated future cash flows, collateral values and historical statistics. Estimates of future cash flows and collateral values require significant management judgments and are subject to volatility.
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Collateral value of real property is generally based on third party appraisals that conform to Uniform Standards of Professional Appraisal Practice, less estimated selling costs. Appraised values are on an “as-is” basis and are not adjusted by us. Appraisals are updated at least annually, or more frequently, if market conditions indicate collateral values may have declined. Collateral value of mineral rights is determined by our internal staff of engineers based on projected cash flows form proven oil and gas reserves under existing economic and operating conditions. The value of other collateral is generally determined by our special assets staff based on projected liquidation cash flows under current market conditions.
General allowances for unimpaired loans are based on migration models. Separate migration models are used to determine general allowances for commercial and commercial real estate loans, residential mortgage loans, and consumer loans. Substantially all commercial and commercial real estate loans and certain residential mortgage and consumer loans are risk-graded based on an evaluation of the borrowers’ ability to repay the loans. Risk grades are updated quarterly by management and may be based on significant subjective judgments. Migration factors are determined for each risk-grade to determine the inherent loss based on historical trends. We use an eight-quarter aggregate accumulation of net losses as a basis for the migration factors. Losses incurred in more recent periods are more heavily weighted by a sum-of-periods-digits formula. The higher of current loss factors based on migration trends or a minimum migration factor judgmentally set by management based upon long-term history is assigned to each risk grade.
Migration models fairly measure loss exposure during an economic cycle. However, because they are based on historic trends, their accuracy is limited near the beginning or ending of a cycle. Because of this limitation, the results of the migration models are evaluated by management quarterly. Management may adjust the resulting general allowance upward or downward so that the allowance for loan losses represents credit losses inherent in the portfolio.
The general allowance for residential mortgage loans is based on an eight-quarter average percent of loss. The general allowance for consumer loans is based on an eight-quarter average percent of loss with separate migration factors determined by major product line, such as indirect automobile loans and direct consumer loans.
Delinquency status is not a significant consideration in the evaluation of impairment or risk-grading of commercial or commercial real estate loans. These evaluations are based on an assessment of the borrowers’ paying capacity and attempt to identify changes in credit risk before payments become delinquent. Changes in the delinquency trends of residential mortgage loans and consumer loans may indicate increases or decreases in expected losses.
Nonspecific allowances are maintained for risks beyond those factors specific to a particular loan or those identified by the migration models. These factors include trends in the general economy in our primary lending areas, conditions in specific industries where we have a concentration and overall growth in the loan portfolio. Evaluation of nonspecific factors considers the effect of the duration of the business cycle on migration factors. Nonspecific factors also consider current economic conditions and other relevant factors. A range of potential losses is determined for each factor identified.
Fair Value Measurement
Certain assets and liabilities are recorded at fair value in the Consolidated Financial Statements. Fair value is defined as the exchange price that would be received to sell an asset or paid to transfer a liability in a principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date, using assumptions market participants would use when pricing an asset or liability. An orderly transaction assumes exposure to the market for a customary period for marketing activities prior to the measurement date and not a forced liquidation or distressed sale.
Fair value measurement and disclosure guidance provides a three level hierarchy that prioritizes the inputs of valuation techniques used to measure fair value into three broad categories: unadjusted quoted prices in active markets for identical assets or liabilities, other observable inputs that can be observed either directly or indirectly and unobservable inputs for assets or liabilities. Fair value may be recorded for certain assets and liabilities every reporting period on a recurring basis or under certain circumstances on a non-recurring basis.
The following represents significant fair value measurements included in the Consolidated Financial Statements based on estimates. See Note 18 of the Consolidated Financial Statements for additional discussion of fair value measurement and disclosure included in the Consolidated Financial Statements.
Mortgage Servicing Rights
We have a significant investment in mortgage servicing rights. These rights are primarily retained from sales of loans we have originated. Occasionally mortgage servicing rights may be purchased from other lenders. Originated mortgage servicing rights are initially recognized at fair value. Purchased servicing rights are initially recognized at their purchase price. Subsequent changes in fair value are recognized in earnings as they occur.
There is no active market for trading in mortgage servicing rights. We use a cash flow model to determine fair value. Key assumptions and estimates including projected prepayment speeds and assumed servicing costs, earnings on escrow deposits, ancillary income and discount rates used by this model are based on current market
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sources. Assumptions used to value our mortgage servicing rights are considered significant unobservable inputs and represent our best estimate of assumptions that market participants would use to value this asset. A separate third party model is used to estimate prepayment speeds based on interest rates, housing turnover rates, estimated loan curtailment, anticipated defaults and other relevant factors. The prepayment model is updated daily for changes in market conditions. We adjust the prepayment projections determined by this model to better correlate with actual performance of our servicing portfolio. The discount rate is based on benchmark rates for mortgage loans plus a market spread expected by investors in servicing rights. Significant assumptions used to determine the fair value of our mortgage servicing rights are presented in Note 7 to the Consolidated Financial Statements. At least annually, we request estimates of fair value from outside sources to corroborate the results of the valuation model.
The assumptions used in this model are primarily based on mortgage interest rates. Evaluation of the effect of a change in one assumption without considering the effect of that change on other assumptions is not meaningful. Considering all related assumptions, we would expect a 50 basis point increase in mortgage interest rates to increase the fair value of our servicing rights by $14 million. We would expect a $17 million decrease in the fair value of our mortgage servicing rights from a 50 basis point decrease in mortgage interest rates.
Valuation of Derivative Instruments
We use interest rate derivative instruments to manage our interest rate risk. We also offer interest rate, commodity, and foreign exchange derivative contracts to our customers. All derivative instruments are carried on the balance sheet at fair value. Fair values for exchange-traded contracts are based on quoted prices in an active market for identical instruments. Fair values for over-the-counter interest rate contracts used to manage our interest rate risk are provided either by third-party dealers in the contracts or by quotes provided by independent pricing services. Information used by these third-party dealers or independent pricing services to determine fair values are considered significant other observable inputs. Fair values for interest rate, commodity and foreign exchange contracts used in our customer hedging programs are based on valuations generated internally by third-party provided pricing models. These models use significant other observable market inputs to estimate fair values. Changes in assumptions used in these pricing models could significantly affect the reported fair values of derivative assets and liabilities, though the net effect of these changes should not significantly affect earnings.
Credit risk is considered in determining the fair value of derivative instruments. Deterioration in the credit rating of customers or dealers reduces the fair value of asset contracts. The reduction in fair value is recognized in earnings during the current period. Deterioration in our credit rating below investment grade would affect the fair value of our derivative liabilities. In the event of a credit down-grade, the fair value of our derivative liabilities would decrease. The reduction in fair value would be recognized in earnings in the current period.
Valuation of Securities
The fair value of our securities portfolio is generally based on a single price for each financial instrument provided to us by a third-party pricing service determined by one or more of the following:
The underlying methods used by the third-party pricing services are considered in determining the primary inputs used to determine fair values. The methodologies employed by the third-party pricing services are evaluated by comparing the price provided by the pricing service with other sources, including brokers’ quotes, sales or purchases of similar instruments and discounted cash flows to establish a basis for reliance on the pricing service values. Significant differences between the pricing service provided value and other sources are discussed with the pricing service to understand the basis for their values. Based on this evaluation, we determined that the results represent prices that would be received to sell assets or paid to transfer liabilities in orderly transactions in the current market.
A portion of our securities portfolio is comprised of debt securities for which third-party services have discontinued providing price information due primarily to a lack of observable inputs and other relevant data. We estimate the fair value of these securities based on significant unobservable inputs, including projected cash flows discounted at rates indicated by comparison to securities with similar credit and liquidity risk. We would expect the fair value to decrease $671 thousand if credit spreads utilized in valuing these securities widened by 100 basis points.
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Goodwill for each reporting unit is evaluated for impairment annually as of October 1st or more frequently if conditions indicate that impairment may have occurred. The evaluation of possible goodwill impairment involves significant judgment based upon short-term and long-term projections of future performance.
We identify the geographical market underlying each operating segment as reporting units for the purpose of performing the annual goodwill impairment test. This is consistent with the manner in which management assesses the performance of the Company and allocates resources. See additional discussion of the operating segments in the Assessment of Operations – Lines of Business section following.
The fair value of each of our reporting units is estimated by the discounted future earnings method. Income growth is projected for each of our reporting units over five years and a terminal value is computed. The projected income stream is converted to current fair value by using a discount rate that reflects a rate of return required by a willing buyer. Assumptions used to value our reporting units are based on growth rates, volatility, discount rate and market risk premium inherent in our current stock price. These assumptions are considered significant unobservable inputs and represent our best estimate of assumptions that market participants would use to determine fair value of the respective reporting units. Critical assumptions in our evaluation were an 11.00% average expected long-term growth rate, a 0.75% volatility factor for BOK Financial common stock, an 11.73% discount rate and a 12.26% market risk premium.
The fair value, carrying value and related goodwill of reporting units for which goodwill was attributed as of our annual impairment test performed on October 1, 2010 is as follows in Table 2.
1 Carrying value includes intangible assets attributed to the reporting unit.
Based on the results of the primary discounted cash flow test performed as of October 1, 2010, no goodwill impairment was noted.
The fair value of our reporting units determined by the discounted future earnings method was further corroborated by comparison to the market capitalization of publicly traded banks of similar size and characteristics in our geographical footprint. Considering the results of these two methods, management believes that no goodwill impairment existed as of our annual evaluation date.
As of December 31, 2010, the market value of BOK Financial common stock, a primary input in our goodwill impairment analysis, was approximately 18% above the market value used in our most recent annual evaluation. The market value is influenced by factors affecting the overall economy and the regional banks sector of the market. Goodwill impairment may be indicated at our next annual evaluation date if the market value of our stock declines or sooner if we incur significant unanticipated operating losses or if other factors indicate a significant decline in the value of our reporting units. The effect of a sustained 10% negative change in the market value of our common stock on September 30, 2010 was simulated. This simulation indicated that an immaterial impairment in our Colorado Commercial reporting unit may be possible. As of October 1, the fair value of our Colorado Commercial reporting unit exceeds the carrying value by 5%.
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Numerous other factors could affect future impairment analyses including credit losses that exceed projected amounts or failure to meet growth projections. Additionally, fee income may be adversely affected by increasing residential mortgage interest rates and changes in federal regulations.
The Company evaluates impaired debt and equity securities quarterly to determine if impairments are temporary or other-than-temporary.
For impaired debt securities, management first determines whether it intends to sell or if it is more-likely-than-not that it will be required to sell the impaired securities. This determination considers current and forecasted liquidity requirements, regulatory and capital requirements and securities portfolio management. All impaired debt securities we intend to sell or we expect to be required to sell are considered other-than-temporarily impaired and the full impairment loss is recognized as a charge against earnings. All impaired debt securities we do not intend or expect to be required to sell are evaluated further.
Impairment of debt securities consistently rated investment grade by all nationally-recognized rating agencies is considered temporary unless specific contrary information is identified. Impairment of securities rated below investment grade by at least one of the nationally-recognized rating agencies is evaluated to determine if we expect to recover the entire amortized cost basis of the security based on the present value of projected cash flows from individual loans underlying each security. Below investment grade securities we own consist primarily of privately issued residential mortgage-backed securities. The primary assumptions used to project cash flows are disclosed in Note 2 to the Consolidated Financial Statements.
We consider the adjusted loan-to-value ratio and credit enhancement coverage ratio as part of our assessment of cash flows available to recover the amortized cost of our securities. Adjusted loan-to-value ratio is an estimate of the collateral value available to support the realizable value of the security. We calculate the adjusted loan-to-value ratio for each security using loan-level data. The original loan-to-value ratio is adjusted for market-specific home price depreciation and credit enhancement on the specific tranche of each security we own. The credit enhancement coverage ratio is an estimate of currently remaining subordinated tranches available to absorb losses on pools of loans that support the security.
Credit losses, which are defined as the excess of current amortized cost over the present value of projected cash flows, on other-than-temporarily impaired debt securities are recognized as a charge against earnings. Any remaining impairment attributed to factors other than credit losses are recognized in accumulated other comprehensive losses.
Credit losses are based on long-term projections of cash flows which are sensitive to changes in assumptions. Changes in assumptions and differences between assumed and actual results regarding unemployment rates, delinquency rates, default rates, foreclosures costs and home price depreciation can affect estimated and actual credit losses. Deterioration of these factors beyond those described in Note 2 to the Consolidated Financial Statements could result in the recognition of additional credit losses.
We performed a sensitivity analysis of all privately issued mortgage-backed securities rated below AAA. Significant assumptions of this analysis included an increase in the unemployment rate to 12% over the next twelve months, decreasing to 8.5% over 21 months thereafter and an additional 20% house price depreciation. The results of this analysis indicated an additional $29 million to $36 million of credit losses are possible.
Impaired equity securities, including perpetual preferred stocks, are evaluated based on our ability and intent to hold the securities until fair value recovers over a period not to exceed three years. The assessment of the ability and intent to hold these securities considers liquidity needs, asset / liability management objectives and securities portfolio objectives. Factors considered when assessing recovery include forecasts of general economic conditions and specific performance of the issuer, analyst ratings, and credit spreads for preferred stocks which have debt-like characteristics.
Determination of income tax expense and related assets and liabilities is complex and requires estimates and judgments when applying tax laws, rules, regulations and interpretations. It also requires judgments as to future earnings and the timing of future events. Accrued income taxes represent an estimate of net amounts due to or from taxing jurisdictions based upon these estimates, interpretations and judgments.
Quarterly, management evaluates the Company’s effective tax rate based upon its current estimate of net income, tax credits and statutory tax rates expected for the full year. Changes in income tax expense due to changes in the effective tax rate are recognized on a cumulative basis. Annually, we file tax returns with each jurisdiction where we conduct business and settle our return liabilities. We may also provide for estimated liabilities associated with uncertain filing positions.
Deferred tax assets and liabilities are determined based upon the differences between the values of assets and liabilities as recognized in the financial statements and their related tax basis using enacted tax rates in effect for the year in which the
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differences are expected to be recovered or settled. A valuation allowance is provided when it is more likely than not that some portion of the entire deferred tax asset may not be realized based on taxes previously paid in net loss carry-back periods and other factors.
We recognize the benefit of uncertain income tax positions when based upon all relevant evidence it is more-likely-than-not that our position would prevail upon examination, including resolution of related appeals or litigation, based upon the technical merits of the position. An allowance for the uncertain portion of the tax benefit, including estimated interest and penalties, is part of our current accrued income tax liability. Estimated penalties and interest are recognized in income tax expense. This for uncertain tax positions may reduce income tax expense in future periods if the uncertainty is favorably resolved, generally upon completion of an examination by the taxing authorities, expiration of a statute of limitations or changes in facts and circumstances.
Assessment of Operations
Net Interest Revenue
Tax-equivalent net interest revenue totaled $718.2 million for 2010, flat with the prior year. The effect of a $506 million increase in average earning assets was largely offset by a 7 basis point decrease in net interest margin.
The increase in average earning assets was primarily due to a $1.8 billion increase in securities partially offset by a $1.2 billion decrease in net loans. During 2009, we purchased U.S. government agency issued residential mortgage-backed securities to supplement earnings during a period of declining loan demand and to manage our interest rate risk. The larger securities portfolio was maintained throughout 2010. Average commercial, commercial real estate and consumer loans decreased compared to the prior year, partially offset by growth in residential mortgage loans.
Growth in average earning assets was funded primarily by a $1.0 billion increase in average deposits. Average interest-bearing transaction account balances increased $1.5 billion and average demand deposit account balances increased $510 million. Average time deposits decreased $970 million as we decreased higher-costing time deposits. We also decreased average borrowed funds by $630 million during 2010.
Table 3 shows the effects on net interest revenue of changes in average balances and interest rates for the various types of earning assets and interest-bearing liabilities.
Net interest margin, the ratio of tax-equivalent net interest revenue to average earning assets, was 3.50% for 2010 and 3.57% for 2009. The decrease in net interest margin was due primarily to lower yield on our securities portfolio partially offset by lower funding costs.
The tax-equivalent yield on earning assets was 4.19% for 2010, down 40 basis points from 2009. The securities portfolio yield was 3.35%, down 101 basis points from 2009. Low intermediate and long-term interest rates experienced during the late third quarter and early fourth quarter of 2010 increased actual and projected prepayment speeds which drove higher levels of amortization of purchase premium. In addition to increased premium amortization over the second half of 2010, approximately $1.4 billion that had been invested to yield 3.40% was reinvested at 2.20%. The recent 100 basis point increase in interest rates should support a partial recovery of the securities portfolio yield as premium amortization slows and reinvestment rates improve. Loan yields increased 17 basis points to 4.82% primarily due to early payoff penalties, non-use fees and other fees. The cost of interest-bearing liabilities was 0.85% for 2010, down 36 basis points from 2009 due largely to market conditions. The cost of interest bearing deposits decreased 53 basis points to 0.85% and the cost of funds purchased and other borrowings increased 3 basis points to 0.84%. In addition, we reduced certain types of higher-costing time deposits and other borrowings during the year to lower our funding costs. The benefit to net interest margin from earning assets funded by non-interest bearing liabilities was 16 basis points in 2010 compared to 19 basis points in 2009 due to the low rate environment.
Our overall objective is to manage the Company’s balance sheet to be relatively neutral to changes in interest rates as is further described in the Market Risk section of this report. As shown in Table 27, approximately 62% of our commercial and commercial real estate loan portfolios are either variable rate or fixed rate that will re-price within one year. These loans are funded primarily by deposit accounts that are either non-interest bearing, or that re-price more slowly than the loans. The result is a balance sheet that would be asset sensitive, which means that assets generally re-price more quickly than liabilities. Among the strategies that we use to achieve a relatively rate-neutral position, we purchase fixed-rate residential mortgage-backed securities issued primarily by U.S. government agencies and fund them with market rate sensitive liabilities. The liability-sensitive nature of this strategy provides an offset to the asset-sensitive characteristics of our loan portfolio.
We also use derivative instruments to manage our interest rate risk. Interest rate swaps with a combined notional amount of $30 million convert fixed rate liabilities to floating rate based on LIBOR. The purpose of these derivatives is to position our balance sheet to be relatively neutral to changes in interest rates. Net interest revenue increased $4.0 million in 2010, $13.1 million in 2009 and $7.0 million in 2008 from periodic settlements of derivative contracts. This increase in net
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interest revenue contributed 2 basis points to net interest margin in 2010, 6 basis points in 2009 and 4 basis points in 2008. Derivative contracts are carried on the balance sheet at fair value. Changes in the fair value of these contracts are reported as derivative gains or losses in the Consolidated Statement of Earnings.
The effectiveness of these strategies is reflected in the overall change in net interest revenue due to changes in interest rates as shown in Table 3 and in the interest rate sensitivity projections as shown in the Market Risk section of this report.
¹ Changes attributable to both volume and yield/rate are allocated to both volume and yield/rate on an equal basis.
Fourth Quarter 2010 Net Interest Revenue
Tax-equivalent net interest revenue for the fourth quarter of 2010 totaled $165.9 million compared with $186.7 million for the fourth quarter of 2009. Net interest margin was 3.19% for the fourth quarter of 2010 and 3.64% for the fourth quarter of 2009. The decrease in net interest revenue and net interest margin was due primarily to lower yield on average earning assets, partially offset by lower funding costs. Securities portfolio yield decreased 114 basis points to 2.73%. Premium amortization in the residential mortgage-backed securities portfolio increased in the fourth quarter of 2010 due to extremely low intermediate and long term interest rates which accelerated actual and projected prepayment speeds. In addition, approximately $800 million that had been yielding 3.15% was reinvested to yield 2.20%. We expect that the 100 basis point increase in mortgage interest rates late in the fourth quarter of 2010 will reduce amortization expense in 2011.
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Average earning assets increased $567 million or 3%, including a $1.3 billion increase in average securities. Average net loans decreased $835 million compared to the fourth quarter of 2009. Average balances in all major loan categories, except for residential mortgage, decreased. Growth in average earning assets was funded primarily by a $505 million increase in average demand deposits. Other borrowing decreased $1.6 billion compared to the fourth quarter of 2009, partially offset by a $1.2 billion increase in average interest bearing transaction account balances.
2009 Net Interest Revenue
Tax-equivalent net interest revenue for 2009 was $718.4 million compared with $655.1 million for 2008. Average earning assets increased $1.5 billion or 8%, primarily due to a $1.8 billion increase in average securities. Growth in the securities portfolio generally consisted of residential mortgage-backed securities issued by U.S. government agencies. As shown in Table 3, net interest revenue increased $48 million due to changes in earning assets and interest bearing liabilities and increased $16 million due to changes in interest yields and rates. Net interest margin increased to 3.57% in 2009 compared with 3.45% in 2008 primarily due to lower funding costs. The cost of interest-bearing liabilities was 1.21% for 2009, down 134 basis points from 2008. The tax-equivalent yield on earning assets was 4.59% for 2009, down 105 basis points from 2008. Loan yields decreased 118 basis points to 4.65%. However, loan spreads continued to improve. The securities portfolio yield was 4.36%, down 80 basis points from 2008.
Other Operating Revenue
Other operating revenue increased $27.9 million over 2009 including a $35.9 million increase in fees and commission revenue partially offset by a $14.6 million decrease in net gains on securities, derivatives and other assets. Other-than-temporary charges recognized in 2010 earnings were $6.6 million less than in 2009.
1 Includes net derivative credit losses with two bankrupt counterparties of $54 million.
Fees and Commissions Revenue
Diversified sources of fees and commissions revenue are a significant part of our business strategy and represented 42% of total revenue, excluding provision for credit losses and gains and losses on asset sales, securities and derivatives. We believe that a variety of fee revenue sources provide an offset to changes in interest rates, values in the equity markets, commodity prices and consumer spending, all of which can be volatile. We expect continued growth in other operating revenue through offering new products and services and by expanding into markets outside of Oklahoma. However, current and future economic conditions, regulatory constraints, increased competition and saturation in our existing markets could affect the rate of future increases.
Brokerage and trading revenue increased $9.8 million or 11% over 2009. Customer hedging revenue totaled $11.7 million, an increase of $5.0 million over prior year primarily due to energy derivatives. Investment banking revenue totaled $10.0
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million, a $2.3 million or 30% increase over 2009 due to timing and volume of transactions. Retail brokerage revenue increased $3.0 million or 14% to $20.5 million. Securities trading revenue was $56 million for 2010 compared to $57 million for 2009. Increased lending activity by our mortgage banking customers increased related securities transaction volume in 2010. This activity was offset by a decline in municipal trading revenue as credit spreads widened on credit concerns in municipal securities and volumes dropped.
Transaction card revenue depends largely on the volume and amount of transactions processed, the number of ATM locations and the number of merchants served. Transaction card revenue increased $6.8 million or 6% over 2009. Check card revenue totaled $33.1 million, an increase of $3.7 million or 12% over 2009 due primarily to a 9% increase in the number of check card transactions processed in 2010 compared to 2009. Merchant discount fees increased $2.8 million or 10% to $30.4 million on higher transaction volumes. ATM network revenue totaled $48.8 million, up less than 1% over the prior year. The number of TransFund ATM locations totaled 1,943 at December 31, 2010, up 2% over the prior year. Increased ATM transaction volumes were partially offset by a decrease in the average rate charged per transaction. Interchange fee limits proposed by the Federal Reserve Bank as required by the Dodd-Frank Act would significantly reduce transaction card revenue. Based on the $0.12 cap proposed in December to be effective as of July 21, 2011, we would expect a decline in our interchange revenue of $12 million to $15 million in 2011.
Trust fees and commissions increased $2.8 million or 4%. The revenue increase was due to growth in the fair value of trust assets, partially offset by lower balances in our proprietary mutual funds. In order to maintain positive yields in our Cavanal Hill Funds and our cash management sweep fund in the current low short-term interest rate environment, we voluntarily waived $3.7 million of administrative fees in 2010 and $4.7 million of administrative fees in 2009. The fair value of trust assets administered by the Company totaled $32.8 billion at December 31, 2010 compared with $30.4 billion at December 31, 2009.
Deposit service charges and fees declined $12.2 million or 11% compared to 2009. Overdraft fees declined $12.0 million or 16% to $61.8 million. The decrease in overdraft fees was primarily due to changes in federal regulations concerning overdraft changes which were effective July 1, 2010. This performance is consistent with our previously disclosed expectation that changes in overdraft regulations would decrease fee income by $10 million to $15 million over the second half of 2010. This decrease was partially mitigated by a new service charge imposed in the second quarter of 2010 on accounts that remain overdrawn for more than five days. Commercial account service charge revenue decreased by $4.8 million or 14% compared to 2009 to $29.4 million for 2010. Customers kept larger commercial account balances, which increases the earnings credit, a non-cash method for commercial customers to avoid incurring charges for deposit services based on account balances. Service charges on retail deposit accounts increased $585 thousand or 12% to $5.4 million.
Mortgage banking revenue increased $22.6 million or 35% over 2009. Revenue from originating and marketing mortgage loans increased $4.5 million or 10% over the prior year to $49.4 million. Margins on mortgage loans originated for sale were historically wide during parts of 2010 due to high volume and falling interest rates. Mortgage loans originated for sale in the secondary market totaled $2.6 billion in 2010 compared to $2.8 billion in 2009. Mortgage loan servicing revenue totaled $38.2 million or 0.36% of the average outstanding balance of loans serviced for others in 2010 and $20.0 million or 0.34% of loans serviced for others in 2009. The average outstanding balance of loans serviced for others was $10.7 billion for 2010 and $5.9 billion for 2009. During the first quarter of 2010, the Company purchased the rights to service $4.2 billion of residential mortgage loans. The loans to be serviced are primarily concentrated in the New Mexico market and predominately held by Fannie Mae, Freddie Mac and Ginnie Mae. The remaining growth in mortgage loans serviced for others was due to retaining mortgage servicing rights from mortgage loans originated. No mortgage loan servicing rights were purchased in 2009.
Net gains on securities, derivatives and other assets
We recognized $21.9 million of net gains on sales of $2.0 billion of available for sale securities in 2010 and $59.3 million of net gains on sales of $3.1 billion of available for sale securities in 2009. Securities were sold either because they had reached their expected maximum potential return or to mitigate exposure from rising interest rates.
We also maintain a portfolio of securities and derivative contracts designated as an economic hedge of the changes in fair value of mortgage servicing rights that fluctuates due to changes in prepayment speeds and other assumptions as more fully described in Note 7 to the Consolidated Financial Statements. As benchmark mortgage interest rates fall, prepayment speeds increase and the value of our mortgage servicing rights decreases. As benchmark mortgage interest rates increase, prepayment speeds slow and the value of our mortgage servicing rights increase.
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Table 5 Gain (Loss) on Mortgage Servicing Rights, Net of Economic Hedge
In addition to the gain on mortgage hedge derivative contracts, gains (losses) on derivative contracts, net includes fair value adjustments of derivatives used to manage interest rate risk and certain liabilities we have elected to carry at fair value. Derivative instruments generally consist of interest rate swaps where we pay a variable rate based on LIBOR and receive a fixed rate. The fair value of these swaps generally decreases as interest rate rise resulting in a loss to the Company and increases in value as interest rates fall resulting in a gain to the Company. Certain certificates of deposit have been designated as reported at fair value. This determination is made when the certificates of deposit are issued based on the Company’s intent to swap the interest rate on the certificates from a fixed rate to a LIBOR-based variable rate. As interest rates fall, the fair value of these fixed-rate certificates of deposit generally increases and we recognize a loss. Conversely, as interest rates rise, the fair value of these fixed-rate certificates of deposit generally decreases and we recognize a gain. We recognized a net loss on derivatives used to manage interest rate risk of $154 thousand during 2010 compared to a net loss on derivative of $3.4 million in 2009.
The change in Net gain (loss) on other assets is due primarily to a $2.7 million decrease in the fair value of our private equity funds; $2.4 million of the decrease is allocated to limited partners through Net income (loss) attributable to non-controlling interest on the Statement of Earnings.
As more fully described in the Note 2 to the Consolidated Financial Statements, we recognized $27.8 million of other-than-temporary impairment losses in earnings in 2010 related to certain privately issued residential mortgage-backed securities and other equity securities. We recognized $34.4 million of other-than-temporary impairment charges against earnings in 2009 related to certain privately issued residential mortgage-backed securities and preferred stocks.
Fourth Quarter 2010 Other Operating Revenue
Other operating revenue for the fourth quarter of 2010 totaled $111.9 million, up $3.8 million over the prior year. Fees and commission revenue increased $20.0 million or 17% over the fourth quarter of 2009. Net gains on available for sale securities were down $10.7 million.
Mortgage banking revenue increased $11.8 million or 88% over the same period last year. Revenue from originating and marketing mortgage loans increased $7.1 million and mortgage loan servicing revenue increased $4.7 million. Mortgage loans funded for sale totaled $822 million in the fourth quarter of 2010, up from $517 million in the fourth quarter of 2009. Brokerage and trading revenue increased $8.4 million or 41% over the prior year due to a $4.5 million increase in securities trading revenue, a $1.9 million increase in retail brokerage revenue and a $1.9 million increase in investment banking revenue. Transaction card revenue increased $3.2 million or 12% compared to the previous year. ATM fees, debit card processing fees and merchant discount fees all increased over the prior year. Trust revenue increased $1.7 million or 10% compared with the fourth quarter of 2009. The fair value of trust assets was up 8% compared to the prior year.
Deposit service charges and fees were down $5.8 million or 20% due primarily to changes in federal regulation concerning overdraft charges that were effective July 1, 2010. Commercial account service charge revenue also decreased $961 thousand or 11%.
We recognized net gains of $953 thousand on sales $536 million of available for sale securities in the fourth quarter of 2010 compared to net gains of $11.7 million on sales of $765 million of available for sale securities in the fourth quarter of 2009.
For the fourth quarter of 2010, changes in the fair value of mortgage servicing rights increased pre-tax net income by $25.1 million, partially offset by a net loss on mortgage trading securities of $11.1 million and a loss on derivative contracts of $7.4 million held as an economic hedge. For the fourth quarter of 2009, changes in the fair value of mortgage servicing
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rights increased pre-tax net income by $5.3 million, partially offset by a net loss on mortgage trading securities held as an economic hedge of $4.4 million. There were no derivative contracts held as an economic hedge of the mortgage servicing rights at December 31, 2009.
2009 Other Operating Revenue
Other operating revenue totaled $493.0 million for 2009, up $64.3 million over 2008. Fees and commissions revenue increased $65.3 million and net gains on securities, derivatives and other assets increased $28.1 million, offset by a $29.1 million increase in other-than-temporary impairment charges recognized in earnings. Brokerage and trading revenue increased $48.9 million over 2008. Fees and commissions revenue for 2008 was reduced by $54 million from net credit losses on derivative contracts with two bankrupt counterparties. Customer hedging revenue decreased by $15 million or 70% from 2008 due to lower commodity prices, partially offset by a $7.8 million or 16% increase in securities trading revenue over 2008 on increased activity by our mortgage banking customers. Transaction card revenue increased $5.4 million or 8% due to increases in ATM fees and check card revenue. Trust fees and commissions decreased $12.8 million or 16% primarily due to the decrease in the fair value of all trust assets administered by the Company. Service charges on deposit accounts declined $1.7 million or 1% on lower overdraft fees due to decreased transaction volume. Mortgage banking revenue increased $34.4 million or 112% over 2008 due to increases in originating and marketing mortgages and mortgage loan servicing revenue.
Net securities gains totaled $46.1 million for 2009. Other-than-temporary impairment charges of $34.4 million and $5.3 million were recognized in 2009 and 2008, respectively, on certain privately issued residential mortgage-backed securities and variable-rate, perpetual preferred stocks. Losses on mortgage trading securities of $13.2 million were partially offset by changes in the fair value of our mortgage servicing rights of $12.1 million.
Other Operating Expense
Other operating expense totaled $753.2 million for 2010, up $56.4 million over 2009. Changes in the fair value of mortgage servicing rights decreased other operating expenses by $3.7 million in 2010 and decreased other operating expenses by $12.1 million in 2009. In addition, operating expenses for 2009 included $11.8 million for the FDIC special assessment. Excluding these items, other operating expense totaled $756.8 million for 2010, up $59.7 million over 2009. Personnel expenses increased $21.3 million or 6% over the previous year. Non-personnel operating expenses increased $38.4 million or 12% over 2009 due largely to a $23.1 million increase in losses and operating expenses related to repossessed assets.
Personnel expense totaled $401.9 million for 2010 and $380.5 million for 2009. Regular compensation, which consists of salaries and wages, overtime pay and temporary personnel costs, totaled $238.7 million, up $6.8 million or 3% over 2009. The increase in regular compensation was primarily due to an increase in the average regular compensation per full time equivalent employee. Average staffing levels were held at a level consistent with 2009.
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Table 7 Personnel Expense