FirstMerit 10-K 2010
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission file number: 0-10161
Securities registered pursuant to Section 12(b) of the Exchange Act:
Securities registered pursuant to Section 12(g) of the Exchange Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o No þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark 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 registrants 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. o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
As of June 30, 2009, the aggregate market value of the registrants common stock (the only common equity of the registrant) held by non-affiliates of the registrant was $1,449,516,458 based on the closing sale price as reported on The NASDAQ Stock Market.
Indicate the number of shares outstanding of each of the registrants classes of common stock, as of the latest practicable date.
DOCUMENTS INCORPORATED BY REFERENCE
Set forth below is a line graph comparing the yearly percentage change in the cumulative total shareholder return on FirstMerits Common Stock against the cumulative return of the Nasdaq Banks Index, the Nasdaq Index and the S&P 500 Index for the period of five fiscal years commencing December 31, 2004 and ended December 31, 2009. The graph assumes that the value of the investment in FirstMerit Common Stock and each index was $100 on December 31, 2004 and that all dividends were reinvested.
TABLE OF CONTENTS
BUSINESS OF FIRSTMERIT
Registrant, FirstMerit Corporation (FirstMerit or the Corporation), is a $10.5 billion bank holding company organized in 1981 under the laws of the State of Ohio and registered under the Bank Holding Company Act of 1956, as amended (the BHCA). FirstMerits principal business consists of owning and supervising its affiliates. Although FirstMerit directs the overall policies of its affiliates, including lending practices and financial resources, most day-to-day affairs are managed by their respective officers. The principal executive offices of FirstMerit are located at III Cascade Plaza, Akron, Ohio 44308, and its telephone number is (330) 996-6300.
At December 31, 2009, FirstMerit Bank, N.A. (FirstMerit Bank), one of the Corporations principal subsidiaries, operated a network of 160 full service banking offices and 182 automated teller machines. Its offices span a total of 24 counties in Ohio, including Ashland, Ashtabula, Crawford, Cuyahoga, Delaware, Erie, Fairfield, Franklin, Geauga, Holmes, Huron, Knox, Lake, Lorain, Lucas, Madison, Medina, Portage, Richland, Seneca, Stark, Summit, Wayne and Wood Counties, and Lawrence County in Pennsylvania. In its principal market in Northeastern Ohio, FirstMerit serves nearly 599,216 households and businesses in the 16th largest consolidated metropolitan statistical area in the country (which combines the primary metropolitan statistical areas for Cleveland, Lorain/Elyria and Akron, Ohio). FirstMerit and its direct and indirect subsidiaries had approximately 2,495 employees at December 31, 2009.
Through its subsidiaries, FirstMerit operates primarily as a line of business banking organization, providing a wide range of banking, fiduciary, financial, insurance and investment services to corporate, institutional and individual customers throughout northern and central Ohio, and western Pennsylvania. FirstMerits banking subsidiary is FirstMerit Bank.
Prior to 2007, the Corporation managed its operations through the major line of business Supercommunity Banking. To improve revenue growth and profitability as well as enhance relationships with customers, the Corporation moved to a line of business model during the first quarter of 2007. The major lines of business are Commercial, Retail, Wealth and Other. Accordingly, prior period information has been reclassified to reflect this change. Note 15 (Segment Information) to the consolidated financial statements provides performance data for these lines of business.
Other services provided by FirstMerit Bank or its affiliates include automated banking programs, credit and debit cards, rental of safe deposit boxes, letters of credit, leasing, securities brokerage and life insurance products. FirstMerit Bank also operates a trust department, which offers wealth management and trust services. The majority of its customers are comprised of consumers and small and medium size businesses. FirstMerit Bank is not engaged in lending outside the continental United States and is not dependent upon any one significant customer or specific industry.
FirstMerits non-banking direct and indirect subsidiaries provide insurance sales services, credit life, credit accident and health insurance, securities brokerage services, equipment lease financing and other financial services.
FirstMerits principal direct operating subsidiary other than FirstMerit Bank is FirstMerit Community Development Corporation. FirstMerit Community Development Corporation was organized in 1994 to further FirstMerits efforts in identifying the credit needs of its lending communities and meeting the requirements of the Community Reinvestment Act (CRA). Congress enacted the CRA to ensure that financial institutions meet the deposit and credit needs of their communities. Through a community development corporation, financial institutions can fulfill these requirements by nontraditional activities such as acquiring, rehabilitating or investing in real estate in low to moderate income neighborhoods, and promoting the development of small business.
FirstMerit Bank is the parent corporation of 19 wholly-owned subsidiaries a complete list of which is set forth in Exhibit 21 filed as an attachment to this Annual Report on Form 10-K. FirstMerit Mortgage Corporation, located in
Canton, Ohio, originates residential mortgage loans and provides mortgage loan servicing for itself and FirstMerit Bank. FirstMerit Equipment Finance Company, Inc. (f.k.a. FirstMerit Credit Services and FirstMerit Leasing) provides commercial lease financing and related services.
Bank subsidiaries FirstMerit Securities, Inc. and FirstMerit Financial Services, Inc. provide investment securities and annuities to customers. Securities trading has been a brokered program in conjunction with third-party providers since 1999; beginning January 14, 2010 FirstMerit is internalizing broker dealer services through the new FirstMerit Financial Services subsidiary, which will allow investment services and solutions to be provided locally while building operational efficiencies. In addition, FirstMerit Advisors, Inc. provides certain financial planning services to customers of FirstMerit Bank and other FirstMerit subsidiaries.
Two new subsidiaries, CPHCSub, LLC and CREPD, LLC, were opened in 2009 to hold distressed commercial and construction properties, received through the loan foreclosure process during this time of economic downturn. These properties are held as other real estate owned (OREO) while being managed and remarketed for sale. The assets held as OREO for these two subsidiaries were $2.8 million and $1.2 million, respectively at December 31, 2009.
FirstMerit Bank is also the parent corporation of FirstMerit Insurance Group, Inc.; FirstMerit Insurance Agency, Inc., a life insurance and financial consulting firm an insurance agency licensed to sell life insurance products and annuities; FirstMerit Title Agency, Ltd., FirstMerit Mortgage Reinsurance Company, Inc., and FirstMerit Risk Management, Inc., a captive insurance subsidiary.
Although FirstMerit is a corporate entity legally separate and distinct from its affiliates, bank holding companies such as FirstMerit, which are subject to the BHCA, are expected to act as a source of financial strength for their subsidiary banks. The principal source of FirstMerits income is dividends from its subsidiaries. There are certain regulatory restrictions on the extent to which financial institution subsidiaries can pay dividends or otherwise supply funds to FirstMerit. Additional information regarding FirstMerits business is included in Managements Discussion and Analysis of Financial Condition and Results of Operations.
FirstMerit considers from time to time possible acquisitions of other financial institutions and financial services companies. FirstMerit also periodically acquires branches and deposits in its principal markets. FirstMerits strategy for growth includes strengthening market share in its existing markets, expanding into complementary markets and broadening its product offerings.
The financial services industry remains highly competitive. FirstMerit and its subsidiaries compete with other local, regional and national providers of financial services such as other bank holding companies, commercial banks, savings associations, credit unions, consumer and commercial finance companies, equipment leasing companies, brokerage institutions, money market funds and insurance companies. Primary financial institution competitors include PNC Bank, KeyBank, Huntington Bank, US Bank and Fifth Third Bank.
Under the Gramm-Leach-Bliley Act of 1999 (GLBA), securities firms and insurance companies that elect to become financial holding companies may acquire banks and other financial institutions. GLBA continues to change the competitive environment in which FirstMerit and its subsidiaries conduct business and thereby engage in broader activities than previously allowed for bank holding companies under the BHCA.
Mergers between financial institutions within and outside of Ohio continue to add competitive pressure. FirstMerit competes in its markets by offering high quality personal services at a competitive price.
This report on Form 10-K has been posted on the Corporations website, www.firstmerit.com, on the date of filing with the Securities and Exchange Commission (SEC), and the Corporation intends to post all future filings of its reports on Forms 10-K, 10-Q and 8-K on its website on the date of filing with the SEC in accordance with the prompt notice requirements of the SEC.
REGULATION AND SUPERVISION
FirstMerit, its national banking subsidiary FirstMerit Bank, and many of its nonbanking subsidiaries are subject to extensive regulation by federal and state agencies. The regulation of bank holding companies and their subsidiaries is intended primarily for the protection of depositors, borrowers, other customers, the federal deposit insurance fund and the banking system as a whole and not for the protection of security holders. This regulatory environment, among other things, may restrict FirstMerits ability to diversify into certain areas of financial services, acquire depository institutions in certain markets and pay dividends on its capital stock. It also may require FirstMerit to provide financial support to its banking subsidiary, maintain capital balances in excess of those desired by management and pay higher deposit insurance premiums as a result of the deterioration in the financial condition of depository institutions in general.
Bank Holding Company. FirstMerit, as a bank holding company, is subject to regulation under the BHCA and to inspection, examination and supervision by the Board of Governors of the Federal Reserve System (Federal Reserve Board) under the BHCA.
Subsidiary Bank. FirstMerit Bank is subject to regulation and examination primarily by the Office of the Comptroller of the Currency (OCC) and secondarily by the Federal Deposit Insurance Corporation (FDIC).
Nonbank Subsidiaries. Many of FirstMerits nonbank subsidiaries also are subject to regulation by the Federal Reserve Board and other applicable federal and state agencies. FirstMerits investment advisory subsidiary and broker-dealer subsidiary are regulated by the SEC, the Financial Industry Regulatory Authority, and state securities regulators, which require education and licensing of advisors, require reporting and impose business conduct rules. FirstMerits insurance subsidiaries are subject to regulation by applicable state insurance regulatory agencies, which require education and licensing of agencies and individual agents, require reports and impose business conduct rules. Other nonbank subsidiaries of FirstMerit are subject to the laws and regulations of both the federal government and the various states in which they conduct business.
Securities and Exchange Commission and NASDAQ. FirstMerit is also under the jurisdiction of the SEC and certain state securities commissions for matters relating to the offering and sale of its securities. FirstMerit is subject to disclosure and regulatory requirements of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, as administered by the SEC. FirstMerit is listed on The NASDAQ Stock Market LLC (NASDAQ) under the trading symbol FMER, and is subject to the rules of NASDAQ.
Bank Holding Company Regulation
As a bank holding company, FirstMerits activities are subject to extensive regulation by the Federal Reserve Board. FirstMerit is required to file reports with the Federal Reserve Board and such additional information as the Federal Reserve Board may require, and is subject to examinations by the Federal Reserve Board.
The Federal Reserve Board also has extensive enforcement authority over bank holding companies, including, among other things, the ability to:
In general, the Federal Reserve Board may initiate enforcement actions for violations of laws and regulations and unsafe or unsound practices.
Under Federal Reserve Board policy, a bank holding company is expected to serve as a source of financial strength to each subsidiary bank and to commit resources to support those subsidiary banks. Under this policy, the Federal Reserve Board may require a bank holding company to contribute additional capital to an undercapitalized
subsidiary bank and may disapprove of the payment of dividends to the shareholders if the Federal Reserve Board believes the payment of such dividends would be an unsafe or unsound practice.
The BHCA requires prior approval by the Federal Reserve Board for a bank holding company to acquire more than a 5% interest in any bank. Factors taken into consideration in making such a determination include the effect of the acquisition on competition, the public benefits expected to be received from the acquisition, the projected capital ratios and levels on a post-acquisition basis, and the acquiring institutions record of addressing the credit needs of the communities it serves.
The BHCA also governs interstate banking and restricts the nonbanking activities of FirstMerit to those determined by the Federal Reserve Board to be financial in nature, or incidental or complementary to such financial activity, without regard to territorial restrictions. Transactions among FirstMerit Bank and its affiliates are also subject to certain limitations and restrictions of the Federal Reserve Board.
GLBA permits a qualifying bank holding company to become a financial holding company and thereby affiliate with securities firms and insurance companies and engage in other activities that are financial in nature and not otherwise permissible for a bank holding company. FirstMerit has not elected to become a financial holding company.
FirstMerit is a legal entity separate and distinct from its subsidiary bank and other subsidiaries. FirstMerits principal source of funds to pay dividends on its common shares and service its debt is dividends from these subsidiaries. Various federal and state statutory provisions and regulations limit the amount of dividends that FirstMerit Bank may pay to FirstMerit without regulatory approval. FirstMerit Bank generally may not, without prior regulatory approval, pay a dividend in an amount greater than its undivided profits. In addition, the prior approval of the OCC is required for the payment of a dividend if the total of all dividends declared in a calendar year would exceed the total of its net income for the year combined with its retained net income for the two preceding years. If, in the opinion of the applicable regulatory authority, a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, such authority may require, after notice and hearing, that such bank cease and desist from such practice. Depending on the financial condition of the bank, the applicable regulatory authority might deem the bank to be engaged in an unsafe or unsound practice if the bank were to pay dividends. The Federal Reserve Board and the OCC have issued policy statements that provide that insured banks and bank holding companies should generally only pay dividends out of current operating earnings. Thus the ability of FirstMerit Bank to pay dividends in the future is currently influenced, and could be further influenced, by bank regulatory policies and capital guidelines.
FirstMerits banking subsidiary is subject to restrictions under federal law that limit the transfer of funds or other items of value to FirstMerit and its nonbanking subsidiaries, including affiliates, whether in the form of loans and other extensions of credit, investments and asset purchases, or as other transactions involving the transfer of value from a subsidiary to an affiliate or for the benefit of an affiliate. Moreover, loans and extensions of credit to affiliates generally are required to be secured in specified amounts. A banks transactions with its nonbank affiliates also are generally required to be on arms-length terms.
Capital loans from FirstMerit to its subsidiary bank are subordinate in right of payment to deposits and certain other indebtedness of the subsidiary bank. In the event of FirstMerits bankruptcy, any commitment by FirstMerit to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.
The Federal Deposit Insurance Act provides that, in the event of the liquidation or other resolution of an insured depository institution such as FirstMerit Bank, the insured and uninsured depositors, along with the FDIC, will have priority in payment ahead of unsecured, nondeposit creditors, including FirstMerit, with respect to any extensions of credit they have made to such insured depository institution.
Regulation of Nationally-Chartered Banks
As a national banking association, FirstMerit Bank is subject to regulation under the National Banking Act and is periodically examined by the OCC. OCC regulations govern permissible activities, capital requirements, dividend limitations, investments, loans and other matters. Furthermore, FirstMerit Bank is subject, as a member bank, to
certain rules and regulations of the Federal Reserve Board, many of which restrict activities and prescribe documentation to protect consumers. FirstMerit Bank is an insured institution as a member of the Deposit Insurance Fund. As a result, it is subject to regulation and deposit insurance assessments by the FDIC. In addition, the establishment of branches by FirstMerit Bank is subject to prior approval of the OCC. The OCC has the authority to impose sanctions on FirstMerit Bank and, under certain circumstances, may place FirstMerit Bank into receivership.
The Federal Reserve Board has adopted risk-based capital guidelines for bank holding companies. The OCC and the FDIC have adopted risk-based capital guidelines for national banks and state non-member banks, respectively. The guidelines provide a systematic analytical framework which makes regulatory capital requirements sensitive to differences in risk profiles among banking organizations, takes off-balance sheet exposures expressly into account in evaluating capital adequacy, and minimizes disincentives to holding liquid, low-risk assets. Capital levels as measured by these standards are also used to categorize financial institutions for purposes of certain prompt corrective action regulatory provisions.
The minimum guideline for the ratio of total capital to risk-weighted assets (including certain off-balance sheet items such as standby letters of credit) is 8%. At least half of the minimum total risk-based capital ratio (4%) must be composed of common shareholders equity, minority interests in certain equity accounts of consolidated subsidiaries and a limited amount of qualifying preferred stock and qualified trust preferred securities, less goodwill and certain other intangible assets, including the unrealized net gains and losses, after applicable taxes, on available-for-sale securities carried at fair value (commonly known as Tier 1 risk-based capital). The remainder of total risk-based capital (commonly known as Tier 2 risk-based capital) may consist of certain amounts of hybrid capital instruments, mandatory convertible debt, subordinated debt, preferred stock not qualifying as Tier 1 capital, loan and lease loss allowance and net unrealized gains on certain available-for-sale equity securities, all subject to limitations established by the guidelines.
Under the guidelines, capital is compared to the relative risk related to the balance sheet. To derive the risk included in the balance sheet, one of four risk weights (0%, 20%, 50% and 100%) is applied to different balance sheet and off-balance sheet assets, primarily based on the relative credit risk of the counterparty. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
The Federal Reserve Board has established minimum leverage ratio guidelines for bank holding companies. The Federal Reserve Board guidelines provide for a minimum ratio of Tier 1 capital to average assets (excluding the loan and lease loss allowance, goodwill and certain other intangibles), or leverage ratio, of 3% for bank holding companies that meet certain criteria, including having the highest regulatory rating, and 4% for all other bank holding companies. The guidelines further provide that bank holding companies making acquisitions will be expected to maintain strong capital positions substantially above the minimum levels. The OCC and the FDIC have each also adopted minimum leverage ratio guidelines for national banks and for state non-member banks, respectively.
The Federal Reserve Boards review of certain bank holding company transactions is affected by whether the applying bank holding company is well-capitalized. To be deemed well-capitalized, the bank holding company must have a Tier 1 risk-based capital ratio of at least 6% and a total risk-based capital ratio of at least 10%, and must not be subject to any written agreement, order, capital directive or prompt corrective action directive issued by the Federal Reserve Board to meet and maintain a specific capital level for any capital measure. FirstMerits capital ratios meet the requirements to be deemed well capitalized under the Federal Reserve Boards guidelines.
The federal banking agencies have established a system of prompt corrective action to resolve certain of the problems of undercapitalized institutions. This system is based on five capital level categories for insured depository institutions: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized.
The federal banking agencies may (or in some cases must) take certain supervisory actions depending upon a banks capital level. For example, the banking agencies must appoint a receiver or conservator for a bank within 90 days after it becomes critically undercapitalized unless the banks primary regulator determines, with the
concurrence of the FDIC, that other action would better achieve regulatory purposes. Banking operations otherwise may be significantly affected depending on a banks capital category. For example, a bank that is not well capitalized generally is prohibited from accepting brokered deposits and offering interest rates on deposits higher than the prevailing rate in its market, and the holding company of any undercapitalized depository institution must guarantee, in part, specific aspects of the banks capital plan for the plan to be acceptable.
In order to be well-capitalized, a bank must have total risk-based capital of at least 10%, Tier 1 risk-based capital of at least 6% and a leverage ratio of at least 5%, and the bank must not be subject to any written agreement, order, capital directive or prompt corrective action directive to meet and maintain a specific capital level for any capital measure. FirstMerits management believes that FirstMerit Bank meets the ratio requirements to be deemed well capitalized according to the guidelines described above. See Note 20 to the consolidated financial statements.
The Federal Reserve Board may set capital requirements higher than the minimums described previously for holding companies whose circumstances warrant it. For example, holding companies experiencing or anticipating significant growth may be expected to maintain capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets.
The risk-based capital guidelines adopted by the federal banking agencies are based on the International Convergence of Capital Measurement and Capital Standards (Basel I), published by the Basel Committee on Banking Supervision (the Basel Committee) in 1988. In 2004, the Basel Committee published a new, more risk-sensitive capital adequacy framework (Basel II) for large, internationally active banking organizations. In December 2007, the federal banking agencies issued final rules making the implementation of certain parts of Basel II mandatory for any bank that has consolidated total assets of at least $250 billion (excluding certain assets) or has consolidated on-balance sheet foreign exposure of at least $10 billion, and making it voluntary for other banks.
In response to concerns regarding the complexity and cost associated with implementing the Basel II rules, in July 2008, the federal banking agencies issued a notice of proposed rulemaking that would revise the existing risk-based capital framework for banks that will not be subject to the Basel II rules. The proposed rules would allow banks other than the large Basel II banks to elect to adopt the new risk weighting methodologies set forth in the proposed rules or remain subject to the existing risk-based capital rules.
FirstMerit will not be required to implement Basel II. Until the final rules for the non-Basel II banks are adopted by the federal banking agencies, FirstMerit is unable to predict whether and when its subsidiary banks will adopt the new capital guidelines.
Federal law permits the OCC to order the pro rata assessment of shareholders of a national bank whose capital stock has become impaired, by losses or otherwise, to relieve a deficiency in such national banks capital stock. This statute also provides for the enforcement of any such pro rata assessment of shareholders of such national bank to cover such impairment of capital stock by sale, to the extent necessary, of the capital stock owned by any assessed shareholder failing to pay the assessment. As the sole shareholder of FirstMerit Bank, FirstMerit is subject to such provisions.
Insurance premiums for each insured institution are determined based upon the institutions capital level and supervisory rating provided to the FDIC by the institutions primary federal regulator and other information the FDIC determines to be relevant to the risk posed to the deposit insurance fund by the institution. The assessment rate determined by considering such information is then applied to the amount of the institutions deposits to determine the institutions insurance premium. An increase in the assessment rate could have a material adverse effect on the earnings of the affected institutions, depending on the amount of the increase.
Insurance of deposits may be terminated by the FDIC upon a finding that the insured institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, rule, order or condition enacted or imposed by the institutions regulatory agency.
FirstMerits business and earnings are affected significantly by the fiscal and monetary policies of the federal government and its agencies. FirstMerit is particularly affected by the policies of the Federal Reserve Board, which regulates the supply of money and credit in the United States. Among the instruments of monetary policy available to the Federal Reserve are (a) conducting open market operations in United States government securities, (b) changing the discount rates of borrowings of depository institutions, (c) imposing or changing reserve requirements against depository institutions deposits, and (d) imposing or changing reserve requirements against certain borrowing by banks and their affiliates. These methods are used in varying degrees and combinations to affect directly the availability of bank loans and deposits, as well as the interest rates charged on loans and paid on deposits. For that reason alone, the policies of the Federal Reserve Board have a material effect on the earnings of FirstMerit.
Under GLBA, federal banking regulators were required to adopt rules that limit the ability of banks and other financial institutions to disclose non-public information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party.
The USA Patriot Act of 2001 and its related regulations require insured depository institutions, broker-dealers, and certain other financial institutions to have policies, procedures, and controls to detect, prevent, and report money laundering and terrorist financing. The statute and its regulations also provide for information sharing, subject to conditions, between federal law enforcement agencies and financial institutions, as well as among financial institutions, for counter-terrorism purposes. Federal banking regulators are required, when reviewing bank holding company acquisition and bank merger applications, to take into account the effectiveness of the anti-money laundering activities of the applicants.
EESA and ARRA
In response to the ongoing financial crisis affecting the banking system and financial markets, EESA was signed into law on October 3, 2008 and established TARP. As part of TARP, the Treasury established the CPP to provide up to $700 billion of funding to eligible financial institutions through the purchase of mortgages, mortgage-backed securities, capital stock and other financial instruments for the purpose of stabilizing and providing liquidity to the U.S. financial markets. On January 9, 2009, FirstMerit completed the sale to the Treasury of $125.0 million of newly issued FirstMerit non-voting preferred shares as part of the CPP and a warrant to purchase 952,260 FirstMerit common shares at an exercise price of $19.69 per share. The American Recovery and Reinvestment Act of 2009 (ARRA), more commonly known as the economic stimulus or economic recovery package, was signed into law on February 17, 2009, by President Obama. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future TARP recipients, including FirstMerit, until the institution has repaid the Treasury.
On April 22, 2009, FirstMerit completed the repurchase of all 125,000 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A, and on May 27, 2009, FirstMerit completed the repurchase of the warrant held by the Treasury. FirstMerit is therefore no longer subject to the compensation and expenditure limits applicable to TARP recipients.
The Sarbanes-Oxley Act of 2002 effected broad reforms to areas of corporate governance and financial reporting for public companies under the jurisdiction of the SEC. Significant additional corporate governance and financial reporting reforms have since been implemented by NASDAQ, and apply to FirstMerit. FirstMerits corporate governance policies include an Audit Committee Charter, a Compensation Committee Charter, Corporate Governance Guidelines, Corporate Governance and Nominating Committee Charter, and Code of Business Conduct and Ethics.
The Board of Directors reviews FirstMerits corporate governance practices on a continuing basis. These and other corporate governance policies have been provided previously to shareholders and are available, along with other information on FirstMerits corporate governance practices, on the FirstMerit website at www.firstmerit.com.
As directed by Section 302(a) of the Sarbanes-Oxley Act, FirstMerits chief executive officer and chief financial officer are each required to certify that FirstMerits Quarterly and Annual Reports do not contain any untrue statement of a material fact. The rules have several requirements, including having these officers certify that: they are responsible for establishing, maintaining, and regularly evaluating the effectiveness of FirstMerits internal controls, they have made certain disclosures about FirstMerits internal controls to its auditors and the audit committee of the Board of Directors, and they have included information in FirstMerits Quarterly and Annual Reports about their evaluation and whether there have been significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the evaluation.
Various legislation affecting financial institutions and the financial industry is from time to time introduced in Congress. Such legislation may change banking statutes and the operating environment of FirstMerit and its subsidiaries in substantial and unpredictable ways, and could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance depending upon whether any of this potential legislation will be enacted, and if enacted, the effect that it or any implementing regulations, would have on the financial condition or results of operations of FirstMerit or any of its subsidiaries. With the enactment of EESA and ARRA and the current consideration of economic stimulus legislation by Congress, the nature and extent of future legislative and regulatory changes affecting financial institutions is very unpredictable at this time.
To the extent that the previous information describes statutory and regulatory provisions applicable to FirstMerit or its subsidiaries, it is qualified in its entirety by reference to the full text of those provisions or agreement. Also, such statutes, regulations and policies are continually under review by Congress and state legislatures and federal and state regulatory agencies and are subject to change at any time, particularly in the current economic and regulatory environment. Any such change in statutes, regulations or regulatory policies applicable to FirstMerit could have a material effect on the business of FirstMerit.
Difficult economic conditions and market volatility have adversely impacted the banking industry and financial markets generally and may significantly affect our business, financial condition, or results of operation.
Our success depends, to a certain extent, upon economic and political conditions, local and national, as well as governmental monetary policies. Conditions such as inflation, recession, unemployment, changes in interest rates, money supply and other factors beyond our control may adversely affect our asset quality, deposit levels and loan demand and, therefore, our earnings.
Dramatic declines in the housing market beginning in the latter half of 2007, with falling home prices and increasing foreclosures, unemployment and underemployment, have negatively impacted the credit performance of mortgage loans and resulted in significant write-downs of asset values by financial institutions. The resulting write-downs to assets of financial institutions have caused many financial institutions to seek additional capital, to merge with larger and stronger institutions and, in some cases, to seek government assistance or bankruptcy protection.
The capital and credit markets, including the fixed income markets, have been experiencing volatility and disruption. In some cases, the markets have produced downward pressure on stock prices and credit capacity for certain issuers without regard to those issuers financial strength.
Many lenders and institutional investors have reduced and, in some cases, ceased to provide funding to borrowers, including to other financial institutions because of concern about the stability of the financial markets and the strength of counterparties. It is difficult to predict how long these economic conditions will exist, which of our
markets, products or other businesses will ultimately be affected, and whether managements actions will effectively mitigate these external factors. Accordingly, the resulting lack of available credit, lack of confidence in the financial sector, decreased consumer confidence, increased volatility in the financial markets and reduced business activity could materially and adversely affect our business, financial condition and results of operations.
As a result of the challenges presented by economic conditions, we may face the following risks in connection with these events:
The enactment of new legislation and increased regulatory oversight may significantly affect our financial condition.
The financial services industry is extensively regulated. FirstMerit Bank is subject to extensive regulation, supervision and examination by the OCC and the FDIC. As a holding company, we also are subject to regulation and oversight by the Federal Reserve Board. Federal and state regulation is designed primarily to protect the deposit insurance funds and consumers, and not to benefit our shareholders. Such regulations can at times impose significant limitations on our operations. Regulatory authorities have extensive discretion in connection with their supervisory and enforcement activities, including the imposition of restrictions on the operation of an institution, the classification of assets by the institution and the adequacy of an institutions allowance for loan losses. Proposals to change the laws governing financial institutions are frequently raised in Congress and before bank regulatory authorities. Substantial regulatory and legislation initiatives, including a comprehensive overhaul of the regulatory system in the United States, are possible in the years ahead. Changes in applicable laws or policies could materially affect our business, and the likelihood of any major changes in the future and their effects are impossible to determine. Moreover, it is impossible to predict the ultimate form any proposed legislation might take or how it might affect us.
In 2008 and continuing into 2009 and 2010, the Federal Reserve Board, Congress, the Treasury, the FDIC and others have taken numerous actions to address the current liquidity and credit crisis in the financial markets. These measures include homeowner relief that encourages loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; and coordinated efforts to address liquidity and other weaknesses in the banking sector. There can be no assurance as to the actual impact that new legislation will have on the economy or financial markets. The failure of these programs to stabilize the financial markets could weaken public confidence in financial institutions and have a substantial and material adverse effect on our ability to attract and retain new customers.
Further, additional legislation or regulations may be adopted in the future that reduce the amount that our customers are required to pay under existing loan contracts or limit our ability to foreclose on collateral. For example, legislation has been proposed to give judges the ability to adjust the principal and interest payments on residential
mortgages to allow homeowners to avoid foreclosure. There can be no assurance that future legislation will not significantly impact our ability to collect on our current loans or foreclose on collateral.
Additional information regarding regulation and supervision is included in the section captioned Regulation and Supervision in Item 1. Business.
Changes in economic and political conditions, particularly in Ohio, could adversely affect our earnings, cash flows and capital, as our borrowers ability to repay loans and the value of the collateral securing our loans decline.
Our success depends, to a certain extent, upon economic and political conditions, local and national, as well as governmental fiscal and monetary policies. Conditions such as inflation, recession, unemployment, changes in interest rates, money supply and other factors beyond our control may adversely affect our asset quality, deposit levels and loan demand and, therefore, our earnings and our capital. Because we have a significant amount of real estate loans, additional decreases in real estate values could adversely affect the value of property used as collateral and our ability to sell the collateral upon foreclosure. Adverse changes in the economy may also have a negative effect on the ability of our borrowers to make timely repayments of their loans, which would have an adverse impact on our earnings and cash flows.
The substantial majority of the loans made by our subsidiaries are to individuals and businesses in Ohio. Consequently, a significant continued decline in the economy in Ohio could have a materially adverse effect on our financial condition and results of operations and cash flows.
We continue to experience difficult credit conditions in the markets in which we operate. It remains uncertain when the negative credit trends in our markets will reverse. As a result, our future earnings, cash flows and capital continue to be susceptible to further declining credit conditions in the markets in which we operate.
Increases in FDIC insurance premiums may have a material adverse affect on our earnings.
During 2008, there were higher levels of bank failures, which dramatically increased resolution costs of the FDIC and depleted the deposit insurance fund. In order to maintain a strong funding position and restore reserve ratios of the deposit insurance fund, the FDIC voted on December 16, 2008 to increase assessment rates of insured institutions uniformly by 7 basis points (7 cents for every $100 of deposits), beginning with the first quarter of 2009. Additional changes, beginning April 1, 2009, were to require riskier institutions to pay a larger share of premiums by factoring in rate adjustments based on secured liabilities and unsecured debt levels.
The Emergency Economic Stabilization Act of 2008 (the EESA) instituted two temporary programs effective through December 31, 2009 to further insure customer deposits at FDIC-member banks: deposit accounts are now insured up to $250,000 per customer (up from $100,000) and noninterest bearing transactional accounts are fully insured (unlimited coverage). On May 20, 2009, President Obama signed into law the Helping Families Save Their Homes Act of 2009 (the HFSTHA) which, among other things, amends the EESA to extend the effectiveness of these temporary programs through December 31, 2013. On January 1, 2014, the standard insurance amount will return to $100,000 per depositor for all account categories except IRAs and certain other retirement accounts, which will remain at $250,000 per depositor.
On May 22, 2009, the FDIC adopted a final rule that imposed a special assessment for the second quarter of 2009 of 5 basis points on each insured depositary institutions assets minus its Tier 1 capital as of June 30, 2009, which was collected on September 30, 2009 in the amount of $4.9 million.
On November 12, 2009, the FDIC adopted a final rule requiring insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012. The prepaid assessments for these periods were collected on December 30, 2009, along with the regular quarterly risk-based deposit insurance assessment for the third quarter of 2009. For the fourth quarter of 2009 and for all of 2010, the prepaid assessment rate was based on each institutions total basis point assessment in effect on September 30, 2009, adjusted to assume a 5% annualized deposit growth rate; for the 2011 and 2012 periods the computation is adjusted by an additional 3 basis points increase in the assessment rate. The three-year prepayment for FirstMerit totaled $43.9 million, and will be expensed over three years.
In January 2010, the FDIC issued an advance notice of proposed rule-making asking for comments on how the FDICs risk-based deposit insurance assessment system could be changed to include the risks of certain employee compensation as criteria in the assessment system.
We are generally unable to control the amount of premiums that we are required to pay for FDIC insurance. If there are additional financial institution failures, we may be required to pay even higher FDIC premiums than the recently increased levels. Increases in FDIC insurance premiums may materially adversely affect our results of operations and our ability to continue to pay dividends on our common shares at the current rate or at all.
The actions and commercial soundness of other financial institutions could affect our ability to engage in routine funding transactions. Financial services to institutions are interrelated as a result of trading, clearing, counterparty or other relationships. We have exposure to different industries and counterparties, and execute transactions with various counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. Recent defaults by financial services institutions, and even rumors or questions about one or more financial services institution or the financial services industry in general, have led to marketwide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of its counterparty or client. In addition, our credit risk may increase when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due us. Any such losses could materially and adversely affect our results of operations.
The capital and credit markets have been experiencing volatility and disruption for more than a year. In recent months, the volatility and disruption has reached unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers seemingly without regard to those issuers underlying financial strength. If current levels of market disruption and volatility continue or worsen, there can be no assurance that we will not experience an adverse effect, which may be material, on our ability to access capital and on our business, financial condition and results of operations.
The market price for our Common Shares has been volatile in the past, and several factors could cause the price to fluctuate substantially in the future, including:
Changes in interest rates could have a material adverse effect on our financial condition and results of operations.
Our earnings depend substantially on our interest rate spread, which is the difference between (i) the rates we earn on loans, securities and other earning assets and (ii) the interest rates we pay on deposits and other borrowings. These rates are highly sensitive to many factors beyond our control, including general economic conditions and the policies of various governmental and regulatory authorities. As market interest rates rise, we will have competitive pressures to increase the rates we pay on deposits, which will result in a decrease of our net interest income and could have a material adverse effect on our financial condition and results of operations. Additional information regarding
interest rate risk is included in the section captioned Interest Rate Sensitivity within Managements Discussion and Analysis of Financial Condition and Results of Operations.
Our earnings are significantly affected by the fiscal and monetary policies of the federal government and its agencies.
The policies of the Federal Reserve Board impact us significantly. The Federal Reserve Board regulates the supply of money and credit in the United States. Its policies directly and indirectly influence the rate of interest earned on loans and paid on borrowings and interest-bearing deposits and can also affect the value of financial instruments we hold. Those policies determine to a significant extent our cost of funds for lending and investing. Changes in those policies are beyond our control and are difficult to predict. Federal Reserve Board policies can also affect our borrowers, potentially increasing the risk that they may fail to repay their loans. For example, a tightening of the money supply by the Federal Reserve Board could reduce the demand for a borrowers products and services. This could adversely affect the borrowers earnings and ability to repay its loan, which could have a material adverse effect on our financial condition and results of operations.
The primary source of our income from which we pay dividends is the receipt of dividends from FirstMerit Bank, which is subject to regulatory restrictions on its payment of dividends.
The availability of dividends from FirstMerit Bank is limited by various statutes and regulations. It is possible, depending upon the financial condition of FirstMerit Bank and other factors, that the OCC could assert that payment of dividends or other payments is an unsafe or unsound practice. In addition, the payment of dividends by other subsidiaries is also subject to the laws of the subsidiarys state of incorporation. FirstMerits right to participate in a distribution of assets upon a subsidiarys liquidation or reorganization is subject to the prior claims of the subsidiarys creditors. In the event that FirstMerit Bank was unable to pay dividends to us, we in turn would likely have to reduce or stop paying dividends on our Common Shares. Our failure to pay dividends on our Common Shares could have a material adverse effect on the market price of our Common Shares. Additional information regarding dividend restrictions is included in the section captioned Regulation and Supervision Dividends and Transactions with Affiliates in Item 1. Business.
Our loan customers may not repay their loans according to their terms, and the collateral securing the payment of these loans may be insufficient to pay any remaining loan balance. We may experience significant credit losses, which could have a material adverse effect on our operating results. In accordance with accounting principles generally accepted in the United States, we maintain an allowance for credit losses to provide for loan defaults and non-performance and a reserve for unfunded loan commitments, which when combined, we refer to as the allowance for credit losses. Our allowance for loan losses may not be adequate to cover actual credit losses, and future provisions for credit losses could have a material adverse effect on our operating results. Our allowance for loan losses is based on prior experience, as well as an evaluation of the risks in the current portfolio. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond our control, and these losses may exceed current estimates. Federal regulatory agencies, as an integral part of their examination process, review our loans and allowance for loan losses. We cannot assure you that we will not further increase the allowance for loan losses or that regulators will not require us to increase this allowance. Either of these occurrences could have a material adverse effect on our financial condition and results of operations. Additional information regarding the allowance for loan losses is included in the sections captioned Allowance for Loan Losses and Reserve for Unfunded Lending Commitments and Allowance for Credit Losses within Managements Discussion and Analysis of Financial Condition and Results of Operations.
We extend credit to a variety of customers based on internally set standards and the judgment of our loan officers and bank presidents. Our credit standards and on-going process of credit assessment might not protect us from significant credit losses.
We take credit risk by virtue of making loans and leases, extending loan commitments and letters of credit and, to a lesser degree, purchasing non-governmental securities. Our exposure to credit risk is managed through the use of
consistent underwriting standards that emphasize in-market lending while avoiding highly leveraged transactions as well as excessive industry and other concentrations. Our credit administration function employs risk management techniques to ensure that loans and leases adhere to corporate policy and problem loans and leases are promptly identified. While these procedures are designed to provide us with the information needed to implement policy adjustments where necessary, and to take proactive corrective actions, there can be no assurance that such measures will be effective in avoiding undue credit risk.
In deciding whether to extend credit or enter into other transactions with customers and counterparties, we may rely on information provided to us by customers and counterparties, including financial statements and other financial information. We may also rely on representations of customers and counterparties as to the accuracy and completeness of that information and, with respect to financial statements, on reports of independent auditors. For example, in deciding whether to extend credit to a business, we may assume that the customers audited financial statements conform with generally accepted accounting principles and present fairly, in all material respects, the financial condition, results of operations and cash flows of the customer. We may also rely on the audit report covering those financial statements. Our financial condition and results of operations could be negatively impacted to the extent we rely on financial statements that do not comply with generally accepted accounting principles or that are materially misleading.
Derivative transactions may expose us to unexpected risk and potential losses.
We are party to a number of derivative transactions. Many of these derivative instruments are individually negotiated and non-standardized, which can make exiting, transferring or settling the position difficult. We carry borrowings which contain embedded derivatives. These borrowing arrangements require that we deliver underlying securities to the counterparty as collateral. If market interest rates were to decline, we may be required to deliver more securities to the counterparty. We are dependent on the creditworthiness of the counterparties and are therefore susceptible to credit and operational risk in these situations.
Derivative contracts and other transactions entered into with third parties are not always confirmed by the counterparties on a timely basis. While the transaction remains unconfirmed, we are subject to heightened credit and operational risk and, in the event of a default, may find it more difficult to enforce the contract. In addition, as new and more complex derivative products are created, covering a wider array of underlying credit and other instruments, disputes about the terms of the underlying contracts could arise, which could impair our ability to effectively manage our risk exposures from these products and subject us to increased costs. Any regulatory effort to create an exchange or trading platform for credit derivatives and other over-the-counter derivative contracts, or a market shift toward standardized derivatives, could reduce the risk associated with such transactions, but under certain circumstances could also limit our ability to develop derivatives that best suit the needs of our clients and ourselves and adversely affect our profitability.
In the normal course of business, FirstMerit and its subsidiaries are routinely subject to examinations and challenges from federal and state tax authorities regarding the amount of taxes due in connection with investments we have made and the businesses in which we have engaged. Recently, federal and state taxing authorities have become increasingly aggressive in challenging tax positions taken by financial institutions. These tax positions may relate to tax compliance, sales and use, franchise, gross receipts, payroll, property and income tax issues, including tax base, apportionment and tax credit planning. The challenges made by tax authorities may result in adjustments to the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions. If any such challenges are made and are not resolved in our favor, they could have a material adverse effect on our financial condition and results of operations.
Environmental liability associated with commercial lending could have a material adverse effect on our business, financial condition and results of operations.
In the course of our business, we may acquire, through foreclosure, commercial properties securing loans that are in default. There is a risk that hazardous substances could be discovered on those properties. In this event, we could be required to remove the substances from and remediate the properties at our cost and expense. The cost of removal and environmental remediation could be substantial. We may not have adequate remedies against the owners of the properties or other responsible parties and could find it difficult or impossible to sell the affected properties. These events could have a material adverse effect on our financial condition and results of operation.
Our business strategy includes significant growth plans. Our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively.
We intend to continue pursuing a profitable growth strategy both within our existing markets and in new markets. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies in significant growth stages of development. We cannot assure you that we will be able to expand our market presence in our existing markets or successfully enter new markets or that any such expansion will not adversely affect our results of operations. Failure to manage our growth effectively could have a material adverse effect on our business, future prospects, financial condition or results of operations and could adversely affect our ability to successfully implement our business strategy. Also, if we grow more slowly than anticipated, our operating results could be materially adversely affected.
Our ability to grow successfully will depend on a variety of factors, including the continued availability of desirable business opportunities, the competitive responses from other financial institutions in our market areas and our ability to manage our growth. While we believe we have the management resources and internal systems in place to successfully manage our future growth, there can be no assurance growth opportunities will be available or growth will be successfully managed.
We may acquire other financial institutions or parts of those institutions in the future and we may engage in de novo branch expansion. We may also consider and enter into new lines of business or offer new products or services. Acquisitions and mergers involve a number of expenses and risks, including:
We may incur substantial costs to expand, and we can give no assurance such expansion will result in the levels of profits we seek. There can be no assurance integration efforts for any future mergers or acquisitions will be successful. Also, we may issue equity securities in connection with future acquisitions, which could cause ownership and
economic dilution to our current shareholders. There is no assurance that, following any future mergers or acquisitions, our integration efforts will be successful or that, after giving effect to the acquisition, we will achieve profits comparable to or better than our historical experience.
We operate in an extremely competitive market, and our business will suffer if we are unable to compete effectively.
In our market area, we encounter significant competition from other commercial banks, savings and loan associations, credit unions, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market mutual funds and other financial institutions. The increasingly competitive environment is a result primarily of changes in regulation, changes in technology and product delivery systems and the accelerating pace of consolidation among financial service providers. Many of our competitors have substantially greater resources and lending limits than we do and may offer services that we do not or cannot provide. Our financial performance and return on investment to shareholders will depend in part on our continued ability to compete successfully in our market area and on our ability to expand our scope of available financial services as needed to meet the needs and demands of our customers.
Technology and other changes are allowing parties to complete financial transactions that historically have involved banks at one or both ends of the transaction. For example, consumers can now pay bills and transfer funds directly without banks. The process of eliminating banks as intermediaries, known as disintermediation, could result in the loss of fee income, as well as the loss of customer deposits and income generated from those deposits.
Our business is primarily relationship-driven in that many of our key employees have extensive customer relationships. Loss of a key employee with such customer relationships may lead to the loss of business if the customers were to follow that employee to a competitor. While we believe our relationship with our key producers is good, we cannot guarantee that all of our key personnel will remain with our organization. Loss of such key personnel, should they enter into an employment relationship with one of our competitors, could result in the loss of some of our customers.
Impairment of goodwill or other intangible assets could require charges to earnings, which could result in a negative impact on our results of operations.
Under current accounting standards, goodwill and certain other intangible assets with indeterminate lives are no longer amortized but, instead, are assessed for impairment periodically or when impairment indicators are present. Assessment of goodwill and such other intangible assets could result in circumstances where the applicable intangible asset is deemed to be impaired for accounting purposes. Under such circumstances, the intangible assets impairment would be reflected as a charge to earnings in the period during which such impairment is identified.
We may be exposed to liability under non-solicitation agreements to which one or more of our employees may be a party to with certain of our competitors.
From time to time, we may hire employees who may be parties to non-solicitation or non-competition agreements with one or more of our competitors. Although we expect that all such employees will comply with the terms of their non-solicitation agreements, it is possible that if customers of our competitors choose to move their business to us, or employees of our competitor seek employment with us, even without any action on the part of any employee bound by any such agreement, that one or more of our competitors may choose to bring a claim against us and our employee.
Unauthorized disclosure of sensitive or confidential client or customer information, whether through a breach of our computer systems or otherwise, could severely harm our business.
As part of our business we collect, process, and retain sensitive and confidential client and customer information on behalf of FirstMerit and other third parties. Despite the security measures we have in place, our facilities and
systems, and those of our third party service providers, may be vulnerable to security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming and/or human errors, or other similar events. Any security breach involving the misappropriation, loss or other unauthorized disclosure of confidential customer information, whether by FirstMerit or by our vendors, could severely damage our reputation, expose us to the risks of litigation and liability, disrupt our operations and have a material adverse effect on our business.
We may elect or be compelled to seek additional capital in the future, but that capital may not be available when it is needed.
We are required by federal and state regulatory authorities to maintain adequate levels of capital to support our operations. As we experience loan losses, additional capital may need to be infused. In addition, we may elect to raise additional capital to support our business or to finance acquisitions, if any, or we may otherwise elect or be required to raise additional capital. Our ability to raise additional capital will depend on our financial performance, conditions in the capital markets, economic conditions and a number of other factors, many of which are outside our control. Accordingly, there can be no assurance that we can raise additional capital if needed or on terms acceptable to us. If we cannot raise additional capital when needed, it may have a material adverse effect on our financial condition, results of operations and prospects.
Our organizational documents, state laws and regulated industry may discourage a third party from acquiring FirstMerit by means of a tender offer, proxy contest or otherwise.
Certain provisions of our amended and restated articles of incorporation and amended and restated code of regulations, certain laws of the State of Ohio, and certain aspects of the BHCA and other governing statutes and regulations, may have the effect of discouraging a tender offer or other takeover attempt not previously approved by our Board of Directors.
FirstMerits executive offices and certain holding company operational facilities, totaling approximately 108,230 square feet, are located in a seven-story office building at III Cascade in downtown Akron, Ohio owned by FirstMerit Bank. The building is the subject of a ground lease with the City of Akron as the lessor of the land.
The facilities owned or leased by FirstMerit and its subsidiaries are considered by management to be adequate, and neither the location nor unexpired term of any lease is considered material to the business of FirstMerit.
The principal executive offices of FirstMerit Bank are located in a 28-story office building at 106 South Main Street, Akron, Ohio, which is owned by FirstMerit Bank. FirstMerit Bank Akron is the principal tenant of the building, occupying approximately 122,500 square feet of the building. The remaining portion is leased to tenants unrelated to FirstMerit Bank. The properties occupied by 99 of FirstMerit Banks other branches are owned by FirstMerit Bank, while the properties occupied by its remaining 60 branches are leased with various expiration dates. FirstMerit Mortgage Corporation, FirstMerit Title Agency, Ltd., and certain of FirstMerit Banks loan operation and documentation preparation activities are conducted in owned space in Canton, Ohio. There is no mortgage debt owing on any of the above property owned by FirstMerit Bank. FirstMerit Bank also owns automated teller machines, on-line teller terminals and other computers and related equipment for use in its business.
FirstMerit Bank also owns 15.5 acres near downtown Akron, on which FirstMerits primary Operations Center is located. The Operations Center is occupied and operated by FirstMerit Services Division, an operating division of FirstMerit Bank. The Operations Center primarily provides computer and communications technology-based services to FirstMerit and its subsidiaries, and also markets its services to non-affiliated institutions. There is no mortgage debt owing on the Operations Center property. In connection with its Operations Center, the Services Division has a disaster recovery center at a remote site on leased property, and leases additional space for activities related to its operations.
In the normal course of business, FirstMerit is at all times subject to pending and threatened legal actions, some for which the relief or damages sought are substantial. Although FirstMerit is not able to predict the outcome of such actions, after reviewing pending and threatened actions with counsel, management believes that the outcome of such actions will not have a material adverse effect on the results of operations or stockholders equity of FirstMerit. Although FirstMerit is not able to predict whether the outcome of such actions may or may not have a material adverse effect on results of operations in a particular future period as the time and amount of any resolution of such actions and its relationship to the future results of operations are not known.
No matters were submitted to a vote of security holders in the fourth quarter of 2009.
The following persons were the executive officers of FirstMerit as of December 31, 2009. Unless otherwise stated, each listed position was held on January 1, 2005.
FirstMerits common shares are quoted on The NASDAQ Stock Market under the trading symbol FMER. The following table contains bid and cash dividend information for FirstMerit common Shares for the two most recent fiscal years:
Stock Performance and Dividends (1)
On February 6, 2010, there were approximately 7,870 shareholders of record of FirstMerit common shares.
The following table provides information with respect to purchases FirstMerit made of its shares of common shares during the fourth quarter of the 2009 fiscal year.
SELECTED FINANCIAL DATA
FIRSTMERIT CORPORATION AND SUBSIDIARIES
The following commentary presents a discussion and analysis of the Corporations financial condition and results of operations by its management (Management). The review highlights the principal factors affecting earnings and the significant changes in balance sheet items for the years 2009, 2008 and 2007. Financial information for prior years is presented when appropriate. The objective of this financial review is to enhance the readers understanding of the accompanying tables and charts, the consolidated financial statements, notes to financial statements, and financial statistics appearing elsewhere in this report. Where applicable, this discussion also reflects Managements insights of known events and trends that have or may reasonably be expected to have a material effect on the Corporations operations and financial condition.
HIGHLIGHTS OF 2009 PERFORMANCE
FirstMerit Corporation reported fourth quarter 2009 net income of $14.5 million, or $0.17 per diluted share. This compares with $22.8 million, or $0.27 per diluted share, for the third quarter 2009 and $29.1 million, or $0.35 per diluted share, for the fourth quarter 2008. For the full year 2009, the Corporation reported net income of $82.2 million, or $0.90 per diluted share, compared with $119.5 million, or $1.46 per diluted share in 2008.
Returns on average common equity (ROE) and average assets (ROA) for the fourth quarter 2009 were 5.38% and 0.54%, respectively, compared with 8.69% and 0.85%, respectively, for the third quarter 2009 and 12.47% and 1.08% for the fourth quarter 2008. ROE and ROA for the year ended December 31, 2009 were 8.09% and 0.76%, respectively, compared with 12.76% and 1.13%, respectively, for the year ended December 31, 2008.
On December 16, 2009, the FirstMerit Bank acquired $102.0 million in outstanding principal of asset based lending loans (ABL loans), as well as the staff to service and build new business, from First Bank Business Capital, Inc., (FBBC). FBBC is a wholly owned subsidiary of First Bank, a Missouri state chartered bank. This acquisition expands the Corporations market presence and asset based lending business into the Midwest.
Average loans during the fourth quarter of 2009 decreased $108.0 million, or 1.53%, compared with the third quarter of 2009 and also decreased $417.3 million, or 5.66%, compared with the fourth quarter of 2008. Decreases against the respective periods were due to a reduction in both consumer and commercial demand for borrowing. In the fourth quarter of 2009, average commercial loans decreased $46.9 million, or 1.14%, and $214.3 million, or 5.01%, compared with the third quarter of 2009 and fourth quarter of 2008, respectively. Average consumer loans decreased $62.3 million, or 2.15%, and $194.8 million, or 6.78%, over the same periods.
Average deposits were $7.4 billion during the fourth quarter of 2009, up $13.1 million, or 0.18%, compared with the third quarter of 2009, and a decrease of $275.0 million, or 3.58%, compared with the fourth quarter of 2008. For the fourth quarter 2009, average core deposits (which are defined as checking accounts, savings accounts and money market savings products) increased $344.1 million, or 6.24%, compared with the third quarter 2009 and $1.1 billion, or 21.98%, compared with the fourth quarter 2008. Core deposits represented 79.16% of total average deposits, compared with 74.64% for the third quarter 2009 and 62.57% for the fourth quarter 2008. The Corporation increased average core deposits for the ninth consecutive quarter. Strategic retail and business marketing campaigns, primarily focused on new Reality Checking and Savings deposit products, drove the continued growth which began in the fourth quarter of 2007.
Average investments increased $20.8 million, or 0.76%, compared with the third quarter of 2009 and $248.3 million, or 9.93% compared with the fourth quarter of 2008. The Corporations investment portfolio yield decreased in the fourth quarter of 2009, to 4.35%, compared with 4.51% in the third quarter of 2009, and decreased from 5.01% in the fourth quarter of 2008, reflective of the declining interest rate environment.
Net interest margin was 3.64% for the fourth quarter of 2009 compared with 3.61% for the third quarter of 2009 and 3.82% for the fourth quarter of 2008, marking a third consecutive quarter of net interest margin expansion. The Corporations success both migrating existing and attracting new depository accounts into its Reality Checking and Savings products continued to reduce funding costs and positively impact the net interest margin.
Net interest income on a fully tax-equivalent (FTE) basis was $89.2 million in the fourth quarter 2009 compared with $89.1 million in the third quarter of 2009 and $94.9 million in the fourth quarter of 2008. Declining
average loan balances in the fourth quarter of 2009 compared with the third quarter of 2009 offset net interest margin expansion during the quarter.
Noninterest income net of securities transactions for the fourth quarter of 2009 was $50.8 million, an increase of $2.1 million, or 4.37%, from the third quarter of 2009 and a decrease of $0.5 million, or 0.09%, from the fourth quarter of 2008. In the fourth quarter of 2008 the Corporation recorded $5.8 million of other income from the sale of Class B Visa Inc. stock. Noninterest income net of securities transactions as a percentage of net revenue for the fourth quarter of 2009 was 36.28% compared with 35.32% for third quarter of 2009 and 35.07% for the fourth quarter of 2008. Net revenue is defined as net interest income, on an FTE basis, plus other income, less gains from securities sales.
Noninterest expense for the fourth quarter of 2009 was $94.9 million, an increase of $10.7 million, or 12.74%, from the third quarter of 2009 and an increase of $6.6 million, or 7.53%, from the fourth quarter of 2008. The fourth quarter of 2009 noninterest expenses included $2.5 million of professional services related to due diligence and acquisition expense, $1.3 million provision for unfunded lending commitments and $3.9 million related to the discontinuation of hedge accounting for a portfolio of interest rate swaps associated with fixed-rate commercial loans. For the fourth quarter of 2009, the efficiency ratio was 67.74%, compared with 61.05% for the third quarter of 2009 and 60.34% for the fourth quarter of 2008.
Net charge-offs totaled $31.2 million, or 1.79% of average loans, in the fourth quarter of 2009 compared with $18.8 million, or 1.05% of average loans, in the third quarter 2009 and $15.2 million, or 0.82% of average loans, in the fourth quarter of 2008.
Nonperforming assets totaled $101.0 million at December 31, 2009, an increase of $12.1 million, or 13.64%, compared with September 30, 2009. Nonperforming assets at December 31, 2009 represented 1.48% of period-end loans plus other real estate compared with 1.26% at September 30, 2009 and 0.77% million at December 31, 2008.
The allowance for loan losses totaled $115.1 million at December 31, 2009. At December 31, 2009, the allowance for loan losses was 1.68% of period-end loans compared with 1.66% at September 30, 2009 and 1.40% at December 31, 2008. The allowance for credit losses is the sum of the allowance for loan losses and the reserve for unfunded lending commitments. For comparative purposes the allowance for credit losses was 1.77% at December 31, 2009 compared with 1.72% at September 30, 2009 and 1.49% at December 31, 2008. The allowance for credit losses to nonperforming loans was 131.82% at December 31, 2009, compared with 153.27% at September 30, 2009 and 211.38% at December 31, 2008.
The Corporations total assets at December 31, 2009 were $10.5 billion, a decrease of $222.9 million, or 2.07%, compared with September 30, 2009 and a decrease of $561.5 million, or 5.06%, compared with December 31, 2008. Commercial loans decreased $286.2 million, or 6.58% and installment loans decreased $149.2 million or 9.48%, compared with December 31, 2008, contributing to the majority of asset declines over the prior year period.
Total deposits were $7.5 billion at December 31, 2009, an increase of $244.5 million, or 3.36%, from September 30, 2009 and an increase of $81.9 million, or 1.08%, from December 31, 2008. Core deposits totaled $6.2 billion at December 31, 2009, an increase of $576.5 million, or 10.33%, from September 30, 2009 and an increase of $1.34 billion, or 27.80%, from December 31, 2008.
Shareholders equity was $1.08 billion at December 31, 2009, compared with $1.06 billion at September 30, 2009, and $937.8 million at December 31, 2008. The Corporation maintained a strong capital position as tangible common equity to assets was 8.89% at December 31, 2009, compared with 8.65% at September 30, 2009 and 7.27% at December 31, 2008. The common cash dividend per share paid in the fourth quarter 2009 was $0.16.
Prior to 2007, the Corporation managed its operations through the major line of business Supercommunity Banking. To improve revenue growth and profitability as well as enhance relationships with customers, the Corporation moved to a line of business model during the first quarter of 2007. The major lines of business are Commercial, Retail, Wealth and Other. Note 15 (Segment Information) to the consolidated financial statements provides performance data for these lines of business.
AVERAGE CONSOLIDATED BALANCE SHEETS (Unaudited)
Fully Tax-equivalent Interest Rates and Interest Differential
FIRSTMERIT CORPORATION AND SUBSIDIARIES
RESULTS OF OPERATIONS
Net interest income, the Corporations principal source of earnings, is the difference between interest income generated by earning assets (primarily loans and investment securities) and interest paid on interest-bearing funds (namely customer deposits and wholesale borrowings). Net interest income is affected by market interest rates on both earning assets and interest bearing liabilities, the level of earning assets being funded by interest bearing liabilities, noninterest-bearing liabilities, the mix of funding between interest bearing liabilities, noninterest-bearing liabilities and equity, and the growth in earning assets.
Net interest income for the year ended December 31, 2009 was $348.8 million compared to $356.2 million for year ended December 31, 2008 and $337.5 million for the year ended December 31, 2007. The $7.4 million decrease in net interest income occurred because the $94.3 million decrease in interest income was more than the $86.9 million decrease in interest expense during the same period. For the purpose of this remaining discussion, net interest income is presented on a FTE basis, to provide a comparison among all types of interest earning assets. That is, interest on tax-free securities and tax-exempt loans has been restated as if such interest were taxed at the statutory Federal income tax rate of 35% adjusted for the non-deductible portion of interest expense incurred to acquire the tax-free assets. Net interest income presented on a FTE basis is a non-GAAP financial measure widely used by financial services corporations. The FTE adjustment for full year 2009 was $6.9 million compared with $6.0 million in 2008 and $5.5 million in 2007.
Net interest income presented on an FTE basis decreased $6.5 million or 1.80% to $355.6 million in 2009 compared to $362.2 million in 2008 and $343.0 million in 2007. The decrease from 2008 to 2009 occurred because the $93.4 million decrease in interest income was more than the $86.9 million decrease in interest expense during same period. The $19.1 million increase from 2008 to 2007 occurred because the $101.8 million decrease in interest expense was more than the $82.7 million decrease in interest income during same period. As illustrated in the following rate/volume analysis table, interest income and interest expense both decreased due to the decline in interest rates throughout the year.
The average yield on earning assets decreased 105 basis points from 5.75% in 2008 to 4.70% in 2009 decreasing interest income by $102.0 million. Higher outstanding balances on total average earning assets in 2009 caused interest income to increase $8.6 million from year-ago levels. Average balances for investment securities were up from last year increasing interest income by $12.0 million, and lower rates earned on the securities decreased interest income by $9.5 million. Average loans outstanding, down from last year, decreased 2009 interest income by $3.4 million and lower yields earned on the loans, decreased 2009 loan interest income by $92.5 million. Similarly, the average yield on earning assets decreased 103 basis points from 6.78% in 2007 to 5.75% in 2008 decreasing interest income by $100.6 million. Higher outstanding balances on total average earning assets in 2008 caused interest income to increase $16.9 million from 2007 levels. At December 31, 2008 average balances for investment securities were up from the 2007 year increased interest income by $2.5 million, and higher rates earned on the securities also increased interest income by $2.7 million. Average loans outstanding, up from 2007 year, increased 2008 interest income by $16.9 million while lower yields earned on the loans also decreased 2008 loan interest $103.4 million.
The cost of funds for the year as a percentage of average earning assets decreased 91 basis points from 2.03% in 2008 to 1.12% in 2009. The cost of funds for the year as a percentage of average earning assets decreased 113 basis points from 3.16% in 2007 to 2.03% in 2008. As discussed in the deposits and wholesale borrowings section of managements discussion and analysis of financial condition and operating results, the drop in interest rates was the primary factor in this decrease.
CHANGES IN NET INTEREST INCOME- FULLY TAX-EQUIVALENT RATE/VOLUME ANALYSIS
The net interest margin is calculated by dividing net interest income FTE by average earning assets. As with net interest income, the net interest margin is affected by the level and mix of earning assets, the proportion of earning assets funded by non-interest bearing liabilities, and the interest rate spread. In addition, the net interest margin is impacted by changes in federal income tax rates and regulations as they affect the tax-equivalent adjustment.
As discussed in the previous section, the decrease in the net interest margin during 2009 was a result of lack of loan demand and lower interest rates. The increase in 2008 over 2007 was primarily a result of the drop in interest rates and the increase in core deposits.
Excluding investment securities gains, other income totaled $204.3 million in 2009 an increase of $5.0 million or 2.49% from 2008 and an increase of $8.5 million or 4.32% from 2007. Other income as a percentage of net revenue (FTE net interest income plus other income, less gains from securities) was 36.48% compared to 35.50% in 2008. Explanations for the most significant changes in the components of other income are discussed immediately after the following table.
Trust department income decreased by 6.53%, down $1.4 million in 2009 after an increase of 4.81%, or $1.1 million in 2008 over 2007. Service charges on deposits increased by $0.5 million or 0.80% in 2009, and were down $4.5 million or 6.70% in 2008 versus 2007. The decrease in service charges on deposits during both years is due primarily to changes in customer behavior whereby they maintain higher balances in order to avoid being charged fees as well as new product initiatives that do not charge fees. Credit card fees decreased $0.5 million or 1.15% in 2009, and $0.6 million or 1.19% in 2008 over 2007 primarily due to decreasing volumes. ATM and other service charge fees have increased $0.2 million or 1.98% in 2009; this increase was volume driven. Bank owned life insurance income increased $1.7 million or 14.42% compared to 2008 which was up primarily due to death proceeds. Investment services and insurance income decreased $0.5 million in 2009 after a decrease of $0.7 in 2008 over 2007. During 2009, investment securities were sold for a gain of $3.9 million up 183.96% from 2008. Loan sales and servicing income increased $6.0 million or 86.66% in 2009 after a decrease of $3.4 million or 32.69% in 2008 over 2007. This increase was primarily attributable to mortgage modifications. During the first quarter of 2009, the Corporation recorded $9.5 million due to the curtailment of the postretirement medical plan for active employees. During the fourth quarter of 2008, the Corporation recorded $5.8 million from the sale of Class B Visa, Inc stock. This followed a $7.9 million gain from the partial redemption of the shares in the first quarter of 2008. During the first quarter of 2007 $4.1 million of net gains were recorded from the commercial loan sale more fully described in the Asset Quality section of this report.
Federal income tax expense totaled $25.6 million in 2009 compared to $48.9 million in 2008 and $50.4 million in 2007. The effective federal income tax rate for the year ended December 31, 2009 was 23.79%, compared to 29.04% and 29.05% for the year ended December 31, 2008 and 2007, respectively. Tax reserves have been specifically estimated for potential at-risk items in accordance with ASC 740, Income Taxes. Further federal income tax information is contained in Note 11 (Federal Income Taxes) to the consolidated financial statements.
Other expenses were $352.8 million in 2009 compared to $330.6 million in 2008 and $330.2 million in 2007, an increase of $22.2 million or 6.71% over 2008 and an increase of $22.6 million or 6.84% over 2007.
Salaries and wages were $132.6 million in 2009, a decrease of $0.4 million or 0.34% over 2008. There was an increase in salaries and wages in from 2007 to 2008 of $6.4 million or 5.05%. Increases generally reflect the annual employee merit increases which were offset by decrease in headcount. Pension and employee benefits were $43.3 million in 2009, a decrease of $3.1 million or 6.70% from 2008, primarily due to the reduction in the ongoing expense resulting from the curtailment of the postretirement medical plan for active employees. Note 12 (Benefit Plans) to the consolidated financial statements more fully describes the changes in pension and postretirement medical expenses. Professional services expenses increased $4.7 million or 40.35% in 2009 over 2008 due in part to an increase in acquisition due diligence activity. During 2008, the economic environment caused higher levels of bank failures which dramatically increased FDIC resolution costs. The FDIC significantly increased assessments during 2009 which resulted in additional FDIC insurance expense of $15.2 million over 2008 which is recorded in other operating expense.
Also included in other expense is $3.9 million related to the discontinuation of hedge accounting for a portfolio of interest rate swaps associated with fixed-rate commercial loans. In December 2009, the Corporation corrected an error in hedge accounting for a portfolio of interest rate swaps associated with fixed-rate commercial loans recorded in prior periods. The Corporation assessed the materiality of the error in accordance with Staff Accounting Bulletin (SAB) No. 108 and concluded the error was not material, either individually or in the aggregate, to the results of operations of any prior period or for the year ending December 31, 2009, to trends for those periods affected, or to a fair presentation of the Corporations financial statements for those periods. Accordingly, results for prior periods have not been restated. Instead, the Corporation increased other expenses and reduced the commercial loans balance by $3.9 million to correct this error in the fourth quarter. In addition, this portfolio of interest rate swaps was terminated in January 2010.
The efficiency ratio for 2009 was 62.95%, compared to 58.78% in 2008 and 61.12% in 2007. The lower is better efficiency ratio indicates the percentage of operating costs that are used to generate each dollar of net revenue that is during 2009, 62.95 cents were spent to generate each $1 of net revenue. Net revenue is defined as net interest income, on a tax-equivalent basis, plus other income less gains from the sales of securities.
At December 31, 2009, the securities portfolio totaled $2.7 billion; $50.7 million of that amount was held-to-maturity securities and the remainder was securities available-for-sale. In comparison, as of December 31, 2008, the total portfolio was $2.8 billion, including $30.3 million of held-to-maturity securities and $2.6 billion of securities available-for-sale.
Available-for-sale securities are held primarily for liquidity, interest rate risk management and long-term yield enhancement. Accordingly, the Corporations investment policy is to invest in securities with low credit risk, such as U.S. Treasury securities, U.S. Government agency obligations, state and political obligations and mortgage-backed securities (MBSs). Held-to-maturity securities consist principally of securities issued by state and political subdivisions. Other investments include Federal Home Loan Bank (FHLB) and Federal Reserve Bank (FRB) stock.
Net unrealized gains were $55.1 million at December 31, 2009, compared to $1.2 million at December 31, 2008. The improvement in the fair value of the investment securities is driven by government agency securities held in portfolio.
The Corporation conducts a regular assessment of its investment securities to determine whether any securities are other-than-temporary impaired. Only the credit portion of other-than-temporary impairment (OTTI) is to be recognized in current earnings for those securities where there is no intent to sell or it is more likely than not the Corporation would not be required to sell the security prior to expected recovery. The remaining portion of OTTI is to be included in accumulated other comprehensive loss, net of income tax.
Gross unrealized losses of $21.6 million as of December 31, 2009, compared to $38.3 million at December 31, 2008 were concentrated within trust preferred securities held in portfolio. The Corporation holds eight, single issuer, trust preferred securities. Such investments are less than 2% of the fair value of the entire investment portfolio. None of the bank issuers have deferred paying dividends on their issued trust preferred shares in which the Corporation is invested. The fair values of these investments have been impacted by market conditions which have caused risk premiums to increase markedly resulting in the decline in the fair value of the Corporations trust preferred securities.
Further detail of the composition of the securities portfolio and discussion of the results of the most recent OTTI assessment are in Note 3 (Investment Securities) to the consolidated financial statements.
Total loans outstanding at year-end 2009 decreased 6.76% to $6.9 billion compared to one year ago, at $7.4 billion.
The following tables breakdown outstanding loans by category and provide a maturity summary of commercial loans.
Consistent with the slowdown of the manufacturing-based economy in Northeast Ohio commercial loans decreased 6.58% in 2009 but increased 11.42% in 2008. The 2009 decrease was partially mitigated by the ABL Loans acquired from First Bank Business Capital, Inc. Single-family mortgage loans continue to be originated by the Corporations mortgage subsidiary and then sold into the secondary mortgage market or held in portfolio. Low interest rates during 2009 resulted in an increase in mortgage loan originations; however, due to the downturn in the housing market there was an overall decrease of 15.30% in balances retained in portfolio.
Outstanding home equity loan balances increased $19.3 million or 2.63% from December 31, 2008 and installment loans decreased $149.2 million or 9.48% reflecting the on-going economic downturn. Credit card loans were up $3.8 million or 2.52% from December 31, 2008.
There is no predominant concentration of loans in any particular industry or group of industries. Most of the Corporations business activity is with customers located within the state of Ohio.
The Corporation maintains what Management believes is an adequate allowance for loan losses. The Corporation and FirstMerit Bank regularly analyze the adequacy of their allowance through ongoing review of trends in risk ratings, delinquencies, nonperforming assets, charge-offs, economic conditions, and changes in the composition of the loan portfolio. Notes 1 and 4 to the consolidated financial statements provide detailed information regarding the Corporations credit policies and practices.
The Corporation uses a vendor based loss migration model to forecast losses for commercial loans. The model creates loss estimates using twelve-month (monthly rolling) vintages and calculates cumulative three years loss rates within two different scenarios. One scenario uses five year historical performance data while the other one uses two year historical data. The calculated rate is the average cumulative expected loss of the two and five year data set. As a result, this approach lends more weight to the more recent performance and would be more conservative.
The uncertain economic conditions in which we are currently operating have resulted in risks that differ from our historical loss experience. Accordingly, Management deemed it appropriate and prudent to apply qualitative factors (q-factors) and assign additional reserves. These q-factors are supported by judgments made by experienced credit risk management personnel and represent risk associated with the portfolio given the uncertainty and the inherent imprecision of estimating future losses.
At December 31, 2009 the allowance for loan losses was $115.1 million or 1.68% of loans outstanding, compared to $103.8 million or 1.40% at year-end 2008. The allowance equaled 125.55% of nonperforming loans at year-end 2009 compared to 198.76% at year-end 2008. During 2008 additional reserves were established to address identified risks associated with the slow down in the housing markets and the decline in residential and commercial real estate values. These reserves totaled $19.1 million at year-end 2009 and $18.3 million at year-end 2008. The increase in the
additional allocation augmented the increase in the calculated loss migration analysis as the loans were downgraded during 2009. Nonperforming loans have increased by $43.4 million over December 31, 2008 primarily attributable to the declining economic conditions.
As required by current accounting guidance, the acquired ABL loans from FBBC were recorded at fair value as of the date of acquisition, with no carryover of related allowances. The determination of the fair value of the ABL loans resulted in a write-down in the value of the loans, which was assigned to an accretable balance with the accretable balance being recognized as interest income over the remaining term of the loan. Because acquired loans are required to be accounted for at fair value on the date of acquisition, Management believes that asset quality measures excluding the acquired ABL loans are generally more meaningful. Therefore, the asset quality ratios included herein exclude these acquired ABL loans.
Net charge-offs were $87.1 million in 2009 compared to $49.1 million in 2008 and $28.0 million (including the loans held for sale) in 2007. As a percentage of average loans outstanding, net charge-offs and allowance for loans held for sale equaled 1.22% in 2009, 0.68% in 2008 and 0.40% in 2007. Losses are charged against the allowance for loan losses as soon as they are identified.
The allowance for unfunded lending commitments at December 31, 2009, 2008 and 2007 was $5.8 million, $6.6 million and $7.4 million, respectively. The allowance for credit losses, which includes both the allowance for loan losses and the reserve for unfunded lending commitments, amounted to $120.8 million at year-end 2009, $110.3 million at year-end 2008 and $101.6 million at year-end 2007.
Allowance for Credit Losses
The following tables display the components of the allowance for loan losses at December 31, 2009, 2008 and 2007.
A five-year summary of activity follows:
Making a loan to earn an interest spread inherently includes taking the risk of not being repaid. Successful management of credit risk requires making good underwriting decisions, carefully administering the loan portfolio and diligently collecting delinquent accounts.
The Corporations Credit Policy Division manages credit risk by establishing common credit policies for its subsidiaries, participating in approval of their largest loans, conducting reviews of their loan portfolios, providing them with centralized consumer underwriting, collections and loan operations services, and overseeing their loan workouts. Notes 1 and 4 to the consolidated financial statements, provide detailed information regarding the Corporations credit policies and practices.
The Corporations objective is to minimize losses from its commercial lending activities and to maintain consumer losses at acceptable levels that are stable and consistent with growth and profitability objectives.
Nonperforming Loans are defined as follows:
Nonperforming Assets are defined as follows:
During 2009 the economic conditions in our markets continued to be challenging. Residential developers and homebuilders have been the most adversely affected, with the significant decrease of buyer resulting from a combination of the restriction of available credit and economic pressure impacting the consumer. The Corporation executed a comprehensive review of pass grade commercial loans (greater than $250 thousand) corporate-wide utilizing a more conservative interpretation of defined weakness. The review, coordinated by Loan Review, resulted in covering over 71% of the commercial portfolio. Consumers continue to be under pressure due to high debt levels, limited refinance opportunities, increased cost of living and increasing unemployment. These conditions have resulted in increases in bankruptcies as well as charge offs. Commercial nonperforming loans increased $33.8 million while criticized loans increased $73.2 million from December 31, 2008.
During the first quarter of 2007, $73.7 million of commercial loans and $7.1 million of other real estate were sold. The loans were written down to their fair market value of $50.6 million and reclassified as loans held for sale in the fourth quarter of 2006. (Of the loans identified as held for sale, $41.1 million were classified as nonperforming and
$32.6 million were performing.) The loan sale yielded a gain of $4.1 million which was recorded in loan sales and servicing during the first quarter of 2007. The sale of other real estate resulted in a $0.5 million loss and was recorded in other operating loss also during the first quarter of 2007.
In 2009 nonperforming assets, other real estate includes $1.0 million of vacant land no longer considered for branch expansion and in 2008 other real estate includes $1.1 million of vacant land no longer considered for branch expansion and executive relocation properties both of which are not related to loan portfolios.
During 2009 and 2008, total nonperforming loans earned $51.8 thousand and $36.7 thousand, respectively, in interest income. Had they been paid in accordance with the payment terms in force prior to being considered impaired, on nonaccrual status, or restructured, they would have earned $5.5 million and $2.7 million in interest income for the years ended December 31, 2009 and 2008, respectively.
In addition to nonperforming loans and loans 90 day past due and still accruing interest, Management identified potential problem commercial loans (classified as substandard and doubtful) totaling $260.1 million at year-end 2009 and $194.4 million at year-end 2008. These loans are closely monitored for any further deterioration in the borrowers financial condition and for the borrowers ability to comply with terms of the loans.
Nonaccrual commercial loans have increased $33.8 million since December 31, 2008.
Deposits, Securities Sold Under Agreements to Repurchase and Wholesale Borrowings
Average deposits for 2009 totaled $7.5 billion compared to $7.4 billion in 2008. Increases in non-interest bearing and interest bearing demand accounts reflect a shift in customer preference for liquidity.
The following ratios and table provide additional information about the change in the mix of customer deposits.
Total average demand deposits comprised 34.18% of average deposits in 2009 compared to 29.89% in 2008 and 28.74% in 2007. Savings accounts, including money market products, made up 38.44% of average deposits in 2009 compared to 32.34% in 2008 and 30.40% in 2007. CDs made up 27.38% of average deposits in 2009, 37.77% in 2008 and 40.86% in 2007.
The average cost of deposits, securities sold under agreements to repurchase and wholesale borrowings was down 104 basis points compared to one year ago, or 1.46% in 2009 due to a drop in interest rates and the disruption in the capital markets.
The following table summarizes CDs in amounts of $100 thousand or more as of year-end 2009, by time remaining until maturity.
The capital management objectives of the Corporation are to provide capital sufficient to cover the risks inherent in the Corporations businesses, to maintain excess capital to well-capitalized standards and to assure ready access to the capital markets.
Shareholders equity was $1,065.6 million at December 31, 2009, compared with $937.8 million at December 31, 2008. As of December 31, 2009, the annual common share dividend was $0.77. The market price ranges of the Corporations common shares, and dividends by quarter for each of the last two years is shown in Item 5, Market For Registrants Common Equity And Related Stockholder Matters And Issuer Purchases Of Equity Securities of this Report.
On January 9, 2009, the Corporation completed the sale to the United States Department of the Treasury (the Treasury) of $125.0 million of newly issued FirstMerit non-voting preferred shares as part of the Treasurys Troubled Assets Relief Program (TARP) Capital Purchase Program (CPP). FirstMerit issued and sold to the Treasury for an aggregate purchase price of $125.0 million in cash (1) 125,000 shares of FirstMerits Fixed Rate Cumulative Perpetual Preferred Shares, Series A, each without par value and having a liquidation preference of $1,000 per share, and (2) a warrant to purchase 952,260 FirstMerit common shares, each without par value, at an exercise price of $19.69 per share.
On April 22, 2009, the Corporation repurchased all 125,000 shares of its Fixed Rate Cumulative Perpetual Preferred Stock, Series A for $126.2 million which included all accrued and unpaid dividends as well as the unamortized discount on the preferred stock.
On May 27, 2009, the Corporation completed the repurchase of the warrant held by the Treasury. The Corporation paid $5.0 million to the Treasury to repurchase the warrant.
On May 6, 2009, the Corporation entered into a Distribution Agency Agreement with Credit Suisse Securities (USA) LLC (Credit Suisse) pursuant to which the Corporation, from time to time, may offer and sell shares of the Corporations common stock. Sales of the common stock are made by means of ordinary brokers transactions on the Nasdaq Global Select Market at market prices, in block transactions, or as otherwise agreed with Credit Suisse. At
December 31, 2009, the Corporation had sold 4.3 million shares with an average value of $18.98 per share and has authorization to raise an additional $19.0 million through this program.
Capital adequacy is an important indicator of financial stability and performance. The Corporation maintained a strong capital position as tangible common equity to assets was 8.89% at December 31, 2009, compared with 7.27% at December 31, 2008.
Financial institutions are subject to a strict uniform system of capital-based regulations. Under this system, there are five different categories of capitalization, with prompt corrective actions and significant operational restrictions imposed on institutions that are capital deficient under the categories. The five categories are: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.
To be considered well capitalized an institution must have a total risk-based capital ratio of at least 10%, a Tier I capital ratio of at least 6%, a leverage capital ratio of at least 5%, and must not be subject to any order or directive requiring the institution to improve its capital level. An adequately capitalized institution has a total risk-based capital ratio of at least 8%, a Tier I capital ratio of at least 4% and a leverage capital ratio of at least 4%. Institutions with lower capital levels are deemed to be undercapitalized, significantly undercapitalized or critically undercapitalized, depending on their actual capital levels. The appropriate federal regulatory agency may also downgrade an institution to the next lower capital category upon a determination that the institution is in an unsafe or unsound practice. Institutions are required to monitor closely their capital levels and to notify their appropriate regulatory agency of any basis for a change in capital category. At year-end 2009 the Corporation, on a consolidated basis, as well as FirstMerit Bank, exceeded the minimum capital levels of the well capitalized category.
Market Risk Management
Market risk refers to potential losses arising from changes in interest rates, foreign exchange rates, equity prices and commodity prices, including the correlation among these factors and their volatility. When the value of an instrument is tied to such external factors, the holder faces market risk. The Corporation is primarily exposed to interest rate risk as a result of offering a wide array of financial products to its customers.
Interest rate risk management
Changes in market interest rates may result in changes in the fair market value of the Corporations financial instruments, cash flows, and net interest income. The Corporation seeks to achieve consistent growth in net interest income and capital while managing volatility arising from shifts in market interest rates. The Asset and Liability Committee (ALCO) oversees market risk management, establishing risk measures, limits, and policy guidelines for managing the amount of interest rate risk and its effect on net interest income and capital. According to these policies, responsibility for measuring and the management of interest rate risk resides in the Corporate Treasury function.
Interest rate risk