Provident Bankshares 10-Q 2006
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
For the Quarterly Period Ended March 31, 2006
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)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filed, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act).
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
At May 1, 2006, the Registrant had 32,954,736 shares of $1.00 par value common stock outstanding.
TABLE OF CONTENTS
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 2005 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 for the fiscal year ended December 31, 2005 under the headings Forward-Looking Statements and Item 1A. 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. Financial Statements
Condensed Consolidated Statements of Condition
The accompanying notes are an integral part of these statements.
Condensed Consolidated Statements of Income - Unaudited
The accompanying notes are an integral part of these statements.
Condensed Consolidated Statements of Cash Flows Unaudited
The accompanying notes are an integral part of these statements.
Notes to Condensed Consolidated Financial Statements - Unaudited
March 31, 2006
NOTE 1SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Provident Bankshares Corporation (the Corporation), a Maryland corporation, is the bank holding company for Provident Bank (the Bank), a Maryland chartered stock commercial bank. The Bank serves individuals and businesses through a network of banking offices and ATMs in Maryland, Virginia, and southern York County, Pennsylvania. Related financial services are offered through its wholly owned subsidiaries. Securities brokerage, investment management and related insurance services are available through Provident Investment Company and leases through Court Square Leasing and Provident Lease Corporation.
The accounting and reporting policies of the Corporation conform with U.S. generally accepted accounting principles (GAAP) and prevailing practices within the banking industry for interim financial information and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required for complete financial statements and prevailing practices within the banking industry. The following summary of significant accounting policies of the Corporation is presented to assist the reader in understanding the financial and other data presented in this report. Operating results for the three month period ended March 31, 2006 are not necessarily indicative of the results that may be expected for any future quarters or for the year ending December 31, 2006. For further information, refer to the Consolidated Financial Statements and notes thereto included in the Corporations Annual Report on Form 10-K for the year ended December 31, 2005 as filed with the Securities and Exchange Commission (SEC) on March 16, 2006.
Principles of Consolidation and Basis of Presentation
The unaudited Condensed Consolidated Financial Statements include the accounts of the Corporation and its wholly owned subsidiary, Provident Bank and its subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation. Results of operations from purchased companies are included from the date of merger. Assets and liabilities of purchased companies are stated at estimated fair values at the date of merger.
Use of Estimates
The Condensed Consolidated Financial Statements of the Corporation are prepared in accordance with 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 for the reporting periods. Management evaluates estimates on an on-going basis and believes the following represent its more significant judgments and estimates used in preparation of its consolidated financial statements: 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 financial instruments, 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. Each estimate and its financial impact, to the extent significant to financial results, is discussed in the audited Consolidated Financial Statements or in the notes to the audited Consolidated Financial Statements as included in the Corporations 2005 Annual Report on Form 10-K. It is at least reasonably possible that each of the Corporations estimates could change in the near term or that actual results may differ from these estimates under different assumptions or conditions, resulting in a change that could be material to the Corporations unaudited Condensed Consolidated Financial Statements.
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 SFAS 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 derivative. 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 HedgesFor 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 HedgesFor derivatives designated as cash flow hedges, mark-to-market adjustments are recorded net of income taxes as a component of other comprehensive income (OCI) in stockholders 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 DerivativesCertain 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 derivative, 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 accumulated 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 is considered a non-designated derivative and continues to be marked-to-market in the Consolidated Statements of Condition as an asset or liability, and mark-to-market through current period earnings in the Consolidated Statements of Income 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. For significant derivative positions, 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.
Prior to January 1, 2006, the Corporation applied the intrinsic value based method of accounting for its fixed-plan stock options as prescribed by Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees (APB No. 25), and related interpretations, and accordingly, did not record compensation costs for grants of stock options to employees when the initial exercise price equaled the fair market value on the grant date. However, the Corporation did record compensation costs for restricted share grants over the respective vesting periods equal to the fair market value of the common shares on the date of each grant.
Effective January 1, 2006, the Corporation adopted SFAS No.123(R) Share-Based Payment that requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based compensation issued to employees and nonemployees. Under the provisions of SFAS No. 123(R), the Corporation has applied the modified prospective method of adoption, and therefore, results for prior periods have not been restated.
On December 30, 2005, the Corporation approved the accelerated vesting of all outstanding, unvested stock options of the Corporations common stock granted through 2005. As a result, the stock options, that otherwise would have vested during 2006 and thereafter became immediately exercisable. The acceleration of vesting was undertaken in an attempt to eliminate compensation expense that the Corporation would otherwise be required to recognize upon adoption of SFAS No. 123(R). Accordingly, the Corporation will not recognize any compensation cost associated with those stock options in periods subsequent to December 31, 2005.
Compensation cost for stock options granted after January 1, 2006 and restricted share grants will be recognized as non-interest expense in the Condensed Consolidated Statement of Income on a straight-line basis over the requisite service period of each stock option and restricted share grant. Compensation cost for stock options will include the impact of an estimated forfeiture rate. However, the impact of forfeitures on the restricted share grants will be recorded as they occur.
At March 31, 2006, no stock options had vesting conditions linked to the performance of the Corporation. The tax benefits associated with tax deductions in excess of compensation costs are recognized as a financing activity in the Condensed Consolidated Statements of Cash Flows.
Prior to the adoption of SFAS 123(R), the Corporation applied APB 25, to account for its stock-based awards, and the disclosure-only provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, as amended (SFAS 123), to present stock-based compensation disclosure. Under APB 25, because the exercise price of the Corporations stock options equaled the market price of the underlying stock on the date of grant, the stock options had no intrinsic value and therefore no compensation expense was recognized. The following table details the pro forma effects on net income and earnings per share for the three months ended March 31, 2005 had compensation expense been recorded based on the fair value method under SFAS 123, utilizing the Black-Scholes option valuation model:
Other Changes in Accounting Principles
In May 2005, the Financial Accounting Standards Board (FASB) issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS No. 154), which is effective for accounting changes and corrections of errors made in years beginning after December 15, 2005. SFAS No. 154 provides guidance on the accounting for and reporting accounting changes and error corrections. The adoption of SFAS No. 154 did not have any impact on the results of operations of the Corporation.
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments an amendment of FASB Statements No. 133 and 140 (SFAS No. 155), which is effective for all financial instruments acquired and issued after the beginning of an entitys first fiscal year that begins after September 15, 2006. The statement eliminates the exemption from applying SFAS No. 133 to interests in securitized financial assets so that similar instruments will be accounted for on a similar basis regardless of the form of the financial instrument. It also provides for an election of fair value measurement on an instrument-by-instrument basis in cases where a derivative would otherwise have to be bifurcated. The adoption of SFAS No. 155 is not expected to have any impact on the results of operations of the Corporation. As of March 31, 2006, the Corporation did not have any hybrid financial instruments.
In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets an amendment of FASB Statement No. 140 (SFAS No. 156), which is effective for an entitys first fiscal year that begins after September 15, 2006. The statement establishes the accounting for all separately recognized servicing assets and liabilities which require that they be initially recorded at fair value. The statement permits, but does not require, subsequent measurement of the separately recognized servicing assets and liabilities at fair value. The adoption of SFAS No. 156 is not expected to have any impact on the results of operations of the Corporation. Currently, the Corporation does not retain servicing rights for loans sold to third parties.
NOTE 2INVESTMENT SECURITIES
The following table presents the aggregate amortized cost and fair values of the investment securities portfolio as of the dates indicated:
At March 31, 2006, a net unrealized after-tax loss of $25.0 million on the securities portfolio was reflected in net accumulated other comprehensive loss. This compared to net unrealized after-tax losses of $14.2 million and $18.1 million at March 31, 2005 and December 31, 2005, respectively.
Management reviews the investment portfolio on a periodic basis to determine the cause of declines in the fair value of each security. Thorough evaluations of the causes of the unrealized losses are performed to determine whether the impairment is temporary or other than temporary in nature. Considerations such as recoverability of invested amount over a reasonable period of time, the length of time the security is in a loss position and receipt of amounts contractually due, for example, are applied in determining other than temporary impairment. At March 31, 2006, the unrealized losses contained within the Corporations investment portfolio were considered temporary because the declines in fair value were due to changes in market interest rates, not in estimated cash flows of the underlying debt securities.
For further details regarding investment securities at December 31, 2005, refer to Notes 1 and 4 of the Consolidated Financial Statements in the Corporations Form 10-K for the year ended December 31, 2005.
A summary of loans outstanding as of the dates indicated is shown in the table below.
NOTE 4 ALLOWANCE FOR LOAN LOSSES
The following table reflects the activity in the allowance for loan losses for the periods indicated:
NOTE 5INTANGIBLE ASSETS
The table below presents an analysis of the goodwill and deposit-based intangible activity for the three months ended March 31, 2006.
The table below presents a summary of deposits as of the dates indicated:
NOTE 7SHORT-TERM BORROWINGS
The table below presents a summary of short-term borrowings as of the dates indicated:
NOTE 8LONG-TERM DEBT
The table below presents a summary of long-term debt as of the dates indicated:
On March 31, 2005, the Corporation redeemed $30.0 million in aggregate principal amount of 10% Junior Subordinated Debentures issued to Provident Trust II. These Junior Subordinated Debentures had a final stated maturity of March 31, 2030, but were callable at par beginning on March 31, 2005. On July 15, 2005, the Corporation redeemed $5.0 million in aggregate principal amount of 11% Junior Subordinated Debentures issued to Southern Financial Capital Trust I. These Junior Subordinated Debentures were callable beginning July 15, 2005 and had a final stated maturity date of July 15, 2030.
NOTE 9STOCKHOLDERS EQUITY
Plan Description and Adoption of SFAS No. 123(R)
The Corporation issues nonqualified stock options and restricted share grants to certain of its employees and directors pursuant to the 2004 Equity Compensation Plan (the Plan), which has been approved by the shareholders. The Plan allows for a maximum of 12.5 million shares of common stock to be issued. At March 31, 2006, 4.7 million shares were available to be granted by the Corporation.
Stock Option Plan
Stock options (options) are generally granted with an exercise price equal to the market price of the Corporations shares at the date of the grant. The stock options granted subsequent to January 1, 2005 vest based on four years of continuous service and have eight year contractual terms.
Stock options issued in 2004 and prior and in 2005 have contractual terms of ten years and eight years from the date of grant, respectively. As discussed in Note 1, the Corporation accelerated the vesting period for all options granted prior to December 30, 2005. Accordingly, no compensation expense relating to these options has been recognized in the three months ended March 31, 2006.
All options provide for accelerated vesting upon a change in control (as defined in the Plan). Stock options exercised result in the issuance of new shares.
On the date of each grant, the fair value of each award is estimated using the Black-Scholes option pricing model based on assumptions made by the Corporation as follows:
Below is a tabular presentation of the option pricing assumptions and the estimated fair value of the stock options using these assumptions.
The Corporation recognized compensation expense related to stock options of $57 thousand for the three months ended March 31, 2006. The intrinsic value of options exercised for three months ended March 31, 2006 and 2005 was $2.7 million and $889 thousand, respectively. Unrecognized compensation cost related to non-vested options is $1.8 million at March 31, 2006 and is expected to be recognized over a weighted average period of 3.9 years.
The following table presents a summarization of the activity related to options for the period indicated:
Restricted Stock Awards
The Corporation issues restricted share grants, in the form of new shares, to its directors and certain key employees. The restricted share grants are issued at the fair market value of the common shares on the date of each grant. The Corporation grants shares of restricted stock to directors of the Corporation as part of director compensation, as such, the restricted share grants vest immediately. The restricted share grants to the directors may only be exercised six months subsequent to their departure from the board of directors. The restricted share grants to employees vest ratably over four years. The Corporation recorded expense related to these awards of $110 thousand for the three months ended March 31, 2006.
The following table presents a summarization of the activity related to restricted share grants for the period indicated:
At March 31, 2006, unrecognized compensation cost related to non-vested restricted share grants was $2.8 million and is expected to be recognized over a weighted average period of 3.6 years.
NOTE 10DERIVATIVE FINANCIAL INSTRUMENTS
Fair value hedges that meet the criteria for effectiveness have changes in the fair value of the derivative and the designated hedged item recognized in earnings. At and during all periods presented, the derivatives designated as fair value hedges were determined to be effective. Accordingly, the designated hedges and the associated hedged items were marked to fair value by an equal and offsetting amount of $909 thousand and $1.2 million for the three months ended March 31, 2006 and 2005, respectively. Cash flow hedges have the effective portion of changes in the fair value of the derivative, net of taxes, recorded in net accumulated other comprehensive loss. For the three months ended March 31, 2006, the Corporation recorded a decrease in fair value of derivatives of $2.0 million compared to an increase of $1.3 million for the same period in 2005, net of taxes, in net accumulated other comprehensive loss to reflect the effective portion of cash flow hedges. Amounts recorded in net accumulated other comprehensive loss are recognized earnings concurrent with the impact of the hedged item on earnings. For the three months ended March 31, 2006, the ineffective portion of a cash flow hedge resulted in a $4 thousand charge to earnings. For the three months ended March 31, 2005, the Corporation had no ineffective hedges.
Non-designated derivatives are marked to market and the gains or losses are recorded in non-interest income at the end of each reporting period. These non-designated derivatives represent interest rate protection on the Corporations net interest income but do not meet the requirements to receive hedge accounting treatment. For the three months ended March 31, 2006 and 2005, the Corporation recorded a pre-tax net loss of $603 thousand and $3.8 million, respectively, to reflect the decrease in value of the non-designated interest rate swaps. The net cash settlements on the interest rate swaps are recorded in non-interest income. Net cash settlements on interest rate swaps were $290 thousand and $1.6 million for the three months ended March 31, 2006 and 2005, respectively.
The table below presents the Corporations open derivative positions as of the dates indicated:
NOTE 11CONTINGENCIES AND OFF BALANCE SHEET RISK
Commitments to extend credit in the form of consumer, commercial real estate and business loans at the date indicated 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.
The Corporation is involved in various legal actions that arise in the ordinary course of its business. In April 2005, the Corporation became a party to litigation where a former employee alleges a breach by the Corporation of a previously executed employment contract. The former employee claims that, under the terms of the contract, he is due a so-called imputed interest payment valued at approximately $2 million. Further, under a theory of damages put forth, he asserts that he is owed a multiple of the imputed interest payment. The aggregate damage award sought against the Corporation in this action is approximately $6 million. The discovery phase of the litigation process has been completed, however, no trial date has been set. The Corporation believes it has meritorious defenses against this action and is vigorously and actively contesting the allegations against it.
All other active lawsuits entail amounts which management believes, in the aggregate, are immaterial to the financial condition and the results of operations of the Corporation.
NOTE 12NET GAINS (LOSSES)
Net gains (losses) include the following components for the periods indicated:
NOTE 13EARNINGS PER SHARE
The following table presents a summary of per share data and amounts for the periods indicated.
NOTE 14COMPREHENSIVE INCOME
Presented below is a reconciliation of net income to comprehensive income including the components of other comprehensive loss for the periods indicated.
NOTE 15EMPLOYEE BENEFIT PLANS
The actuarially estimated net benefit cost includes the following components for the periods indicated:
On March 31, 2005, the Corporation announced that the pension plan would be frozen for new entrants. Employees who were already participants in the plan were not affected by this change. Also on March 31, 2005, the Corporation communicated to retirees under the age of 65 currently receiving postretirement health care benefits that these benefits would be eliminated and no longer offered, effective January 1, 2006. Postretirement life insurance benefits continue to be provided to retirees. This action resulted in the reversal of the actuarially determined liability of $1.6 million at March 31, 2005 associated with health care benefits.
No contributions were made to the qualified pension plan in the three months ended March 31, 2006 and 2005, respectively. The minimum required contribution in 2006 for the qualified plan is estimated to be zero. The decision to contribute further amounts is dependent on other factors including the actual investment performance of the plan assets and the requirements of the Internal Revenue Code. Given these uncertainties, the Corporation is not able to reliably estimate the maximum deductible contribution or the amount that will be contributed in 2006 to the qualified plan. For the unfunded non-qualified pension and postretirement benefit plans, the Corporation will contribute the minimum required amount in 2006, which is equal to the benefits paid under the plans.
NOTE 16BUSINESS SEGMENT INFORMATION
The Corporations lines of business are structured according to the channels through which its products and services are delivered to its customers. For management purposes the lines are divided into the following segments: Consumer Banking, Commercial Banking, and Treasury and Administration.
The Corporation offers consumer and commercial banking products and services through its wholly owned subsidiary, Provident Bank. The Bank offers its services to customers in the key urban areas of Baltimore, Washington and Richmond through 91 traditional and 62 in-store banking offices in Maryland, Virginia and southern York County, Pennsylvania. Additionally, the Bank offers its customers 24-hour banking services through 252 ATMs, telephone banking and the Internet. Consumer banking services include a broad array of small business and consumer loan, deposit and investment products offered to retail and commercial customers through the retail branch network and direct channel sales center. Commercial Banking provides an array of commercial financial services including asset-based lending, equipment leasing, real estate financing, cash management and structured financing to middle market commercial customers. Treasury and Administration is comprised of balance sheet management activities that include managing the investment portfolio, discretionary funding, utilization of derivative financial instruments and optimizing the Corporations equity position.
The financial performance of each business segment is monitored using an internal profitability measurement system. This system utilizes policies that ensure the results reflect the economics for each segment compiled on a consistent basis. Line of business information is based on management accounting practices that support the current management structure and is not necessarily comparable with similar information for other financial institutions. This profitability measurement system uses internal management accounting policies that generally follow the policies described in Note 1. The Corporations funds transfer pricing system utilizes a matched maturity methodology that assigns a cost of funds to earning assets and a value to the liabilities of each business segment with an offset in the Treasury and Administration business segment. The provision for loan losses is charged to the consumer and commercial segments based on actual charge-offs with the balance to the Treasury and Administration segment. Operating expense is charged on a fully absorbed basis. Income tax expense is calculated based on the segments fully taxable equivalent income and the Corporations effective tax rate. Revenues from no individual customer exceeded 10% of consolidated total revenues.
The table below summarizes results by each business segment for the periods indicated.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
Provident Bankshares Corporation (the Corporation), a Maryland corporation, is the holding company for Provident Bank (Provident or the Bank), a Maryland chartered stock commercial bank. At March 31, 2006, the Bank was the second largest independent commercial bank, in asset size, headquartered in Maryland, with $6.4 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, D.C. 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 focuses on providing 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. 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.
Providents mission is to exceed customer expectations by delivering superior service, products and banking convenience. Every employees commitment to serve the Banks customers in this fashion will establish Provident as the primary bank of choice of individuals, families, small businesses and middle market businesses throughout its chosen markets. To achieve this mission and to improve financial fundamentals, the strategic focus of the organization is to:
Maximize Providents position as the right size bank in the marketplace. Providents position as the second largest bank headquartered in Maryland provides a unique opportunity as the right size bank in its footprint. The Bank provides the service of a community bank combined with the convenience and wide array of products and services that a strong regional bank offers. In addition, the 62 in-store banking offices throughout its footprint reinforce its right size strategy through convenient locations, hours and a full line of products and services. Provident currently has 153 banking offices concentrated in the Baltimore-Washington, D.C. corridor and beyond to Richmond, Virginia. Of the 153 banking offices, 44% are located in the Greater Baltimore region and 56% are located in the Greater Washington, D.C. and Central Virginia regions, reflecting the successful development of the Bank into a highly competitive regional commercial bank. Provident also offers its customers 24-hour banking services through ATMs, telephone banking and the Internet. The network of 252 ATMs enhances the banking office network by providing customers increased opportunities to access their funds.
Grow and deepen consumer and small business relationships in Maryland and Virginia. Consumer banking continues to be an important component of the Banks business strategy. Consumer banking services include a broad array of consumer and small business loan, lease, deposit and investment products offered to consumer and commercial
customers through Providents banking office network and ProvidentDirect, the Banks direct channel sales center. 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.
Grow and deepen commercial and real estate relationships in Maryland and Virginia. Commercial banking is the other key component to the Corporations regional presence in its market area. The Commercial Banking group provides customized banking solutions to middle market commercial and real estate customers. The Bank has an experienced team of relationship managers with expertise in real estate and business lending to companies in various industries in the region. It also has a suite of cash management products managed by responsive account teams that deepen customer relationships through consistently priced deposit based services, responsive service and maintenance of frequent personal contact with each customer.
Move from a product driven organization to a customer relationship focused sales culture. The Corporations transition to a customer relationship driven sales culture requires deepening relationships through cross-selling and the continuing emphasis on retention of valued customers. The Bank has segmented its customers to better understand and anticipate their financial needs and provide Providents sales force with a targeted approach to customers and prospects. The successful execution of this strategy will be centered on the right size bank commitment - providing the service of a community bank combined with the convenience and wide array of products and services that a strong regional bank offers.
Create a high performance culture that focuses on employee development and retention. Provident has always placed a high priority on its employees and has approached employee development and training with renewed emphasis. Employee development is viewed as a critical part of executing Providents strategy as the right size bank and transforming the Companys sales culture with a focus on the employees development and approach with Providents customers.
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 periods indicated. This discussion and tabular presentations should be read in conjunction with the accompanying unaudited Condensed Consolidated Financial Statements and Notes as well as the other information herein.
The Condensed Consolidated Financial Statements of the Corporation 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 for the reporting periods. Management evaluates estimates on an on-going basis, and believes the following represent its more significant judgments and estimates used in preparation of its consolidated financial statements: 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 financial instruments, 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. Management believes the following critical accounting policies affect its more significant judgments and estimates used in preparation of its Condensed 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 and its financial impact, to the extent significant to financial results, is discussed in the notes to the unaudited Condensed Consolidated Financial Statements. It is at least reasonably possible that each of the Corporations estimates could change in the near term or that actual results may differ from these estimates under different assumptions or conditions, resulting in a change that could be material to the unaudited Condensed Consolidated Financial Statements.
Overview of Income and Expenses
The Corporation has two primary sources of pre-tax income. The first is net interest income. Net interest income is the difference between interest income which is the income that the Corporation earns on its loans and investmentsand interest expensewhich is the interest that is paid on its deposits and borrowings.
The second principal source of pre-tax income is non-interest incomethe revenue received from providing products and services. The majority of the non-interest income comes from service charges on deposit accounts. The Corporation also earns revenue from insurance commissions, mortgage banking fees and other fees and charges.
The Corporation recognizes gains or losses as a result of sales of investment securities or the disposition of loans, foreclosed property or fixed assets. These gains and losses are not a regular part of the Corporations income. In addition, the Corporation also recognizes gains or losses on its outstanding non-designated derivative financial instruments.
The expenses the Corporation incurs in operating its business consist of salaries and employee benefits expense, occupancy expense, furniture and equipment expense, external processing fees, deposit insurance premiums, advertising expenses, and other miscellaneous expenses.
Salaries and benefits expense consists primarily of the salaries and wages paid to employees, payroll taxes, fees paid to directors and expenses for retirement and other employee benefits.
Occupancy expense, which are fixed or variable costs associated with building and equipment, consist primarily of lease payments, real estate taxes, depreciation charges, maintenance and cost of utilities.
Furniture and equipment and external processing include fees paid to third-party data processing services and expenses and depreciation charges related to office and banking equipment. Depreciation of premises and equipment is computed using the straight-line method based on the useful lives of related assets. Estimated lives are 2 to 40 years for building and improvements, and 2 to 15 years for furniture and equipment.
Other expenses include expenses for attorneys, accountants and consultants, franchise taxes, charitable contributions, insurance, office supplies, postage, telephone, merger expense and other miscellaneous operating expenses.
The financial condition of the Corporation reflects the continued improvement in financial fundamentals through the consistent execution of the Banks key strategies and the balance sheet transition towards growing loans and deposits in the Banks core business segments. The expanded market presence experienced over the past few years has been successful in growing and deepening relationships across the Corporations key major markets of Greater Baltimore, Greater Washington and Central Virginia. The successful efforts have led to growth in average loans of $160.5 million, or 4.5%, and average deposits of $257.8 million, or 6.9%, over the first quarter of 2005. At March 31, 2006, total assets were $6.4 billion which is essentially flat with the periods ended December 31, 2005 and March 31, 2005. Over the past 12 months, growth in internally generated loan portfolios has been offset by a decline in non-core or wholesale loans (originated and acquired residential mortgages) and investment securities as the Corporation continues to execute its strategy of transitioning the balance sheet towards core assets and away from wholesale assets.
Total average loan balances increased to $3.7 billion in the first quarter of 2006, an increase of $160.5 million, or 4.5%, from the first quarter 2005 (prior year quarter). The following table summarizes the composition of the Banks average loans for the periods indicated.
Strong loan growth in the Corporations core loan portfolios (loans other than the Companys originated and acquired residential mortgage loans) was offset by continued strategic reductions in non-core or wholesale portfolios (originated and acquired residential mortgages). The average loan balances of loans other than originated and acquired residential mortgage loans increased in the aggregate, $360.8 million, or 12.4%, over the same quarter in 2005. This increase was a result of the Corporations expanded presence and successful marketing efforts to grow its home equity and residential and commercial construction loan portfolios. As a result, total average loans increased by 4.5% and was mainly driven by an increase of $189.5 million in average home equity loans and $215.3 million in average residential and commercial constructions loans. These increases more than offset planned reductions in originated and acquired residential mortgage loans of $200.3 million.
The home equity loan suite of products has been a key component of the Banks strategy to deepen its consumer relationships. This market strategy resulted in the $189.5 million, or 26.1%, increase in home equity average balances, continuing the growth of $205.7 million, or 39.6%, that occurred in first quarter 2005. The production of direct consumer loans, primarily home equity loans and lines, are generated by the Banks retail banking offices, phone center and internet units. The strong growth in home equity lending was partially offset by a decline in marine and other consumer loans. The Corporations marine lending loan growth has been restricted due to low pricing margins in the industry.
Commercial banking is the other key component to the Corporations regional presence in its market area. Average total commercial loans increased $205.3 million, or 12.0%, compared to the 2005 quarter. Commercial and residential construction loans posted increases during the quarter of $187.9 million and $27.4 million, respectively, reflecting strong regional demand for construction loans in the Banks markets. This growth has occurred within the Corporations market footprint and is a reflection of the lending areas ability to deepen historical lending relationships with seasoned borrowers in familiar markets. These expanded relationships and associated risks are managed through a strong level of loan administration and credit monitoring by a very experienced lending staff. The result is a well-balanced mix of revenue sources between consumer and commercial loan products with $1.8 billion, or 48.4%, in consumer loans, and $1.9 billion, or 51.6%, in commercial loans. Geographically, average loan balances of $1.4 billion originated in the Greater Washington and Central Virginia regions represent 37% of total average loans in first quarter 2006.
The following table presents information with respect to non-performing assets and 90-day delinquencies as of the dates indicated.
The asset quality within the Corporations loan portfolio continues to remain strong in the first quarter of 2006. Strong asset quality within the Corporations loan portfolio is a reflection of managements credit policies and strategy of shifting the balance sheet to core loan portfolios. In addition, regional credit conditions remained favorable for the first quarter 2006. Non-performing assets were $28.1 million at March 31, 2006, a 2.4% increase, or $667 thousand, from the level at December 31, 2005. The increase in non-performing assets was due to the $1.3 million increase in originated and acquired residential mortgages offset by a $584 thousand decline in non-performing commercial business loans during the quarter. Non-performing commercial business loans include $1.3 million of loans that have U.S. government guarantees.
The level of non-performing assets to total loans was 0.76% at March 31, 2006 compared to 0.74% at December 31, 2005. The level of 90-day delinquent loans declined during the same period, decreasing $3.1 million, or 38.3%, to $5.0 million from the $8.1 million level at December 31, 2005 and $10.8 million at March 31, 2005. Overall, the asset quality ratios of the Corporation remain favorable, but no assurances can be given regarding the level of non-performing assets in the future.
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 loan 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 that 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 risk rating based upon an assessment of the borrowers financial capacity to service the debt and the presence and value of collateral for the loan.
In addition to being used to categorize risk, the Banks internal ten-point risk rating system is used to determine the allocated allowance for the commercial portfolio. Reserve factors, based on the actual loss history for a 5-year period for criticized loans, are assigned. If the factor, based on loss history for classified credits is lower than the minimum established factor, the higher factor is applied. For loans with satisfactory risk profiles, the factors are based on the rating profile of the portfolio and the consequent historic losses of bonds with equivalent ratings.
For the consumer portfolios, 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; historic loss rates, 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 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 Audit Committee of the Board of Directors. Such reviews also assist management in establishing the level of the allowance.
Management believes that it uses the relevant 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.
The FDIC examines the Bank periodically and, accordingly, as part of this examination, 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.
At March 31, 2006, the allowance was $44.8 million, or 1.21%, as a percentage of total loans outstanding, compared to an allowance at December 31, 2005 of $45.6 million, or 1.24%, as a percentage of total loans outstanding. The allowance coverage of 169.83% of non-performing loans at March 31, 2006 compared to 177.78% at December 31, 2005. Portfolio-wide net charge-offs represented 0.13% of average loans in first quarter 2006, compared to 0.24% in first quarter 2005 and 0.09% from the fourth quarter 2005.
The following table summarizes the composition of the Corporations average deposit balances for the periods indicated.
Average deposits increased $257.8 million, or 6.9%, in the first quarter 2006 over the same quarter last year. Consumer deposits grew $48.2 million, or 1.8%, while commercial deposits experienced growth of $128.9 million, or 17.7%. The primary driver in the commercial deposit growth was the increase in certificates of deposit in the Greater Washington and Central Virginia regions and higher commercial money market balances associated with commercial real estate lending activities in the Greater Baltimore region. In addition, brokered deposits issued also increased as a less expensive alternative to borrowing.
Geographically, average customer deposits in the Greater Washington and Central Virginia regions represent 39% of total customer deposits. The Bank currently has 86 retail banking offices in this market or 56% of total banking offices.
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. In managing the investment portfolio to achieve its stated objective, the Corporation invests predominately in U.S. Treasury and Agency securities, mortgage-backed securities (MBS) and other debt securities, which include corporate bonds and asset-backed securities (ABS).
At March 31, 2006, the investment securities portfolio was $1.9 billion, or 30.1% of total assets. The Banks investment portfolio declined $229 million from March 31, 2005 to March 31, 2006, reflecting managements strategy to de-emphasize wholesale investments. The reduction in balances occurred in the MBS portfolio, which was reduced from $1.5 billion to $1.0 billion over that time period. Floating rate ABS were increased by $213 million over the same time period.
At March 31, 2006, 51% of the investment portfolio was invested in MBS. The allocation to floating rate ABS and corporate bonds was increased to 36%, to take advantage of rising short-term interest rates. The ABS portfolio, representing 34% of the total portfolio, consists predominately of Aaa and single A rated classes of pooled trust preferred securities. The re-allocation of investment securities out of MBS and into floating rate ABS achieved the objectives of 1) reducing the portfolios market value sensitivity to rising interest rates and 2) increasing the percentage of the portfolio that reprices with one-month or three month LIBOR in order to increase the Banks asset sensitivity position. Other debt securities primarily include investments in single issuer corporate bonds rated investment-grade by Moodys or S&P, single or double A rated home equity ABS, and U.S. Treasury, Agency, and municipal securities. 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 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 3.5%. In the current economic environment, the duration is targeted for the middle of that range. Another risk in the investment portfolio is credit risk. At March 31, 2006, over 65% of the entire investment portfolio was rated AAA, 34% was investment grade below AAA, and 1% was rated below investment grade or was not rated.
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. If 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 March 31, 2006. 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 March 31, 2006.
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 and 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 trusts are presented net of unamortized issuance costs as long-term debt in the Condensed Consolidated Statements of Condition and are includable in Tier 1 capital for regulatory capital purposes, subject to certain limitations. 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 March 31, 2005, the Corporation redeemed $30 million aggregate value of Junior Subordinated Debentures issued to Provident Trust II at an annual rate of 10%. On July 15, 2005, the Corporation redeemed $5 million aggregate value of Junior Subordinated Debentures issued to Southern Financial Capital Trust I at an annual rate of 11%. There are no issuances callable in 2006.
Treasury borrowings rose slightly from December 2005 to March 2006, to fund core loan growth. Comparing monthly average balances, March 2006 borrowings rose $78 million from December 2005, from $1.67 billion to $1.75 billion. Short-term borrowings rose $250 million while long-term borrowings were reduced $150 million, as management took advantage of lagging rates increases in the Fed Funds market by increasing this segment of its borrowing portfolio. In addition, brokered CDs were reduced by $21 million.
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 for 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 March 31, 2006, $1.0 billion of secured borrowings were employed, with sufficient collateral available to immediately raise an additional $1.1 billion. An excess liquidity position of $672 million remains after covering $445 million of unsecured funds that mature in the next three months. 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 sources of unsecured funding that it uses routinely. At March 31, 2006, the Bank possessed over $900 million of unsecured overnight borrowing capacity, of which $378 million was in use. The Bank also accesses the brokered CD market when the pricing of CDs is favorable to other secured or unsecured sources. Additionally, the Corporation has access to public and private debt markets, and most recently issued $71 million of trust preferred securities in December 2003.
As an alternative to raising secured funds, the Bank can raise liquidity through asset sales. At March 31, 2006, over $500 million of the Banks investment portfolio was immediately saleable at a market value equaling or exceeding its amortized cost basis. Additionally, over a 90-day time frame, a majority of the Banks $1.8 billion consumer loan portfolio is saleable in an efficient market.
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 Junior Subordinated Debentures. 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 Condensed 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 Condensed 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 at March 31, 2006 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.
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 March 31, 2006 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 March 31, 2006, the Corporation did not have any firm commitments to purchase loans.
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, which finances earning assets, 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 April 1, 2006 for the March 31, 2006 data and on January 1, 2006 for the December 31, 2005 data and evenly increase or decrease over a 6-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 projected outcomes presented below are based on a balance sheet growth forecast and parallel shifts in interest rates, i.e. all interest rates moving by the same amount. Management models many non-parallel rate change scenarios as well, including several yield-curve flattening scenarios. The results of each scenario differ; however, the results below are an accurate indication of the magnitude and direction of the Corporations interest rate risk.
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 3.1% under the assumed 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. Management pays close attention to the risk of continued flattening of the yield curve. Short-term interest rates, such as the fed funds rate, have increased approximately 200 basis points over the past year while long-term rates have risen about 60 basis points. Further yield curve flattening is possible, either through further increases in short-term rates, further decreases in long-term rates, or both. Management routinely models several yield curve flattening scenarios as part of its interest rate risk management function, and this modeling discloses little risk under most yield curve flattening scenarios.
Management employs the investment, borrowings, and derivatives portfolios in implementing the Banks interest rate strategy. As noted above, mitigating yield curve flattening risk has been a significant element of interest rate risk management. To protect the Bank from rising short-term interest rates, over $600 million of the investment portfolio reprices semiannually or more frequently. In the borrowings portfolio, over $270 million of funds reset their rates with long-term interest rates, such as the 10-year constant maturity swap rate, to protect the net interest margin from falling long-term interest rates. The interest expense associated with these borrowings declines when long-term interest rates decline. Additionally, $366 million of interest rate swaps were in force to reduce interest rate risk, and $165 million of interest rate caps were employed specifically to protect against rising interest rates in the future.
In addition to managing interest rate risk, which applies to both assets and liabilities, the Corporation must understand and manage risks specific to lending. Much of the fundamental lending business of Provident is based upon understanding, measuring and controlling credit risk. Credit risk entails both general risks, which are inherent in the process of lending, and risk specific to individual borrowers. Each consumer and residential lending product has a generally predictable level of credit loss based on historical loss experience. Home mortgage and home equity loans and lines generally have the lowest credit loss experience. Loans with medium credit loss experience are primarily secured products such as auto and marine loans. Unsecured loan products such as personal revolving credit have the highest credit loss experience; therefore the Bank has chosen not to engage in a significant amount of this type of lending. Credit risk in commercial lending varies significantly, as losses as a percentage of outstanding loans can shift widely from period to period and are particularly sensitive to changing economic conditions. Generally improving economic conditions result in improved operating results on the part of commercial customers, enhancing their ability to meet debt service requirements. However, this improvement in operating cash flow is often at least partially offset by rising interest rates often seen in an improving economic environment. In addition, changing economic conditions often impact various business segments differently, giving rise to the need to manage industry concentrations within the loan portfolio. Further discussion relating to asset quality was presented on page 25.
Other lending risks include liquidity risk and specific risk. The liquidity risk of the Corporation arises from its obligation to make payment in the event of a customers contractual default. The evaluation of specific risk is a basic function of underwriting and loan administration, involving analysis of the borrowers ability to service debt as well as the value of pledged collateral. In addition to impacting individual lending decisions, this analysis may also determine the aggregate level of commitments the Corporation is willing to extend to an individual customer or a group of related customers.
Total stockholders equity was $630.2 million at March 31, 2006, a decrease of $299 thousand from December 31, 2005. The change in stockholders equity for the period was attributable to $18.3 million in earnings that was partially offset by dividends paid of $9.4 million. Net accumulated other comprehensive loss increased by $9.3 million during the period primarily due to the impact of rising interest rates on the market value of the debt securities portfolio. Capital was also reduced by $5.4 million associated with stock-based payment and by $5.3 million from the repurchase of 149 thousand shares of the Corporations common stock at an average price of $35.90. The Corporation is authorized to repurchase an additional 1.1 million 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.
As of March 31, 2006, the Corporation is considered well capitalized for regulatory purposes.
RESULTS OF OPERATIONS
For Three Months Ended March 31, 2006 Compared to Three Months Ended March 31, 2005
Provident reported net income of $18.3 million, or $0.55 per diluted share, in the quarter ended March 31, 2006 compared to $15.8 million and $0.47 per diluted share in first quarter 2005. The financial results of first quarter 2006 reflect the Companys continued improvement in financial fundamentals through the consistent execution of the Banks key strategies and transition of the balance sheet. The Corporation showed improvement in its key performance measurements over first quarter 2005, as return on assets, return on common equity and net interest margin were 1.17%, 11.40% and 3.72%, respectively, in the quarter ended March 31, 2006 compared to 0.99%, 10.32%, and 3.46%, respectively, over the prior year quarter. The financial results in the first quarter of 2006 reflect the Corporations continued commitment to produce positive core results by executing the basic strategies of broadening its presence and customer base in the Greater Washington and Central Virginia regions, growing commercial business in all markets, and enhancing core business results in all markets.
Solid loan growth of $360.8 million in the Corporations core business segments provided continued improvement in the quantity as well as quality of the Corporations earnings. This improvement was accomplished on a lower level of average assets and debt and a higher level of capital. Improved earnings included an increase of $2.5 million in net interest income, a $1.3 million decrease in provision for loan losses, and an increase in non-interest income of $5.2 million, offset by an increase of $5.3 million in non-interest expense and a $1.1 increase in income tax expense, resulting in a $2.5 million increase in net income from first quarter 2005.
The financial results reflect the continued balance sheet transition toward growing loans and deposits in core business segments. An overview of the strategies is discussed on pages 21 and 22 of Managements Discussion and Analysis of Financial Condition and Results of Operations. Asset quality continues to remain strong, as non-performing assets to loans were 0.76% and charge-offs to average loans were 0.13% for the quarter.
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 following table presents information regarding the average balance of assets and liabilities, as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing income or expense by the average balances of assets or liabilities, respectively, for the periods presented. Nonaccrual loans are included in average balances, however, accrued interest income has been excluded from these loans. The tables on the following pages also 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
Three Months Ended March 31, 2006 and 2005
Consolidated Average Balances and Analysis of Changes in Tax Equivalent Net Interest Income (Continued)
Three Months Ended March 31, 2006 and 2005
The net interest margin, on a tax-equivalent basis, increased 26 basis points to 3.72% and was driven by the continuation of the balance sheet transitioning and by the solid growth in core lending activities. Managements strategy to replace lower net interest-earning assets with higher net interest-earning assets has been very successful. The Corporation has seen solid loan growth in its home equity and residential and commercial construction loan portfolios since the same period a year ago. Growth in these portfolios was offset by planned declines in non-core investment securities and originated and acquired residential portfolios. Overall, average earning assets decreased $86.4 million to $5.6 billion which was attributable to a $248.1 million reduction in investment securities partially offset by net loan growth of $160.5 million. The yields on investments and loans grew 70 and 89 basis points, respectively. The yield increase in the portfolio was mainly the result of the rising interest rate environment over the past year and the Corporations greater emphasis on variable rate securities. Interest-bearing liabilities decreased $131.6 million while the average rate paid increased 75 basis points. The increase in the average rate paid was primarily due to rising interest rates and the mix of interest-bearing liabilities. Interest expense benefited from a $7.9 million increase in average noninterest-bearing deposit balances during the quarter.
The 6.22% yield on earning assets correspondingly increased as a result of rising interest rates and its product mix of loans that more than offset the increased funding costs of 2.90%. Net interest income on a tax-equivalent basis was $51.7 million in first quarter 2006, compared to $48.9 million in first quarter 2005. Total interest income increased $11.0 million and total interest expense increased $8.3 million resulting in the growth in net interest income of $2.8 million on a tax-equivalent basis.
The Corporation has an ongoing risk management strategy of using derivative transactions to maintain a stable net interest margin. As a result of derivative transactions accounted for as hedges undertaken to mitigate the affect of interest rate risk on the Corporation, interest income increased by $11 thousand and interest expense increased by $95 thousand, for a total decrease of $84 thousand in net interest income relating to derivative transactions for the quarter ended March 31, 2006.
Future growth in net interest income will depend upon consumer and commercial loan demand, growth in deposits and the general level of interest rates.
Provision for Loan Losses
The Corporations continued emphasis on quality underwriting as well as aggressive management of charge-offs and potential problem loans resulted in a provision for loan losses of $318 thousand in first quarter 2006 compared to $1.6 million in first quarter 2005. Net charge-offs were $1.2 million, or 0.13% of average loans, in first quarter 2006 compared to $2.1 million, or 0.24% of average loans, in first quarter 2005. Originated and acquired residential loan net charge-offs as a percentage of average originated and acquired residential loans continue to decline during the period, from 0.41% in first quarter 2005 to 0.31% in first quarter 2006.
Non-interest income increased to $28.2 million, or 22.5%, from $23.0 million in first quarter 2005. Deposit fee income increased $2.7 million, or 14.0%, reflecting increases mainly in consumer deposit fees which were a result of implementing a number of fundamental processing changes in the second quarter 2005 along with the addition of new branches via de-novo expansion. Net cash settlement on swaps, representing interest income and expense on non-designated interest rate swaps, decreased $1.3 million from first quarter 2005, as a result of rising short-term interest rates. Providents non-designated interest rate swaps are receive fixed/pay LIBOR positions. LIBOR rates have increased approximately 190 basis points from first quarter 2005 to first quarter 2006. Other non-interest income benefited from increases in mortgage banking income and income associated with bank owned life insurance.
Net gains were $540 thousand in first quarter 2006, compared to net losses of $776 thousand in first quarter 2005. First quarter 2006 included investment/borrowing transactions that were focused on reducing fixed rate mortgage-backed securities to reduce interest rate risk. These transactions generated net gains of $521 thousand. The first quarter of 2006 also included net gains of $123 thousand primarily from the sale of loans. These gains were partially offset by losses of $122 thousand from the extinguishment of $100 million of FHLB borrowings. Prior years losses were primarily the result of an $876 thousand loss from the sale of securities that was focused on improving future interest yield performance and net losses of $51 thousand from the extinguishment of $36 million of FHLB borrowings. Derivative losses on swaps
declined $3.2 million, from a net loss of $3.8 million in the 2005 first quarter to a net loss of $603 thousand in the 2006 first quarter. This decline resulted mainly from the decline in the amount of interest rate swaps the Corporation had on during the first quarter 2006.
Non-interest expense increased by $5.3 million, or 11.2%. Salaries and employee benefits had the largest change, rising $4.9 million, or 21.7%. This increase is mainly attributable to increased labor costs of $1.5 million from increased staffing in the branch network and operations support along with additional staffing required to meet regulatory compliance, as well as an increase of $433 thousand in costs associated with incentive and commission programs due to higher levels of production in both consumer and commercial lending. Salaries and employee benefits expense also included an increase in health care costs of $569 thousand, employment taxes of $262 thousand, Corporations 401k plan of $186 thousand and stock compensation expense of $120 thousand relating to restricted stock and stock options. In addition, the first quarter 2005 included a reduction of $1.6 million relating to the termination of the Corporations post-retirement benefits plan. Occupancy and furniture and equipment expense increased $838 thousand reflecting the increased branch network, increased lease equipment depreciation expense associated with the leasing companys operating leases and increased depreciation on furniture and equipment. Non-interest expense also includes $675 thousand reduction in costs related to regulatory compliance obligations.
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 carryforwards. 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. The valuation allowance was approximately $2.4 million at March 31, 2006 versus $1.8 million at March 31, 2005. The valuation allowance relates to additional state operating losses that are unlikely to be realized in the foreseeable future.
The Corporation recorded income tax expense of $8.1 million based on pre-tax income of $26.4 million, representing an effective tax rate of 30.75% in first quarter 2006. In first quarter 2005, the Corporation recorded a tax expense of $7.0 million on pre-tax income of $22.7 million, an effective tax rate of 30.65%.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
For information regarding market risk at December 31, 2005, see Interest Sensitivity Management and Note 15 to the Consolidated Financial Statements in the Corporations Form 10-K filed with the Securities and Exchange Commission on March 16, 2006. The market risk of the Corporation has not experienced any material changes as of March 31, 2006 from December 31, 2005. Additionally, refer to Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations for additional quantitative and qualitative discussions about market risk at March 31, 2006.
Item 4. Controls and Procedures
The Corporations management, including the Corporations principal executive officer and principal financial officer, have evaluated the effectiveness of the Corporations disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, (the Exchange Act). Based upon their evaluation, the principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Corporations disclosure controls and procedures were effective for the purpose of ensuring that the information required to be disclosed in the reports that the Corporation files or submits under the Exchange Act with the Securities and Exchange Commission (the SEC) (1) is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms, and (2) is accumulated and communicated to the Corporations management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. In addition, based on that evaluation, no change in the Corporations internal control over financial reporting occurred during the quarter ended March 31, 2006 that has materially affected, or is reasonably likely to materially affect, the Corporations internal control over financial reporting.
Item 1. Legal Proceedings
The Corporation is involved in various legal actions that arise in the ordinary course of its business. In April 2005, the Corporation became a party to litigation where a former employee alleges a breach by the Corporation of a previously executed employment contract. The former employee claims that, under the terms of the contract, he is due a so-called imputed interest payment valued at approximately $2 million. Further, under a theory of damages put forth, he asserts that he is owed a multiple of the imputed interest payment. The aggregate damage award sought against the Corporation in this action is approximately $6 million. The discovery phase of the litigation has been completed, however, no trial date has been set. The Corporation believes it has meritorious defenses against this action and is vigorously and actively contesting the allegations against it.
All other active lawsuits entail amounts which management believes, in the aggregate, are immaterial to the financial condition and the results of operations of the Corporation.
Item 1A. Risk Factors
For information regarding risk factors at December 31, 2005, see Item 1A. Risk Factors in the Corporations Form 10-K filed with the Securities and Exchange Commission on March 16, 2006. The risk factors of the Corporation have not changed materially as of March 31, 2006 from December 31, 2005.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
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. On June 17, 2005, the Corporation approved an additional stock repurchase of up to 1.3 million shares from time to time subject to market conditions. Currently, the maximum number of shares remaining to be purchased under this plan is 1,088,658. All shares have been repurchased pursuant to the publicly announced plan. The repurchase plan will continue until it is completed or terminated by the Board of Directors. No plans expired during the three months ended March 31, 2006. The Corporation currently has no plans to terminate the stock repurchase plan prior to its expiration.
The following table provides certain information with regard to shares repurchased by the Corporation in the first quarter of 2006.
Item 6. Exhibits
The exhibits and financial statements filed as a part of this report are as follows:
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.