Provident Bankshares 10-K 2005
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For Fiscal Year Ended December 31, 2004
For the Transition Period From to .
Commission File Number 0-16421
PROVIDENT BANKSHARES CORPORATION
(Exact Name of Registrant as Specified in its Charter)
114 East Lexington Street, Baltimore, Maryland 21202
(Address of Principal Executive Offices)
(Registrants Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Name of each exchange on which registered
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $1.00 per share
$0.55 Redeemable Capital Securities
10% Trust Preferred Securities
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K(§229.405 of this Chapter) 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/A or any amendment to this Form 10-K/A. ¨
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant as of the last sold price or average bid and asked price as of last business day of most recently completed second fiscal quarter was $939,261,207. For purposes of this calculation, officers and directors of the Registrant are considered affiliates.
At March 10, 2005, the Registrant had 33,019,483 shares of $1.00 par value common stock outstanding.
This Amendment to Form 10-K (this Amendment) is being filed by Provident Bankshares Corporation (the Corporation) to amend its Annual Report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission (the SEC) on March 10, 2005 (the Initial Form 10-K). As previously reported in the Corporations Form 10-Q for the period ended September 30, 2005, this Amendment is required due to the restatement of financial statements included in the Initial Form 10-K related to corrections of errors related to the Corporations accounting for derivatives under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). As a result of errors in the application of the short-cut method, the Corporation was precluded from applying hedge accounting to various derivative instruments as described in NOTE 2. This Amendment restates Consolidated Financial Statements for the year ended December 31, 2004. For information regarding the restatement, see Item 7 our Consolidated Financial Statements contained herein. This Amendment includes a restatement, which changes Part I, Item 1 and Part II, Items 6,7,8 and 9A, including related changes to the disclosures in Managements Discussion and Analysis of Financial Condition and Results of Operations. This Amendment also includes changes in Controls and Procedures to reflect managements revised assessment of the Corporations disclosure controls and procedures as of December 31, 2004.
Except as otherwise specifically noted, all information contained herein is as of December 31, 2004 and does not reflect any events or changes that have occurred subsequent to that date.
This report, as well as other written communications made from time to time by Provident Bankshares Corporation and its subsidiaries (the Corporation) (including, without limitation, the Corporations 2004 Annual Report to Stockholders) and oral communications made from time to time by authorized officers of the Corporation, may contain statements relating to the future results of the Corporation (including certain projections and business trends) that are considered forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995 (the PSLRA). Such forward-looking statements may be identified by the use of such words as believe, expect, anticipate, should, planned, estimated, intend and potential. Examples of forward-looking statements include, but are not limited to, possible or assumed estimates with respect to the financial condition, expected or anticipated revenue, and results of operations and business of the Corporation, including earnings growth determined using U.S. generally accepted accounting principles (GAAP); revenue growth in retail banking, lending and other areas; origination volume in the Corporations consumer, commercial and other lending businesses; asset quality and levels of non-performing assets; current and future capital management programs; non-interest income levels, including fees from services and product
sales; tangible capital generation; market share; expense levels; and other business operations and strategies. For these statements, the Corporation claims the protection of the safe harbor for forward-looking statements contained in the PSLRA.
The Corporation cautions you that a number of important factors could cause actual results to differ materially from those currently anticipated in any forward-looking statement. Such factors include, but are not limited to: the factors identified in the Corporations Form 10-K/A for the fiscal year ended December 31, 2004 under the headings Forward-Looking Statements and Risk Factors, prevailing economic conditions, either nationally or locally in some or all areas in which the Corporation conducts business or conditions in the securities markets or the banking industry; changes in interest rates, deposit flows, loan demand, real estate values and competition, which can materially affect, among other things, consumer banking revenues, revenues from sales on non-deposit investment products, origination levels in the Corporations lending businesses and the level of defaults, losses and prepayments on loans made by the Corporation, whether held in portfolio or sold in the secondary markets; changes in the quality or composition of the loan or investment portfolios; the Corporations ability to successfully integrate any assets, liabilities, customers, systems and management personnel the Corporation may acquire into its operations and its ability to realize related revenue synergies and cost savings within expected time frames; the Corporations timely development of new and competitive products or services in a changing environment, and the acceptance of such products or services by customers; operational issues and/or capital spending necessitated by the potential need to adapt to industry changes in information technology systems, on which it is highly dependent; changes in accounting principles, policies, and guidelines; changes in any applicable law, rule, regulation or practice with respect to tax or legal issues; risks and uncertainties related to mergers and related integration and restructuring activities; conditions in the securities markets or the banking industry; changes in the quality or composition of the investment portfolio; litigation liabilities, including costs, expenses, settlements and judgments; or the outcome of other matters before regulatory agencies, whether pending or commencing in the future; and other economic, competitive, governmental, regulatory and technological factors affecting the Corporations operations, pricing, products and services. Additionally, the timing and occurrence or non-occurrence of events may be subject to circumstances beyond the Companys control. Readers are cautioned not to place undue reliance on these forward-looking statements which are made as of the date of this report, and, except as may be required by applicable law or regulation, the Corporation assumes no obligation to update the forward-looking statements or to update the reasons why actual results could differ from those projected in the forward-looking statements.
Item 1. Business
Provident Bankshares Corporation (the Corporation), a Maryland corporation, is the bank holding company for Provident Bank (Provident or the Bank), a Maryland chartered stock commercial bank. At December 31, 2004, the Bank was the second largest independent commercial bank, in asset size, headquartered in Maryland, with $6.6 billion in assets. Provident is a regional bank serving Maryland and Virginia, with emphasis on the key urban centers within these states the Baltimore, Washington and Richmond metropolitan areas.
Providents principal business is to acquire deposits from individuals and businesses and to use these deposits to fund loans to individuals and businesses. Provident also offers related financial services through wholly owned subsidiaries. Securities brokerage, investment management and related insurance services are available through Provident Investment Company (PIC) and leases through Court Square Leasing and Provident Lease Corporation.
The Corporations Internet website is www.provbank.com. The Corporation makes available free of charge on or through its website its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after the Corporation electronically files such material with, or furnishes it to, the Securities and Exchange Commission (SEC).
With banking offices throughout most of Maryland and a growing presence in Virginia, Provident serves one of the most vibrant regions in the country. As of June 2004 (the most recently available statewide deposit share data), Provident ranked eighth among commercial banks operating in Maryland with 4.01% share of statewide deposits. Providents share of deposits in Virginia increased to 0.4% in 2004.
Marylands economy is performing at or above national levels, based on the most current data on unemployment and job growth. In addition, Maryland has the second highest median income in the country. Metropolitan Baltimore is a regional center for the shipping and trucking industries given its deepwater harbor and proximity to Interstate 95. As a consequence, it is also a major provider of warehouse operations for retail distribution and logistics providers. Importantly, this metropolitan area is diversifying from a blue-collar to a white-collar business environment. It is gaining from such major employers as John Hopkins University and Health Systems, Northrop Grumman, Verizon, Baltimore Gas and Electric and the University of Maryland Medical Systems.
To complement its presence in the attractive Maryland market, Provident has expanded into Virginia. Northern Virginia is the fastest growing area in Virginia and is home to nearly two million people. The technology sector, one of the largest in the United States, has been growing vigorously in the region. Residential construction continues to highlight northern Virginias economic strengths. At nearly $85,000, the northern Virginia region also has one of the highest median incomes in the country.
Important to both Maryland and Virginia is the accessibility to other key neighboring markets such as Philadelphia, New York and Pittsburgh, as well as the ports in Baltimore and Norfolk. In addition, the Baltimore-Washington corridor gains from the presence and employment stability of the federal government and related service industries. The market has benefited from increased federal spending, particularly in the defense and security sectors. In addition, the region stands to expand economically through anticipated growth in health care and educational spending in the near term.
Provident is well positioned in its region to provide the products and services of its largest competitors, while delivering the level of service provided by the best community banks. Over the past several years, the Corporations focus has been on the consistent execution of a group of fundamental business strategies: to broaden its presence and customer base in the Virginia and metropolitan Washington D.C. markets; to grow its commercial business in all of its markets; to focus its resources in core business lines; and to improve financial fundamentals.
Efforts against these strategies were accelerated with the merger with Southern Financial Bancorp, Inc. of Warrenton, Virginia (Southern Financial), which was finalized on April 30, 2004. The addition of Southern Financials franchise supports the Banks strategy to expand in the Virginia and metropolitan Washington markets. The merger also complements the Banks strategy to enhance its consumer and commercial business lines, as Southern Financials commercial banking strength is combined with Providents proven ability to attract consumer loans and low cost deposits. Southern Financials deposit and loan customer base was converted to Providents core processing system on May 31, 2004. On October 15, 2004, the Corporation sold three Norfolk/Tidewater banking offices that were acquired in the merger because these branches were outside of Providents strategic footprint. On December 1, 2004, the Corporation sold its 24.99% interest in a loan servicing company acquired in the merger. There was no gain or loss associated with the settlement of these transactions.
With the completion of the acquisition of Southern Financial and the related transition into Provident, the strategic focus of the organization has been more clearly defined. At a high level, these strategies are to:
Through these strategies, Provident provides its products and services to three segments of customers individuals, small businesses and middle market businesses. The Corporation offers consumer and commercial banking products and services through the Consumer Banking group and the Commercial Banking group.
Consumer banking services include a broad array of consumer and small business loan, lease, deposit and investment products offered to retail and commercial customers through Providents banking office network and Provident Direct, the Banks direct channel sales center that serves consumers via the Internet and in-bound and out-bound telephone operations. The small business segment is further supported by relationship managers who provide comprehensive business product and sales support to expand existing customer relationships and acquire new clients.
Commercial Banking provides an array of commercial financial services to middle market commercial customers. The Bank has an experienced team of loan officers with expertise in real estate and business lending to companies in various industries in the region. The Bank has a suite of cash management products managed by responsive account teams that deepen customer relationships through consistently priced deposit based services.
The cornerstone of the Banks ability to serve its customers is its banking office network, which consists of 89 traditional banking office locations and 60 in-store banking offices at December 31, 2004. In 1993, Provident was the first Maryland bank to offer in-store banking which enables customers to bank where they shop, seven days a
week. Today, the network of 60 in-store banking offices is located in a broad range of supermarkets and national retail superstores. The Banks primary agreements are with four premier store partners: SUPERVALU to operate banking offices in their Shoppers Food Warehouse supermarkets in Maryland and Virginia, WalMart and BJs Wholesale Club to operate banking offices in selected Baltimore and Washington, D.C. metropolitan stores, and SuperFresh to operate banking offices in selected Maryland stores.
Of the 149 banking offices at December 31, 2004, 44% are located in the Baltimore metropolitan region and 56% are located in the metro Washington and Virginia regions, reflecting the successful development of the Bank into a highly competitive regional commercial bank. The merger with Southern Financial, net of the banking offices sold on October 15, 2004, added 30 traditional banking offices in the Washington and Richmond metropolitan areas. These offices complement Providents existing network of in-store banking offices in the Washington region. Provident opened two new in-store banking offices and consolidated one in-store banking office into another existing location during 2004 in the Washington metropolitan area. Additional banking office opportunities complementary to existing locations will be sought when the cost of entry is reasonable. The Bank has several new banking offices in various stages of planning. Provident also offers its customers 24-hour banking services through ATMs, telephone banking and the Internet. The network of 241 ATMs enhances the banking office network by providing customers increased opportunities to access their funds.
Provident offers a diversified mix of residential and commercial real estate, business and consumer loans and leases. The following table sets forth information concerning the Banks loan portfolio by type of loan at December 31.
Loan Portfolio Summary:
Contractual Loan Principal Repayments
The following table presents contractual loan maturities and interest rate sensitivity at December 31, 2004. The cash flow from loans is expected to significantly exceed contractual maturities due to refinances and early payoffs.
Loan Maturities and Rate Sensitivity:
A wide range of loans including installment loans secured by real estate, boats, or automobiles, home equity lines, and unsecured personal lines of credit are available to consumers. At December 31, 2004, consumer loans represented 52% of the total loan portfolio. Of these loans, 74% are secured by residential real estate, 24% by boats or automobiles, and 2% are unsecured.
The banking office network and ProvidentDirect are the origination sources for new home equity loans and lines and other direct consumer loans, representing 21% of total loans. For the origination of marine loans, representing 12% of total loans, the Bank utilizes a network of correspondent brokers as the source of loan applications from key boating areas across the country. Provident individually underwrites each loan, including both credit and loan to value considerations.
The Bank also purchases portfolios of loans (consisting of first mortgages, home equity loans and lines) secured by residential real estate from other financial services companies. All acquired portfolios go through a due diligence process prior to a purchase commitment. Over the past several years, the Bank has increased its credit quality requirements for new acquisitions and shifted its lien position focus from predominantly second lien position to entirely first lien position. At December 31, 2004, approximately 82% of the acquired portfolio was in first lien position. Management intends to continue to purchase loans secured by residential real estate to maintain an average acquired portfolio size of approximately $600 million.
The residential real estate mortgage portfolio consists of loans originated by a subsidiary of the Bank prior to 2001, as well as loans originated by Southern Financial prior to its merger with the Bank. The Bank currently provides mortgages to its consumer customers through a third party loan processor, and does not retain any of the mortgages originated from that process. At December 31, 2004, the portfolio of residential real estate mortgage loans represented 5% of consumer loans.
Commercial Real Estate Lending
The Banks commercial real estate lending focus has been on financing commercial and residential construction, as well as on intermediate-term commercial mortgages. Properties securing these loans include office buildings, shopping centers, apartment complexes, warehouses, hotels and tract developments. These portfolios totaled $1.0 billion at December 31, 2004, or 28% of total loans.
Commercial Business Lending
Provident makes business loans primarily to small and medium sized businesses in the Baltimore, Maryland and Washington, D.C. metropolitan areas. Within this context, the Bank is well diversified from an industry perspective with no major concentrations in any industry. Commercial business loans represent 20% of the Banks total loans, and consist of term loans, equipment leases and revolving lines of credit for the purpose of current asset financing, equipment purchases, owner occupied real estate financing and business expansion. Commercial business loans are originated directly from offices in Baltimore City and Montgomery County, Maryland, Fairfax County and Richmond, Virginia, as well as the Banks banking office network. Leases originated by Court Square Leasing, which utilizes a network of vendors to source small equipment leases, and Provident Lease Corporation, which originates general equipment leases, represented 16% of the commercial business portfolio at December 31, 2004.
At December 31, 2004, the Bank participated in $72.8 million of loans syndicated by other financial institutions, of which $44.9 million was included in commercial business loans and $27.9 million was included in commercial real estate loans. The Bank has minimal exposure to highly leveraged transactions (HLTs), which are loans to borrowers for the purpose of purchasing or recapitalizing a business in which the loans represent a majority of the borrowers liabilities. HLTs totaled $7.2 million as of December 31, 2004, and all are performing in accordance with their contractual terms.
Non-Performing Assets and Delinquent Loans
Non-performing assets include non-accrual loans, renegotiated loans and real estate and other assets that have been acquired through foreclosure or repossession. The Corporations credit procedures require monitoring of commercial credits to determine the collectibility of contractually due principal and interest to assess the need for providing for inherent losses. If a loan is identified as impaired, it is placed on non-accrual status. At December 31, 2004, commercial loans totaling $15.1 million were considered to be impaired.
Delinquencies occur in the normal course of business. The Corporation focuses its efforts on the management of loans that are in various stages of delinquency. These include loans that are 90 days or more delinquent that are still accruing interest because they are well secured and in the process of collection. Closed-end consumer loans secured by non-residential collateral are generally charged-off to the collaterals fair value less costs to sell (net fair value) at 120 days delinquent. Unsecured open-end consumer loans are charged-off in full at 180 days delinquent. Demand deposit overdrafts that have been reclassified as loans generally are charged off in full at 60 days delinquent. Loans secured by residential real estate are placed on non-accrual status at 120 days delinquent, unless well secured and in the process of collection. Any portion of an outstanding loan balance secured by residential real estate in excess of the net fair value is charged-off when it is no more than 180 days delinquent. Regardless of collateral value, with isolated exceptions, these loans are placed on non-accrual status at 210 days delinquent. Commercial loans are placed on non-accrual status at 90 days delinquent unless well secured and in the process of collection. Charge-offs of delinquent loans secured by commercial real estate are generally recognized when losses are reasonably estimable and probable.
The table below presents the average deposit balances and rates paid for the three years ended December 31, 2004.
Average deposits obtained from customers (rather than brokers) represented over 90% of the Banks deposit funding in 2004 and 2003, compared to 71% in 2001, achieving managements strategic goal to shift the mix of deposits to customer deposits. Customer deposits are generated by cross sales and calling efforts of the banking office and commercial cash management sales force. At December 31, 2004, deposits were evenly balanced between transaction accounts, savings accounts and time deposits. As a result of the banking office expansion efforts, including the Southern Financial merger, approximately 38% of customer deposit balances at year-end were from Virginia and the Washington metropolitan area. Further, the percentage of commercial deposits continued to improve, with commercial deposit balances representing 22% of customer deposits at year-end.
Transaction accounts remain a key part of the Banks deposit gathering strategy. Transaction accounts not only serve as an important cross-sell tool in terms of deepening customer relationships, but also are an important source of fee income to the Bank. Totally Free Checking, a product that Provident introduced to the Baltimore area in 1993, remains the Banks most popular checking account product. Management believes its checking account products, combined with the Banks service options available through both traditional and in-store banking offices, ensure that Provident remains a leader in the deposit gathering process.
In the face of competitive pressure, Provident has determined that it competes most effectively by being the right size bank. Management believes Provident is the right size bank because it continues to provide the products and services of its largest competitors, while delivering the level of service found in only the best community banks.
The Treasury Division manages the wholesale segments of the balance sheet, including investments, purchased funds, long-term debt and derivatives. Managements objective is to achieve the maximum level of stable earnings over the long term, while controlling the level of interest rate and liquidity risk, and optimizing capital utilization. Treasury strategies and activities are overseen by the Banks Asset / Liability Committee (the ALCO), which also reviews all trades. ALCO activities are summarized and reviewed monthly with the Corporations Board of Directors.
At December 31, 2004, the investment securities portfolio was $2.3 billion, or 35% of total assets. The portfolio objective is to obtain the maximum sustainable interest margin over match-funded borrowings, subject to liquidity, credit and interest rate risk; as well as capital, regulatory and economic considerations. Typically, management classifies securities as available for sale to maximize management flexibility, although securities may be purchased with the intention of holding to maturity.
The following table sets forth information concerning the Corporations investment securities portfolio at December 31 for the periods indicated.
Investment Securities Summary:
The following table presents the expected cash flows and interest yields of the Banks investment securities portfolio at December 31, 2004.
Investment Securities Portfolio:
To achieve its stated objective, the Corporation invests predominantly in U.S. Treasury and Agency securities, mortgage-backed securities (MBS) and other debt securities, which include corporate bonds and asset-backed securities. At December 31, 2004, 72% of the investment portfolio was invested in MBS. The MBS portfolio is well diversified with respect to issuer, both agency and non-agency; structure, including passthroughs and collateralized mortgage obligations (CMOs); and re-pricing specifications, which employ fixed rate bonds as well as monthly, annual, and 5 to 7 year reset Adjustable Rate Mortgages (ARMs). Issuer, coupon, vintage, maturity, and average loan size further diversify the agency MBS portfolio. The asset-backed securities (ABS) portfolio, representing 17% of the total portfolio, consists predominantly of Aaa and single A rated tranches of pooled trust preferred securities. Other debt securities representing 6% of the portfolio at December 31, 2004, are primarily invested in single issuer securities rated investment grade by Moodys and S&P rating agencies.
The primary risk in the investment portfolio is duration risk. Duration measures the expected change in the market value of an investment for a 100 basis point (or 1%) change in interest rates. The higher an investments duration, the longer the time until its rate is reset to current market rates. The Banks risk tolerance, as measured by the duration of the investment portfolio, is typically between 2% and 4%. In the current economic environment, the duration is targeted for the middle of that range. In 2004, $275 million of floating rate ABS were added to the portfolio to reduce the overall portfolio duration risk and increase asset sensitivity to short-term rate changes. Another risk in the investment portfolio is credit risk. At December 31, 2004, over 82% of the entire investment portfolio was rated AAA, 17% was investment grade below AAA, and 1% was rated below investment grade or was not rated. The AAA rated percentage declined from December 31, 2003 due to the increased allocation to A and AA rated floating rate ABS.
Investment securities are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized. The Corporation had a limited number of securities in a continuous loss position for 12 months or more at December 31, 2004. Because the declines in fair value were due to changes in market interest rates, not in estimated cash flows, no other than temporary impairment was recorded at December 31, 2004.
Providents funds management objectives are two-fold: to minimize the cost of borrowings while assuring sufficient funding availability to meet current and future borrowing requirements; and to contribute to interest rate risk management goals through match-funding loan or investment activity. Management utilizes a variety of sources to raise borrowed funds at competitive rates, including federal funds purchased (fed funds), Federal Home Loan Bank (FHLB) borrowings, securities sold under repurchase agreements (repos), and brokered and jumbo certificates of deposit (CDs). FHLB borrowings and repos typically are borrowed at rates approximating the LIBOR rate for the equivalent term because they are secured with investments or high quality real estate loans. Fed funds, which are generally overnight borrowings, are typically purchased at the Federal Reserve target rate. Brokered CDs are generally added when market conditions permit issuance at rates favorable to other funding sources.
The Corporation formed wholly owned statutory business trusts in 1998, 2000 and 2003. In 2004, the Corporation acquired three wholly owned statutory business trusts from Southern Financial as part of the merger. In all cases, the trusts issued trust preferred securities that were sold to outside third parties. The junior subordinated debentures issued by the Corporation to the Trust are presented net of unamortized issuance costs as Long-Term Debt in the Consolidated Statements of Condition and are includable in Tier 1 capital for regulatory capital purposes, subject to certain limitations. See Note 12 for a description of the six issues. Any of the junior subordinated debentures are redeemable at any time in whole, but not in part, from the date of issuance on the occurrence of certain events. On February 28, 2005, the Corporation announced the redemption of $30 million aggregate value of capital securities issued by Provident Trust II at an annual rate of 10%. The redemption is expected to occur on March 31, 2005.
At December 31, 2004, the Corporation and its subsidiaries had 1,854 full-time equivalent employees. The Corporation currently maintains what management considers to be a comprehensive, competitive employee benefits program. A collective bargaining unit does not represent employees and management considers its relationship with its employees to be good.
The Corporation encounters substantial competition in all areas of its business. There are three commercial banks based in Maryland with deposits in excess of $1 billion. There are sixteen additional commercial banks with deposits in excess of $1 billion operating in Maryland that have headquarters in other states. There are ten commercial banks based in Virginia with deposits in excess of $1 billion. There are twenty additional commercial banks with deposits in excess of $1 billion operating in Virginia that have headquarters in other states. The Bank also faces competition from savings and loans, savings banks, mortgage banking companies, credit unions, insurance companies, consumer finance companies, money market and mutual fund firms and various other financial services institutions.
Current federal law allows the merger of banks by bank holding companies nationwide. Further, federal and Maryland laws permit interstate banking. Legislation has broadened the extent to which financial services companies, such as investment banks and insurance companies, may control commercial banks. As a consequence of these developments, competition in the Banks principal markets may increase, and a further consolidation of financial institutions in Maryland may occur.
The Corporation is registered as a bank holding company under the Bank Holding Company Act of 1956 (HOLA). As such, the Corporation is subject to regulation and examination by the Federal Reserve Board, and is required to file periodic reports and any additional information that the Federal Reserve Board may require. HOLA imposes certain restrictions upon the Corporation regarding the merger of substantially all of the assets, or direct or indirect ownership or control, of any bank of which it is not already the majority owner; or, with certain exceptions, of any company engaged in non-banking activities.
The Bank is subject to supervision, regulation and examination by the Commissioner of the Division of Financial Regulation of the State of Maryland and the Federal Deposit Insurance Corporation (FDIC). Asset growth, deposits, reserves, investments, loans, consumer law compliance, issuance of securities, payment of dividends, establishment of banking offices, mergers and consolidations, changes in control, electronic funds transfer, management practices and other aspects of operations are subject to regulation by the appropriate federal and state supervisory authorities. The Bank is also subject to various regulatory requirements of the Federal Reserve Board applicable to FDIC insured depository institutions.
The Gramm-Leach-Bliley Act of 1999 authorizes a bank holding company that meets specified conditions to become a financial holding company and thereby engage in a broader array of financial activities than previously permitted. Such activities may include insurance underwriting and investment banking. The Gramm-Leach-Bliley Act also authorizes banks to engage through financial subsidiaries in certain of the activities permitted for financial holding companies. To date, the Corporation has not elected financial holding company status.
The Corporation and the Bank are affected by fiscal and monetary policies of the federal government, including those of the Federal Reserve Board, which regulates the national money supply in order to mitigate recessionary and inflationary pressures. Among the techniques available to the Federal Reserve Board are engaging in open market transactions of U.S. Government securities, changing the discount rate and changing reserve requirements against bank deposits. These techniques are used in varying combinations to influence the overall growth of bank loans, investments and deposits. Their use may also affect interest rates charged on loans and paid on deposits. The effect of governmental policies on the earnings of the Corporation and the Bank cannot be predicted.
Banks are required to maintain a sufficient level of capital in order to sustain growth, absorb unforeseen losses and meet regulatory requirements. The standards used by federal bank regulators to evaluate capital adequacy are the leverage ratio and risk-based capital guidelines. The Corporations core (or tier 1) capital is equal to total stockholders equity less net accumulated Other Comprehensive Income (Loss) (OCI) plus capital securities less intangible assets. Total regulatory capital consists of core capital plus the allowance for loan losses, subject to certain limitations. The trust preferred securities are considered capital securities, and accordingly, are includable as tier 1 capital, subject to certain limitations.
The leverage ratio represents core capital divided by quarterly average total assets. Guidelines for the leverage ratio require the ratio to be 100 to 200 basis points above a 3% minimum, depending on risk profiles and other factors. Risk-based capital ratios measure core and total regulatory capital against risk-weighted assets. Risk-weighted assets are determined by applying a weighting to asset categories as prescribed by regulation and certain off-balance sheet commitments based on the level of credit risk inherent in the assets. At December 31, 2004, the Corporation exceeded all regulatory capital requirements.
Rising interest rates may reduce the Corporations net income and future cash flows.
Interest rates were recently at historically low levels. However, since June 30, 2004, the U.S. Federal Reserve has increased its target for the federal funds rate five times to 2.25%. If interest rates continue to rise, and if rates on the Corporations deposits and borrowings reprice upwards faster than the rates on the Corporations loans and investments, the Corporation would experience compression of its interest rate spread and net interest margin, which would have a negative effect on the Corporations profitability.
Recent and possible future acquisitions could involve risks and challenges that could adversely affect the Corporations ability to achieve its profitability goals for acquired businesses or realize anticipated benefits of those acquisitions.
The Corporation has experienced moderate growth in the past several years and its strategy of future growth includes the possible acquisition of banking branches, other financial institutions and other financial services companies. Most recently, the Corporation completed its merger with Southern Financial on April 30, 2004. However, the Corporation cannot assure investors that it will be able to identify suitable future acquisition opportunities or finance and complete any particular acquisition, combination or other transaction on acceptable terms and prices. All acquisitions involve a number of risks and challenges that could adversely affect the Corporations ability to achieve anticipated benefits of acquisitions.
The Corporations allowance for loan losses may be inadequate, which could hurt the Corporations earnings.
The Corporations reserve for possible credit losses may not be adequate to cover actual loan losses and if the Corporation is required to increase its reserve, current earnings may be reduced. When borrowers default and do not repay the loans that the Bank makes to them, the Corporation may lose money. The Corporations experience shows that some borrowers either will not pay on time or will not pay at all, which will require the Corporation to cancel or charge-off the defaulted loan or loans. The Corporation provides for losses by reserving what it believes to be an adequate amount to absorb any probable inherent losses. A charge-off reduces the Corporations reserve for possible credit losses. If the Corporations reserves were insufficient, it would be required to increase reserves by recording a larger provision for loan losses, which would reduce earnings for that period.
Changes in economic conditions could cause an increase in delinquencies and non-performing assets, including loan charge-offs, which in turn may negatively affect the Corporations income and growth.
The Corporations loan portfolio includes many real estate secured loans, demand for which may decrease during economic downturns as a result of, among other things, an increase in unemployment, a decrease in real estate values or increases in interest rates. These factors could depress the Corporations earnings and consequently its financial condition because:
Any of the latter three scenarios could cause an increase in delinquencies and non-performing assets or require the Corporation to charge-off a percentage of its loans and/or increase the Corporations provisions for loan losses, which would reduce the Corporations earnings.
Because the Corporation competes primarily on the basis of the interest rates it offers depositors and the terms of loans it offers borrowers, the Corporations margins could decrease if it were required to increase deposit rates or lower interest rates on loans in response to competitive pressure.
The Corporation faces intense competition both in making loans and attracting deposits. The Corporation competes primarily on the basis of its depository rates, the terms of the loans it originates and the quality of the Corporations financial and depository services. This competition has made it more difficult for the Corporation to make new loans and at times has forced the Corporation to offer higher deposit rates in its market area. The Corporation expects competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to market entry, enabled banks to expand their geographic reach by providing services over the Internet and enabled non-depository institutions to offer products and services that traditionally have been provided by banks. Recent changes in federal banking law permit affiliation among banks, securities firms and insurance companies, which also will change the competitive environment in which the Corporation conducts business. Some of the institutions with which the Corporation competes are significantly larger than the Corporation and, therefore, have significantly greater resources.
The Corporation is subject to events that could impact or disrupt its business, although its goal is to ensure continuous service delivery to its customers. The Corporation has undertaken an enterprise-wide Business Continuity Plan in order to respond to and guard against this risk. However, no Plan can fully eliminate such risk and there can be no assurance that the Corporations Plan will be successful.
Various factors could hinder or prevent takeover attempts.
Provisions of the Corporations Articles of Incorporation and Bylaws and federal and state regulations make it difficult and expensive to pursue a takeover attempt that management opposes. These provisions will also make the removal of the current board of directors or management, or the appointment of new directors, more difficult. For example, the Corporations Articles of Incorporation and Bylaws contain provisions that could impede a takeover or prevent the Corporation from being acquired, including a classified board of directors and limitations on the ability of the Corporations stockholders to remove a director from office without cause. The Corporations board of directors may issue additional shares of common stock or establish classes or series of preferred stock with rights, preferences and limitations as determined by the board of directors without stockholder approval. These factors give the board of directors the ability to prevent, or render more difficult or costly, the completion of a takeover transaction that the Corporations stockholders might view as being in their best interests.
Item 2. Properties
The Corporation has 162 offices from which it conducts, or intends to conduct, business which are located in the Maryland, Virginia and southern Pennsylvania. The Bank owns 21 and leases 141 of these offices. Most of these leases provide for the payment of property taxes and other costs by the Bank, and include one or more renewal options ranging from five to ten years. Some of the leases also contain a purchase option.
Item 3. Legal Proceedings
The Corporation is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Management believes such routine legal proceedings, in the aggregate, will not have a material adverse affect on the Corporations financial condition or results of operations.
Item 5. Market for the Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
The common stock of Provident Bankshares Corporation is traded over-the-counter and is quoted in the NASDAQ National Market. Such over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. The NASDAQ symbol is PBKS. At March 10, 2005, there were approximately 4,100 holders of record of the Corporations common stock.
For the year 2004, the Corporation declared and paid dividends of $1.01 per share of common stock outstanding. Declarations or payments of dividends are subject to a determination by the Corporations Board of Directors, which takes into account the Corporations financial condition, results of operations, economic conditions and other factors, including the regulatory restrictions which affect the payment of dividends by the Bank to the Corporation. No assurances can be given, however, that any dividends will be paid or, if commenced, will continue to be paid.
As of December 31, 2004, Provident Bankshares had approximately 4,200 holders of record (excluding the number of persons or entities holding stock in street name through various brokerage firms), and 33,102,385 shares outstanding.
The following table sets forth high and low sales prices for each quarter during the fiscal years ended December 31, 2004 and December 31, 2003 for Provident Bankshares common stock, and corresponding quarterly dividends paid per share.
During 1998, the Corporation initiated a stock repurchase program for its outstanding stock. Under this plan the Corporation approved the repurchase of specific additional amounts of shares without any specific expiration date. As the Corporation fulfilled each specified repurchase amount, additional amounts were approved. Most recently, on January 15, 2003, the Corporation approved an additional stock repurchase of 1.0 million shares. Currently, the maximum number of shares remaining to be purchased under this plan is 609,215. All shares have been repurchased pursuant to the publicly announced plan.
The following table provides certain information with regard to shares repurchased by the Corporation in the fourth quarter of 2004.
On January 18, 2005, the Corporations Stockholder Protection Rights Agreement, together with any rights issued in connection with the Stockholder Protection Rights Agreement, lapsed. The Corporation has made no determination with respect to the reinstatement of a similar agreement in the future.
Item 6. Selected Financial Data
The Corporation has derived the following selected consolidated financial and other data of the Corporation in part from the consolidated financial statements and notes appearing elsewhere in this Form 10-K/A and from consolidated financial statements previously filed.
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
The principal objective of this Financial Review is to provide an overview of the financial condition and results of operations of Provident Bankshares Corporation and its subsidiaries for the three years ended December 31, 2004. This discussion and tabular presentations should be read in conjunction with the accompanying Consolidated Financial Statements and Notes as well as the other information herein, particularly the information regarding the Corporations business operations as described in Item 1.
RESTATEMENT OF PREVIOUSLY REPORTED RESULTS OF OPERATIONS
On November 7, 2005, management of Provident Bankshares Corporation (Provident or the Corporation) determined that Providents financial statements for the quarters ended June 30, 2005 and March 31, 2005 should no longer be relied upon as a result of the accounting treatment applied by Provident to interest rate swaps associated with Providents interest rate risk hedging program. Subsequently, management made a similar determination with respect to the financial statements for the year ended December 31, 2004.
As a result, the Corporation has restated the financial statements for quarters ended June 30, 2005 and March 31, 2005, and for the year ended December 31, 2004. The restatements are primarily the result of corrections of errors related to the Corporations accounting for derivatives under SFAS No. 133. Historically, Provident has entered into various interest rate swaps to hedge the interest rate risk inherent in certain of its brokered Certificates of Deposit (CDs), FHLB Borrowings (FHLB Borrowings) and Junior Subordinated Debentures (Junior Subordinated Debentures) (which are owned by trusts which issue trust preferred securities with identical terms to outside third parties). From the inception of hedge accounting, Provident has applied the short-cut method of fair value and cash flow hedge accounting under SFAS No.133 to the swaps associated with brokered CDs, FHLB Borrowings and Junior Subordinated Debentures transactions, allowing Provident to assume no hedge ineffectiveness for these derivatives. Provident has determined that the brokered CD swaps, a portion of the FHLB swaps, and the swaps associated with the debt transaction did not qualify for the short-cut method in the first and second quarter of 2005 and for calendar year ended December 31, 2004. The brokered CD swaps did not qualify for short-cut application because a related CD broker placement fee was determined (in retrospect) to be imbedded in the swap contracts, causing the swap to have a value other than zero at inception. A portion of the FHLB swaps did not qualify because the maturity of the swaps exceed the maturity of the FHLB Borrowings. Regarding the debt swaps, the swaps were documented as hedging the trust preferred securities, and were not redesignated as hedging the Junior Subordinated Debentures upon adoption of FIN 46R. As a result of these errors in the application of the short cut method, the Corporation is precluded from applying hedge accounting to these derivative instruments for these periods. The financial results beginning January 1, 2004 have therefore been restated for the affected derivatives and their related hedged items.
Management believes the financial statement impact of applying the long-haul method of effectiveness testing using SFAS No. 133 and the results under the short-cut method would have indicated no material difference in the effectiveness of the swaps. However, hedge accounting under SFAS No. 133 is not allowed for the affected periods because the hedge documentation required for the long-haul method was not in place at the inception of the hedges. Fair value hedge accounting allows a company to record changes in the fair value of a hedged item (in this case, the brokered CDs and the Junior Subordinated Debentures) as an adjustment to income that offsets the fair value adjustment of the related interest rate swaps. Cash flow hedge accounting allows a company to record changes in the fair value, net of income taxes, as a component of Other Comprehensive Income in Stockholders Equity. Amounts recorded in OCI are recognized into earnings concurrent with the hedged items impact on earnings. Under fair value and cash flow hedge accounting, net cash flows associated with the swapped interest payments are included in interest expense.
Elimination of hedge accounting reverses fair value adjustments made on the brokered CDs so that they are carried at par, net of the unamortized balance of the CD broker placement fee. The net swap interest rate payments were reclassified from an adjustment to interest expense on the brokered CDs to non-interest income.
The CD broker placement fees, which were incorporated into the swap, adjusted the par amount of the brokered CDs and will be amortized through the maturity date of the related CDs as an adjustment to the rate paid. The interest expense on the FHLB Borrowings was treated in a manner similar to the CD interest expense. Hedge accounting for cash flow hedges allows a company to record the effective portion of the hedge into other comprehensive income, net of tax. Elimination of the hedge accounting reversed the fair value adjustments recorded to OCI and recorded the fair value adjustment directly to non-interest income in the Consolidated Statement of Income.
Prior to January 1, 2004, the interest expense on trust preferred securities was netted with the interest payments received from the designated swaps. However, the adoption of FASB Interpretation No. 46 Consolidation of Variable Interest Entities (FIN 46) on January 1, 2004 and the resultant deconsolidation of the trusts which issued the securities, required redesignation of the swaps to the Junior Subordinated Debentures issued by the Corporation in order to continue to apply hedge accounting. The lack of documented redesignation resulted in the elimination of hedge accounting for the Junior Subordinated Debentures. The fair value basis adjustment of the trust preferred securities at the adoption date was deferred as a basis adjustment to the Junior Subordinated Debentures. This basis adjustment is being amortized into interest expense over the life of the Junior Subordinated Debentures as a result of the elimination of hedge accounting. Fair value adjustments on the swaps subsequent to the date of adoption of FIN 46 have been reflected as derivative gains (losses).
Accordingly, the financial statements for first and second quarters of 2005 and the year ended December 31, 2004 have been restated to reflect the required accounting treatment. Adjustments to the Consolidated Statements of Income for amounts previously reported affect interest expense on deposits and long-term debt through the reversal of the swap income that offset interest expense on the brokered CDs, FHLB Borrowings and the Junior Subordinated Debentures, affect non-interest income for the fair value adjustments related to the associated swaps and affect the net cash settlements on the swaps, and affect the related tax impact of the respective adjustments.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Discussion and analysis of the financial condition and results of operations are based on the consolidated financial statements of the Corporation, which are prepared in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Management evaluates estimates on an on-going basis, including those related to the allowance for loan losses, non-accrual loans, other real estate owned, estimates of fair value and intangible assets associated with mergers, other than temporary impairment of investment securities, pension and post-retirement benefits, asset prepayment rates, goodwill and intangible assets, stock-based compensation, derivative positions, recourse liabilities, litigation and income taxes. Management bases its estimates on historical experience and various other factors and assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Management believes the following critical accounting policies affect its more significant judgments and estimates used in preparation of its consolidated financial statements: allowance for loan losses, other than temporary impairment of investment securities, derivative financial instruments, goodwill and intangible assets, asset prepayment rates and income taxes. Each estimate is discussed below. The financial impact of each estimate, to the extent significant to financial results, is discussed in the applicable sections of Managements Discussion and Analysis. It is at least reasonably possible that each of the Corporations estimates could change in the near term and the effect of the change could be material to the Corporations Consolidated Financial Statements.
Allowance for Loan Losses
The Corporation maintains an allowance for loan losses (the allowance), which is intended to be managements best estimate of probable inherent losses in the outstanding loan portfolio. The allowance is reduced by actual credit losses and is increased by the provision for loan losses and recoveries of previous losses. The provisions for loan losses are charges to earnings to bring the total allowance to a level considered necessary by management.
The allowance is based on managements continuing review and evaluation of the loan portfolio. This process provides an allowance consisting of two components, allocated and unallocated. To arrive at the allocated component of the allowance, the Corporation combines estimates of the allowances needed for loans analyzed individually and on a pooled basis. The allocated component of the allowance is supplemented by an unallocated component.
The portion of the allowance that is allocated to individual internally criticized and non-accrual loans is determined by estimating the inherent loss on each problem credit after giving consideration to the value of underlying collateral. Management emphasizes loan quality and close monitoring of potential problem credits. Credit risk identification and review processes are utilized in order to assess and monitor the degree of risk in the loan portfolio. The Corporations lending and credit administration staff are charged with reviewing the loan portfolio and identifying changes in the economy or in a borrowers circumstances which may affect the ability to repay debt or the value of pledged collateral. A loan classification and review system exists that identifies those loans with a higher than normal risk of uncollectibility. Each commercial loan is assigned a grade based upon an assessment of the borrowers financial capacity to service the debt and the presence and value of collateral for the loan.
For portfolios such as consumer loans, commercial business loans and loans secured by real estate, the determination of the allocated allowance is conducted at an aggregate, or pooled, level. Each quarter, historical rolling loss rates for homogenous pools of loans in these portfolios provide the basis for the allocated reserve. For any portfolio where the Bank lacks sufficient historic experience, industry loss rates are used. If recent history is not deemed to reflect the inherent losses existing within a portfolio, older historic loss rates during a period of similar economic or market conditions are used.
The Banks credit administration group adjusts the indicated loss rates based on qualitative factors. Factors that are considered in adjusting loss rates include risk characteristics, credit concentration trends and general economic conditions, including job growth and unemployment rates. For commercial and real estate portfolios, additional factors include the level and trend of watched and criticized credits within those portfolios; commercial real estate vacancy, absorption and rental rates; and the number and volume of syndicated credits, construction loans, or other portfolio segments deemed to carry higher levels of risk. Upon completion of the qualitative adjustments, the overall allowance is allocated to the components of the portfolio based on the adjusted loss factors.
The unallocated component of the allowance exists to mitigate the imprecision inherent in managements estimates of expected credit losses and includes its judgmental determination of the amounts necessary for concentrations, economic uncertainties and other subjective factors that may not have been fully considered in the allocated allowance. The relationship of the unallocated component to the total allowance may fluctuate from period to period. Although management has allocated the majority of the allowance to specific loan categories, the evaluation of the allowance is considered in its entirety.
Lending management meets at least quarterly with executive management to review the credit quality of the loan portfolios and to evaluate the allowance. The Corporation has an internal risk analysis and review staff that continuously reviews loan quality and reports the results of its reviews to executive management and the Board of Directors. Such reviews also assist management in establishing the level of the allowance.
Management believes that it uses the best information available to make determinations about the allowance and that it has established its existing allowance in accordance with GAAP. If circumstances differ substantially from the assumptions used in making determinations, adjustments to the allowance may be necessary and results of operations could be affected. Because events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above.
The Bank is examined periodically by the FDIC and, accordingly, as part of this exam, the allowance is reviewed for adequacy utilizing specific guidelines. Based upon their review, the regulators may from time to time require reserves in addition to those previously provided.
Other Than Temporary Impairment of Investment Securities
Securities are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term other than temporary is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.
Derivative Financial Instruments
The Corporation uses various derivative financial instruments as part of its interest rate risk management strategy to mitigate the exposure to changes in market interest rates. The derivative financial instruments used separately or in combination are interest rate swaps, caps and floors. Derivative financial instruments are required to be measured at fair value and recognized as either assets or liabilities in the financial statements. Fair value represents the payment the Corporation would receive or pay if the item were sold or bought in a current transaction. Fair values are generally based on market quotes. The accounting for changes in fair value (gains or losses) of a derivative is dependent on whether the derivative is designated and qualifies for hedge accounting. In accordance with Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS No. 133), the Corporation assigns derivatives to one of these categories at the purchase date: fair value hedge, cash flow hedge or non-designated hedge. SFAS No. 133 requires an assessment of the expected and ongoing hedge effectiveness of any derivative designated a fair value hedge or cash flow hedge. Derivatives are included in other assets and other liabilities in the Consolidated Statements of Condition.
Fair Value Hedges For derivatives designated as fair value hedges, the derivative instrument and related hedge item are marked-to-market through the related interest income or expense, as applicable, except for the ineffective portion which is recorded in non-interest income.
Cash Flow Hedges For derivatives designated as cash flow hedges, mark-to-market adjustments are recorded net of income taxes as a component of Other Comprehensive Income in Shareholders Equity, except for the ineffective portion which is recorded in non-interest income. Amounts recorded in OCI are recognized into earnings concurrent with the hedged items impact on earnings.
Non-Designated Derivatives Certain economic hedges are not designated as cash flow or as fair value hedges for accounting purposes. As a result, changes in the fair value are recorded in non-interest income in the Consolidated Statements of Income. Interest income or expense related to non-designated derivatives is also recorded in non-interest income.
All qualifying relationships between hedging instruments and hedged items are fully documented by the Corporation. Risk management objectives, strategies and the projected effectiveness of the chosen derivatives to hedge specific risks are also documented. At inception of the hedging relationship and periodically as required under SFAS No. 133, the Corporation evaluates the effectiveness of its hedging instruments. For hedges qualifying for short-cut treatment at inception, the ongoing effectiveness testing includes a review of the hedge and the hedged item to determine if the hedge continues to qualify for short-cut treatment. An assumption of no hedge ineffectiveness is allowed for derivatives qualifying for short-cut treatment. For all other derivatives qualifying for hedge accounting, a quantitative assessment of the effectiveness of the hedge is required at each reporting date. The Corporation performs effectiveness testing quarterly for all of its hedges. The Corporation
uses benchmark interest rates such as LIBOR to hedge the interest rate risk associated with interest-earning assets or interest-bearing liabilities. Using benchmark rates and complying with specific criteria set forth in SFAS No.133, the Corporation has concluded that for qualifying hedges, changes in fair value or cash flows that are attributable to risks being hedged will be highly effective at the hedges inception and on an ongoing basis.
When it is determined that a derivative is not, or ceases to be effective as a hedge, the Corporation discontinues hedge accounting prospectively. When a fair value hedge is discontinued due to ineffectiveness, the Corporation continues to carry the derivative on the Consolidated Statements of Condition at its fair value, as a non-designated hedge but discontinues marking-to-market the hedged asset or liability for changes in fair value. Any previous mark-to-market adjustments recorded to the hedged item are amortized over the remaining life of the asset or liability. All ineffective portions of fair value hedges are reported in and affect net income immediately. When a cash flow hedge is discontinued due to termination of the derivative, the Corporation continues to carry the previous mark-to-market adjustments in OCI and recognizes the amount into earnings in the same period or periods during which the hedged item affects earnings. If the cash flow hedge is discontinued due to ineffectiveness, the derivative would be considered a non-designated hedge and would continue to be marked-to-market in the Consolidated Statement of Condition as an asset or liability. Additionally, the Consolidated Statements of Income would record the mark-to-market through current period earnings and not through OCI.
Counter-party credit risk associated with derivatives is controlled by dealing with well-established brokers that are highly rated by credit rating agencies and by establishing exposure limits for individual counter-parties. Market risk on interest rate swaps is minimized by using these instruments as hedges and by continually monitoring the positions to ensure ongoing effectiveness. Credit risk is controlled by entering into bilateral collateral agreements with brokers, in which the parties pledge collateral to indemnify the counter-party in the case of default. The Corporations hedging activities and strategies are monitored by the Banks Asset / Liability Committee (ALCO) as part of its oversight of the treasury function.
Goodwill and Intangible Assets
For purchase acquisitions, the Corporation records the assets acquired, including identified intangible assets, and liabilities assumed at their fair value, which in many instances involves estimates based on third party valuations, such as appraisals, or valuations based on discounted cash flow analyses or other valuation techniques. The determination of the useful lives of intangible assets is subjective, as is the appropriate amortization period for such intangible assets. These estimates also include the establishment of various accruals and allowances based on planned facilities dispositions and employee severance considerations, among other acquisition-related items. In addition, purchase acquisitions typically result in goodwill, which represents the excess of the purchase price over the fair value of the net assets acquired by the Corporation. The Corporation tests goodwill annually for impairment. Such tests involve the use of estimates and assumptions. Intangible assets other than goodwill, such as deposit-based intangibles, which are determined to have finite lives are amortized over their estimated remaining useful lives which range from 3 to 8 years.
The Corporation accounts for income taxes under the asset/liability method. Deferred tax assets and liabilities are recognized for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as operating loss and tax credit carry forwards. A valuation allowance is established against deferred tax assets when in the judgment of management, it is more likely than not that such deferred tax assets will not become realizable. It is at least reasonably possible that managements judgment about the need for a valuation allowance for deferred taxes could change in the near term.
Total assets were $6.6 billion at December 31, 2004, an increase of $1.4 billion from December 31, 2003. The ongoing transformation of the balance sheet has resulted in a higher percentage of loans and deposits that have been originated by the Banks core business lines. The merger with Southern Financial on April 30, 2004 added $676 million in loan balances and $1.0 billion in deposit balances. The Corporation acquired Southern Financial on April 30, 2004, using the purchase method of accounting. Accordingly, the results of operations of Southern Financial are not included in 2003. The year ended 2004 includes the results of operations of Southern Financial for the eight months subsequent to the acquisition.
Total average earning asset balances increased to $5.5 billion in 2004, an increase of $827 million, or 18%, from 2003. The following table summarizes the composition of the Banks average earning assets for the periods indicated.
Average Earning Assets:
Total average loan balances increased to $3.3 billion in 2004, an increase of $690 million, or 27%, from 2003. The Corporations expanded presence in the Baltimore-Washington metropolitan regions was the primary contributor to the achievement of the 27% growth in average loans. The average loan growth of $690 million is comprised of $209 million, or 13%, in consumer loans and $480 million, or 48% in commercial loans. The result is a balanced mix of revenue sources between the two product segments with $1.8 billion, or 55%, in consumer loans, and $1.5 billion, or 45% in commercial loans.
The growth of $480 million in average commercial loans was split between commercial real estate (including construction and mortgage) loans, which grew $264 million, and commercial business loans, which grew $216 million. While commercial loans acquired with the Southern Financial merger contributed to the increase, organic loan production from existing Provident units continued to grow at a double digit pace.
The growth in average consumer loans was driven by strong production of home equity loans and lines. Production of direct consumer loans, primarily home equity loans and lines generated by the Banks retail banking offices, phone center and Internet unit, totaled $466 million in 2004, a 22% increase from 2003
production. The strong production in the current year resulted in a $179 million, or 43%, net increase in average home equity loan and line balances to $600 million. Average consumer loan balances from the Washington market grew 83% in 2004, reflecting the Banks continued expansion into that market. Average marine loans, which are originated indirectly through brokers but underwritten individually by the Bank, had modest growth and represented 25% of average consumer loans in 2004.
The Corporations portfolio of acquired residential mortgage loans (consisting of first mortgages, home equity loans and lines) represented 19% of average total loans in 2004, compared to 35% in 2003. Over the past several years, the Bank has increased its credit quality requirements for new acquisitions and shifted its lien position focus from predominantly second lien position to entirely first lien position. In 2004, the Corporation purchased $123 million in loans secured by residential real estate, all of which were in first lien position, including $44 million in loans to borrowers residing in the Banks footprint. Provident will service the loans within its footprint in order to cultivate additional relationships with the borrowers. At December 31, 2004, approximately 82% of the acquired portfolio was in first lien position. Management intends to continue to purchase residential loans to maintain an average acquired portfolio size of approximately $600 million.
Average balances in the originated residential mortgage portfolio continued to decline during 2004, to $101 million, since the Bank does not retain new residential loan originations.
The growth in the investment portfolio average balances of $134 million in 2004 was primarily as a result of the merger with Southern Financial. Although over $500 million of investments were acquired in the merger, Provident reduced its portfolio by approximately $400 million in the second quarter to achieve a more profitable asset mix.
The following table presents information with respect to non-performing assets and 90-day delinquencies for the years indicated.
Asset Quality Summary:
The asset quality within the Corporations loan portfolios remained strong in 2004. Non-performing assets were $27.3 million at December 31, 2004, up $1.8 million from the level at December 31, 2003. The level of non-performing assets was elevated by the addition of non-performing commercial business and commercial real estate construction loans acquired in the merger. The level of non-performing assets at December 31, 2004 is consistent with historical trends of the two companies on a combined basis. Of the total non-performing assets, $10.6 million are in the consumer and residential mortgage loan portfolios, which are collateralized by 1 to 4 family residences. Non-performing commercial business loans include $1.4 million of loans that have U.S. government guarantees. With the vast majority of non-performing loans already written down to net fair value, management expects little further loss on those loans. During 2004, the Corporation sold approximately $5 million of its non-performing acquired residential loan portfolio.
The overall asset quality ratios of the Corporation, including the impact of the Southern Financial portfolio, remain consistent with pre-merger levels. At December 31, 2004, non-performing assets as a percentage of loans outstanding were 0.77% compared to 0.92% at December 31, 2003. Although no assurances can be given, management believes that non-performing assets will remain relatively stable in the near term.
Total 90-day delinquencies increased $2.3 million in 2004; however, total delinquencies as a percentage of total loans outstanding were 0.34% in 2004 compared to 0.35% in 2003. Presented below is interest income that would have been recorded on all non-accrual loans if such loans had been paid in accordance with their original terms and the interest income on such loans that was actually received and recorded for the year.
Interest Income Lost Due to Non-Accrual Loans:
Allowance for Loan Losses
The following table reflects the allowance for loan losses and the activity during each of the periods indicated.
Loan Loss Experience Summary:
The following table reflects the allocation of the allowance at December 31 to the various loan categories. The entire allowance is available to absorb losses from any type of loan.
Allocation of Allowance for Loan Losses:
As a result of the acquisition of Southern Financial, the Corporation recorded an additional allowance of $12.1 million, or approximately 1.7% of the loans acquired. Net charge-offs exceeded the provision for loan losses by
$1.5 million, as the application of Provident collection and credit standards resulted in higher net charge-offs in the commercial portfolio. The allowance as a percentage of loans outstanding increased from 1.28% at December 31, 2003 to 1.30% at December 31, 2004. The allowance coverage remained fairly consistent, with coverage of 180% of non-performing loans at December 31, 2004, compared to 159% at December 31, 2003. Portfolio-wide net charge-offs represented 0.27% of average loans in 2004, down from 0.34% in 2003. For consumer portfolios that experienced losses, the twelve-month rolling loss rates in each of the portfolios continued to be at their lowest levels in several years.
Management believes that the allowance at December 31, 2004 represents its best estimate of probable losses inherent in the portfolio and that it uses the best information available to make such determinations. If circumstances differ substantially from the assumptions used in making determinations, future adjustments to the allowance may be necessary and results of operations could be affected. Based on information currently available to the Corporation, management believes it has established its existing allowance in accordance with GAAP. Because events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that increases to the allowance will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above.
Sources of Funds
The following table summarizes the composition of the Corporations average deposit and borrowing balances for the periods indicated.
Average Deposits and Borrowings:
Average deposits increased $513 million, or 16%, in 2004. Similar to the loan businesses, the growth was evenly balanced between deposits from consumers, which grew $267 million, or 11%, and deposits from businesses, which grew $252 million, or 54%. Brokered deposits remained fairly constant.
Average borrowings increased $342 million in 2004. Average fed funds increased $39 million, reflecting managements intentions to match fund more of the Banks prime-based loan portfolio with these borrowings. Average FHLB borrowings increased $165 million; offsetting run-off of higher cost pre-merger brokered CDs. In 2004, the Bank restructured $295 million of FHLB borrowings. Debt that was either short-term or floating rate of $100 million was restructured in the second quarter, with no loss, in conjunction with the Southern Financial merger. Debt that was either fixed rate or CMS-based of $195 million, with an average rate of 4.26%, was
extinguished in the third and fourth quarters. Losses of $2.4 million were incurred in connection with this restructuring, which is shown in Net Gains (Losses) in the Consolidated Statements of Income. The borrowings were replaced with short-term or floating rate borrowings at market rates of approximately 1.25-2.00%. Average repo balances increased $55 million, representing commercial cash management products. Average trust preferred balances increased $84 million, due to $71 million of floating rate trust preferred securities issued in December 2003 in contemplation of the merger, combined with $23 million of trust preferred securities acquired as part of the merger.
An important component of the Banks asset/liability structure is the level of liquidity available to meet the needs of customers and creditors. Traditional sources of bank liquidity include deposit growth, loan repayments, investment maturities, asset sales, borrowings and interest received. Management believes the Bank has sufficient liquidity to meet funding needs in the foreseeable future.
The Banks primary source of liquidity beyond the traditional sources is the assets it possesses, which can either be pledged as collateral for secured borrowings or sold outright. The Banks primary sources for raising secured borrowings are the FHLB and securities broker/dealers. At December 31, 2004, $1.6 billion of secured borrowings were employed, with sufficient collateral available to immediately raise an additional $400 million. An excess liquidity position of $35 million remains after covering $365 million of unsecured funds that mature in the next three months. In January 2005, the Corporation added $280 million of secured borrowing facilities to enhance its sources of liquidity. Additionally, over $300 million of assets are maintained as collateral with the Federal Reserve that is available as a contingent funding source.
The Bank also has several unsecured funding sources available should the need arise. At December 31, 2004, the Bank possessed over $800 million of overnight borrowing capacity, of which only $330 million was in use at year-end. The brokered CD and unsecured debt markets, which generally are more expensive than secured funds of similar maturity, are also viable funding alternatives. In 2004, the Bank issued $85 million of brokered CDs at favorable pricing levels.
As an alternative to raising secured funds, the Bank can raise liquidity through asset sales. At December 31, 2004, over $500 million of the Banks investment portfolio was immediately saleable at a market value equaling or exceeding its amortized cost basis. In 2004, the Corporation transferred $115 million of securities from securities available for sale to securities held to maturity, in order to reduce the potential impact of rising interest rates on other comprehensive income. Additionally, over a 90-day time frame, a majority of the Banks $1.8 billion consumer loan portfolio is saleable in an efficient market.
Provident Trust II, a $30 million 10% dividend security, is redeemable after March 31, 2005. On February 28, 2005, the Corporation announced the redemption of this issue on March 31, 2005.
A significant use of the Corporations liquidity is the dividends it pays to shareholders. The Corporation is a one-bank holding company that relies upon the Banks performance to generate capital growth through Bank earnings. A portion of the Banks earnings is passed to the Corporation in the form of cash dividends. As a commercial bank under the Maryland Financial Institution Law, the Bank may declare cash dividends from undivided profits or, with the prior approval of the Commissioner of Financial Regulation, out of paid-in capital in excess of 100% of its required capital stock, and after providing for due or accrued expenses, losses, interest and taxes. These dividends paid to the holding company are utilized to pay dividends to stockholders, repurchase shares and pay interest on trust preferred securities. The Corporation and the Bank, in declaring and paying dividends, are also limited insofar as minimum capital requirements of regulatory authorities must be maintained. The Corporation and the Bank comply with such capital requirements. If the Corporation or the Bank were unable to comply with the minimum capital requirements, it could result in regulatory actions that could have a material impact on the Corporation.
Contractual Obligations, Commitments and Off Balance Sheet Arrangements
The Corporation has various contractual obligations, such as long-term borrowings, that are recorded as liabilities in the Consolidated Financial Statements. Other items, such as certain minimum lease payments for the use of banking and operations offices under operating lease agreements, are not recognized as liabilities in the Consolidated Financial Statements, but are required to be disclosed. Each of these arrangements affects the Corporations determination of sufficient liquidity.
The following table summarizes significant contractual obligations and commitments at December 31, 2004 and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal payments on outstanding borrowings. Additional details regarding these obligations are provided in the Notes to the Consolidated Financial Statements, as referenced in the following table.
Arrangements to fund credit products or guarantee financing take the form of loan commitments (including lines of credit on revolving credit structures) and letters of credit. Approvals for these arrangements are obtained in the same manner as loans. Generally, cash flows, collateral value and a risk assessment are considered when determining the amount and structure of credit arrangements. Commitments to extend credit in the form of consumer, commercial real estate and business loans at December 31, 2004 were as follows:
Historically, many of the commitments expire without being fully drawn; therefore, the total commitment amounts do not necessarily represent future cash requirements. Obligations also take the form of commitments to purchase loans. At December 31, 2004, the Corporation did not have any firm commitments to purchase loans.
Contingencies and Risk
The Corporation enters into certain transactions that may either contain risks or represent contingencies. These risks or contingencies may take the form of concentrations of credit risk or litigation. Disclosure of these arrangements is found in Note 16 to the Consolidated Financial Statements.
The nature of the banking business, which involves paying interest on deposits at varying rates and terms and charging interest on loans at other rates and terms, creates interest rate risk. As a result, earnings and the market value of assets and liabilities are subject to fluctuations, which arise due to changes in the level and directions of interest rates. Managements objective is to minimize the fluctuation in the net interest margin caused by changes in interest rates using cost-effective strategies and tools. The Bank manages several forms of interest rate risk, including asset/liability mismatch, basis and prepayment risk.
The Corporation purchases amortizing loan pools and investment securities in which the underlying assets are residential mortgage loans subject to prepayments. The actual principal reduction on these assets varies from the expected contractual principal reduction due to principal prepayments resulting from borrowers elections to refinance the underlying mortgages based on market and other conditions. Prepayment rate projections utilize actual prepayment speed experience and available market information on like-kind instruments. The prepayment rates form the basis for income recognition of premiums or discounts on the related assets. Changes in prepayment estimates may cause the earnings recognized on these assets to vary over the term that the assets are held, creating volatility in the net interest margin. Prepayment rate assumptions are monitored and updated monthly to reflect actual activity and the most recent market projections. Basis risk exists as a result of having much of the Banks earning assets priced using either the Prime rate or the U.S. Treasury yield curve, while much of the liability portfolio is priced using the CD yield curve or LIBOR yield curve. These different yield curves typically do not move in lock-step with one another.
Measuring and managing interest rate risk is a dynamic process that management performs continually to meet the objective of maintaining a stable net interest margin. This process relies chiefly on simulation modeling of shocks to the balance sheet under a variety of interest rate scenarios, including parallel and non-parallel rate shifts, such as the forward yield curves for both short and long term interest rates. The results of these shocks are measured in two forms: first, the impact on the net interest margin and earnings over one and two year time frames; and second, the impact on the market value of equity. In addition to measuring the basis risks and prepayment risks noted above, simulations also quantify the earnings impact of rate changes and the cost / benefit of hedging strategies.
The following table shows the anticipated effect on net interest income in parallel shift (up or down) interest rate scenarios. These shifts are assumed to begin on January 1, 2004 for the December 31, 2003 data and on January 1, 2005 for the December 31, 2004 data and evenly ramp-up or down over a six-month period. The effect on net interest income would be for the next twelve months. Given the interest environment in the periods presented, a 200 basis point drop in rate is unlikely and has not been shown.
The percentage changes displayed in the table above relate to the Corporations projected net interest income. Managements intent is for derivative interest income to mitigate risk to the Corporations net interest income stemming from changes in interest rates. For comparison purposes, these projections include all interest earned on derivatives in net interest income. The analysis includes the interest income and expense relating to non-designated interest rate swaps that is classified in non-interest income as Net Cash Settlement on Swaps.
The isolated modeling environment, assuming no action by management, shows that the Corporations net interest income volatility is less than 3.5% under probable single direction scenarios. The Corporations one-year forward earnings are slightly asset sensitive, which will result in net interest income moving in the same direction as future interest rates. The Corporations interest rate risk profile is little changed from 2003 to 2004, reflecting managements intentions to maintain a low level of interest rate risk and to benefit modestly from a rising rate environment.
The Corporation maintains an overall interest rate management strategy that incorporates structuring of investments, purchased funds, variable rate loan products, and derivatives in order to minimize significant fluctuations in earnings or market values. The Bank continues to employ hedges to mitigate interest rate risk. Borrowings totaling over $440 million have been employed which reset their rates monthly or quarterly based on the level of long-term interest rates specifically, the 10-year constant maturity swap rate rather than short-term rates, to offset the effect of mortgage prepayments on asset yields. There is a high correlation between changes in the 10-year constant maturity swap rate and the 30-year mortgage rate. Additionally, $662 million notional amount in interest rate swaps were in force to reduce interest rate risk, and $300 million of interest rate caps were employed to protect the interest margin from rising interest rates in the future.
Total stockholders equity was $618 million at December 31, 2004, an increase of $294 million from December 31, 2003. The change in stockholders equity for the year was attributable to $62.0 million in earnings, $261 million primarily from the issuance of common stock relating to the Southern Financial merger and an increase of $5.0 million in net accumulated Other Comprehensive Income (OCI). This was partially offset by dividends paid of $31.5 million, or $1.01 per share. Capital was also reduced by $4.2 million from the repurchase of 116,900 shares of the Corporations common stock at an average price of $36.10. The Corporation is authorized to repurchase an additional 609,215 shares under its stock repurchase program.
The Corporation is required to maintain minimum amounts and ratios of core capital to adjusted quarterly average assets (leverage ratio) and of tier 1 and total regulatory capital to risk-weighted assets. The actual regulatory capital ratios and required ratios for capital adequacy purposes under FIRREA and the ratios to be categorized as well capitalized under prompt corrective action regulations are summarized in the following table.
The composition of regulatory capital changed as a result of the Southern Financial merger. Regulatory capital increased as a result of the $251 million of equity capital issued as part of the merger transaction, the inclusion of $23 million of Southern Financials trust preferred securities and the increased allowance for loan losses. These additions were partially offset by the $260 million of additional goodwill and other intangible assets arising from the merger that are deducted from regulatory capital. On February 28, 2005, the Corporation announced its intention to call Provident Trust II, a $30 million 10% dividend trust preferred security on March 31, 2005. These securities will be excluded from capital ratio calculations beginning March 31, 2005. Following the redemption, the Corporations capital ratios are expected to continue to comply with all applicable regulatory capital requirements and the Corporation is expected to continue to be considered well-capitalized for regulatory purposes.
RESULTS OF OPERATIONS
DISCUSSION AND RECONCILIATION OF NET INCOME AND OPERATING INCOME
As a result of the restatement, management has included a reconciliation of net income and operating income. Although operating income is not a measure of performance calculated in accordance with GAAP, the Corporation believes that operating income measures are important because they provide readers with a more meaningful presentation of the Corporations core results of operations from period to period. The Corporation calculates operating income by adding or subtracting, as the case may be, income gains and losses on sales of securities and gains and losses associated with corrections to the Corporations derivative accounting method as described in Note 2 to the Consolidated Financial Statements (which are included in the net income measures) because the Corporation believes those items are not reflective of the Corporations core results of operations. The Corporation believes that operating income measures are useful to investors seeking to evaluate its operating performance and to compare its performance with other companies in the banking industry that also report operating income. Operating income should not be considered in isolation or as a substitute for net income, cash flows from operating activities, or other income or cash flow statement data prepared in accordance with GAAP. Moreover, the manner in which the Corporation calculates operating income may differ from that of other companies reporting measures with similar names. A reconciliation of the Corporations net income and operating income for the year ended December 31, 2004 and December 31, 2003 follows below:
For the Year Ended December 31, 2004 Compared to Year Ended December 31, 2003
Providents banking growth, including the Southern Financial merger, translated to record earnings for 2004. The Corporation recorded net income of $62.0 million in 2004, a 20% increase over 2003. Diluted earnings per share were $2.00 and $2.05 for 2004 and 2003, respectively. Earnings for 2004 included the impacts of $0.18 per share in net securities losses associated with the balance sheet restructure in the second quarter, $0.07 per share of merger costs and $0.02 per share of costs related to professional services associated with Sarbanes-Oxley compliance. Increases of $36.9 million in the net interest margin after provision for loan losses and $12.6 million in non-interest income more than offset a $26.5 million increase in non-interest expense and a $12.5 million increase in income tax expense, resulting in a $10.5 million increase in net income. The financial results in 2004 reflect the Corporations commitment to produce positive core results by executing the business strategies of broadening its presence and customer base in the Virginia and metropolitan Washington markets, growing commercial business in all markets, and enhancing core business results in all markets.
Return on assets and return on common equity decreased from 1.03% and 16.47%, respectively for 2003 to 1.02% and 12.06%, respectively, for 2004. The Corporations key performance measurements such as operating return on assets and operating return on common equity were 1.06% and 12.50% respectively, for the year ended December 31, 2004 compared to 1.10% and 17.52%, respectively for the prior year.
These items are discussed in more detail, as follows.
Net Interest Income
The Corporations principal source of revenue is net interest income, the difference between interest income on earning assets and interest expense on deposits and borrowings. Interest income is presented on a tax-equivalent basis to recognize associated tax benefits in order to provide a basis for comparison of yields with taxable earning assets. The tables on the following pages analyze the reasons for the changes from year-to-year in the principal elements that comprise net interest income. Rate and volume variances presented for each component will not total the variances presented on totals of interest income and interest expense because of shifts from year-to-year in the relative mix of interest-earning assets and interest-bearing liabilities.
Consolidated Average Balances and Analysis of Changes in Tax Equivalent Net Interest Income:
Consolidated Average Balances and Analysis of Changes in Tax Equivalent Net Interest Income (Continued):