South Financial Group 10-K 2006
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission File Number: 0-15083
The South Financial Group, Inc.
(Exact Name of Registrant as Specified in its Charter)
Registrants telephone number, including area code
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $1.00 Par Value
(Title of Class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o.
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o.
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check One):
Large Accelerated Filer þ Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ.
The aggregate market value of the voting and non-voting common stock held by non-affiliates of the registrant, computed by reference to the closing price of such stock on June 30, 2005, was approximately $2.0 billion.
The number of shares of the Registrants common stock, $1.00 par value, outstanding on March 1, 2006 was 74,870,033.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement relating to the 2006 Annual Meeting of Shareholders filed with the Securities and Exchange Commission are specifically identified and incorporated by reference into Part II and III.
The Exhibit Index begins on page 123
Item 1. Business
The South Financial Group, Inc. is a South Carolina corporation headquartered in Greenville, South Carolina. TSFG refers to The South Financial Group, Inc. and its subsidiaries, except where the context requires otherwise. TSFG is a financial holding company, as defined by the Gramm-Leach-Bliley Act of 1999. TSFG operates principally through Carolina First Bank, a South Carolina-chartered commercial bank, and Mercantile Bank, a Florida-chartered commercial bank.
TSFGs subsidiaries provide a full range of financial services, including banking, cash management, retail investment services, mortgage banking, insurance, and trust and investment management services, designed to meet the financial needs of its customers. TSFG currently conducts business through 80 branch offices in South Carolina, 66 in Florida, and 26 in North Carolina. At December 31, 2005, TSFG had $14.3 billion in assets, $9.5 billion in loans, $9.2 billion in deposits, $1.5 billion in shareholders equity, and $2.1 billion in market capitalization.
TSFG began its operations in 1986 under the name Carolina First Corporation with the de novo opening of its banking subsidiary, Carolina First Bank, in Greenville, South Carolina. Its opening was undertaken, in part, in response to opportunities resulting from the takeovers of several South Carolina-based banks by larger southeastern regional bank holding companies in the mid-1980s. In the late 1990s, TSFG perceived a similar opportunity in Florida where banking relationships were in a state of flux due to the acquisition of several larger Florida banks. In 1999, TSFG entered the Florida market with the same strategy of capitalizing on the environment created by these acquisitions.
TSFG has pursued a strategy of growth through internal expansion and the acquisition of financial institutions and branch locations in selected market areas. TSFG seeks to expand selectively in fast-growing markets in the Southeast, concentrating its growth in metropolitan statistical areas (MSAs). TSFG has emphasized internal growth through the acquisition of market share from the large out-of-state bank holding companies and other competitors. It attempts to acquire market share by providing quality banking services and personal service to individuals and business customers. Since inception, TSFG has consummated 20 acquisitions of financial institutions, six non-bank financial service companies, and four insurance agencies. Approximately 49% of TSFGs total asset growth has come from acquisitions. TSFG expects to continue to seek similar acquisitions that fit its acquisition criteria.
All of TSFGs electronic filings with the Securities and Exchange Commission (SEC), including its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and other documents filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, are accessible at no cost on TSFGs web site, www.thesouthgroup.com, through the Investor Relations link. In addition, through this same link, TSFG makes available its Corporate Governance Guidelines, Code of Conduct, Code of Ethics for Senior Executive and Financial Officers, Whistleblower Policy, and charters for Board Committees, including the Executive, Audit, Compensation, Nominating and Corporate Governance, and Capital and Risk Management Committees. TSFGs SEC filings are also available through the SECs web site at www.sec.gov.
TSFG manages its banking subsidiaries by dividing its franchise into banking markets run by market presidents. This structure allows TSFG to operate like a community bank focusing on personal customer service. However, because of the size of the overall organization, TSFGs subsidiary banks can also offer a full range of sophisticated products and services more typical of larger regional banks.
Carolina First Bank. Carolina First Bank, headquartered in Greenville, South Carolina, engages in a general banking business through Carolina First Bank, which serves South Carolina and coastal and western North Carolina. Carolina First Bank operated through 106 branches with $9.0 billion in assets, $5.7 billion in loans, and $5.6 billion in deposits at December 31, 2005.
Carolina First Bank currently focuses its operations in the following six principal market areas, which represent the largest
MSAs in the states:
Myrtle Beach and Hilton Head Island are coastal resort areas that serve a significant number of tourists primarily during the summer months. Because of the seasonal nature of these market areas, most of the businesses, including financial institutions, are subject to moderate swings in activity between the winter and summer months. Otherwise, Carolina First Banks business is not subject to significant seasonal factors.
Carolina First Bank targets small and middle market businesses and consumers in its market areas. Carolina First Bank provides a full range of commercial and consumer banking services, including deposit accounts, secured and unsecured loans through direct and indirect channels, residential mortgage originations, treasury services, and wealth management, which includes certain insurance and brokerage services. In 1999, Carolina First Bank began offering Internet banking services, including bill payment, through Carolina First Banks web site and Bank CaroLine, an Internet-only banking product. Carolina First Banks deposits are insured by the Federal Deposit Insurance Corporation (FDIC).
Mercantile Bank. Mercantile Bank, headquartered in Orlando, Florida, engages in a general banking business through 66 branches with $5.7 billion in assets, $3.9 billion in loans, and $3.6 billion in deposits at December 31, 2005. It currently operates in five principal Florida market areas:
TSFG entered Florida in 1999 with two acquisitions in central Florida and a de novo branch in Jacksonville. It operated as Citrus Bank, the name of the larger acquired company, until 2002. In 2002, TSFG expanded into the Tampa Bay market with the acquisitions of Gulf West Banks, Inc. (Gulf West), the bank holding company for Mercantile Bank, and Central Bank of Tampa. Following the Gulf West acquisition, TSFG changed the name of its Florida banking operation to Mercantile Bank.
Mercantile Bank targets small and middle market businesses and consumers in its market areas. Mercantile Bank provides a full range of commercial and consumer banking services, including deposit accounts, secured and unsecured loans through direct and indirect channels, residential mortgage originations, treasury services, and wealth management, which includes certain insurance and brokerage services. In 2000, Mercantile Bank began offering Internet banking services, including bill payment, through Mercantile Banks web site. Mercantile Banks deposits are FDIC insured.
TSFG has a number of non-bank subsidiaries. The following describes certain of the more significant subsidiaries.
American Pensions, Inc. In 2003, TSFG acquired American Pensions, Inc. (API), which is a benefit plan administrator headquartered in Mount Pleasant, South Carolina. At December 31, 2005, API had 220 corporate accounts and managed approximately $400 million in plan assets.
Bowditch Insurance Corporation. In 2005, TSFG acquired Bowditch Insurance Corporation and the assets and certain liabilities of Lossing Insurance Agency, both property and casualty insurance companies operating in northern Florida.
Carolina First Community Development Corporation. In 2003, Carolina First Bank formed a subsidiary, Carolina First
Community Development Corporation (CFCDC), to underwrite low-income community business loans. CFCDC has been certified by the Department of the Treasury as a qualified Community Development Entity and meets the eligibility requirements for participation in the New Markets Tax Credit Program.
Koss Olinger. In 2005, TSFG acquired the Koss Olinger group of companies, a wealth management group based in Gainesville, Florida. TSFG intends to use Koss Olinger as a platform to build its wealth management-related business in that market area.
REIT Subsidiaries. In 1999, 2001 and 2003, TSFG formed three real estate investment trust subsidiaries (REITs), which have issued preferred and debt securities to institutional investors as a means of raising regulatory capital. They do not engage in other activities apart from the internal management of their assets and liabilities.
South Group Insurance Services, Inc. In 2005, TSFG combined Gardner Associates, Inc., which operates an insurance agency business primarily in the Midlands area of South Carolina, with several of its smaller insurance subsidiaries to create South Group Insurance Services, Inc. TSFG intends to utilize South Group Insurance Services, Inc. as a platform to build its insurance-related business in that market area.
South Financial Asset Management, Inc. In December 2002, TSFG formed South Financial Asset Management, Inc. (SFAM) for the purpose of engaging in an asset management business. SFAM is a registered investment advisor and targets large endowments, pension funds and similar entities for fund management.
Summit Title, LLC. In April 2004, TSFG acquired the stock of Summit Title, LLC (Summit), a North Carolina limited liability company. Summit is a title insurance agency based in Hendersonville, North Carolina.
Item 8, Note 34 to the Consolidated Financial Statements discusses TSFGs business segments, which information is incorporated herein by reference.
Each of TSFGs markets is highly competitive with the largest banks in their respective states represented. The competition among the various financial institutions is based upon a variety of factors including interest rates offered on deposit accounts, interest rates charged on loans, credit and service charges, the quality of services rendered, the convenience of banking facilities and, in the case of loans to large commercial borrowers, relative lending limits. In addition to banks and savings associations, TSFG competes with other financial institutions, such as securities firms, insurance companies, credit unions, leasing companies, and finance companies.
The banking industry continues to consolidate, which presents opportunities for TSFG to gain new business. However, consolidation may further intensify competition if additional financial services companies enter TSFGs market areas through the acquisition of local financial institutions.
Size gives larger banks certain advantages in competing for business from large commercial customers. These advantages include higher lending limits and the ability to offer services in other areas of South Carolina, North Carolina, Florida, and the Southeastern United States region. As a result, TSFG concentrates its efforts on small- to medium-sized businesses and individuals. TSFG believes it competes effectively in this market segment by offering quality, personalized service.
At December 31, 2005, TSFG and its subsidiaries employed 2,607 full-time equivalent employees. TSFG provides a variety of benefit programs including retirement and stock ownership plans as well as health, life, disability, and other insurance. TSFG also maintains training, educational, and affirmative action programs designed to prepare employees for positions of increasing responsibility. TSFG believes that its relations with employees are good.
The policies of regulatory authorities, including the Board of Governors of the Federal Reserve System (the Federal Reserve) affect TSFGs earnings. An important function of the Federal Reserve is regulation of the money supply. Various methods employed by the Federal Reserve include open market operations in U.S. Government securities, changes in the target Federal funds rate on bank borrowings, and changes in reserve requirements against member bank deposits. The Federal Reserve uses these methods in varying combinations to influence overall growth and distribution of bank loans, investments, and deposits. The use of these methods may also affect interest rates charged on loans or paid on deposits.
The monetary policies of the Federal Reserve have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Due to the changing conditions in the national economy and money markets, as well as the effect of actions by monetary and fiscal authorities, TSFG can make no prediction as to the future impact that changes in interest rates, securities, deposit levels, or loan demand may have on its business and earnings. TSFG strives to manage the effects of interest rates through its asset/liability management processes.
Impact of Inflation
Unlike most industrial companies, the assets and liabilities of financial institutions such as TSFGs subsidiaries are primarily monetary in nature. As a result, interest rates generally have a more significant impact on the performance of a financial institution than the effects of general levels of inflation. TSFG strives to manage the effects of inflation through its asset/liability management processes.
Supervision and Regulation
TSFG and its subsidiaries are extensively regulated under federal and state law. To the extent that the following information describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory and regulatory provisions. Any change in applicable laws may have a material effect on TSFGs business and prospects. TSFGs operations may be affected by possible legislative and regulatory changes and by the monetary policies of the United States.
The South Financial Group. TSFG, a financial holding company and bank holding company registered under the Bank Holding Company Act of 1956, as amended (the BHCA), is subject to regulation and supervision by the Federal Reserve. Under the BHCA, TSFGs activities and those of its subsidiaries are limited to banking, managing or controlling banks, furnishing services to or performing services for its subsidiaries or engaging in any other activity that the Federal Reserve determines to be so closely related to banking or managing or controlling banks as to be a proper incident thereto. The BHCA prohibits TSFG from acquiring direct or indirect control of more than 5% of any class of outstanding voting stock, or substantially all of the assets of any bank, or merging or consolidating with another bank holding company without prior approval of the Federal Reserve. The BHCA prohibits TSFG from acquiring ownership or control of more than 5% of the outstanding voting stock of any company engaged in a nonbanking business unless such business is determined by the Federal Reserve to be so closely related to banking or managing or controlling banks as to be properly incident thereto, except to the extent permitted by financial holding companies, as discussed below.
Beginning June 1, 1997, a bank headquartered in one state was authorized to merge with a bank headquartered in another state, as long as neither of the states had opted out of such interstate merger authority prior to such date. After a bank has established branches in a state through an interstate merger transaction, the bank may establish and acquire additional branches at any location in the state where a bank headquartered in that state could have established or acquired branches under applicable federal or state law.
The Federal Deposit Insurance Act, as amended (FDIA), authorizes the merger or consolidation of any Bank Insurance Fund (BIF) member with any Savings Association Insurance Fund (SAIF) member, the assumption of any liability by any BIF member to pay any deposits of any SAIF member or vice versa, or the transfer of any assets of any BIF member to any SAIF member in consideration for the assumption of liabilities of such BIF member or vice versa, provided that certain conditions are met. In the case of any acquiring, assuming or resulting depository institution which is a BIF member, such institution will continue to make payment of SAIF assessments on the portion of liabilities attributable to any acquired, assumed or merged SAIF-insured institution (or, in the case of any acquiring, assuming or resulting depository institution which is a SAIF member, that such institution will continue to make payment of BIF assessments on the portion of liabilities attributable to any acquired, assumed or merged BIF-insured institution).
In addition, the cross-guarantee provisions of the FDIA require insured depository institutions under common control to reimburse the FDIC for any loss suffered by either the SAIF or the BIF as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the SAIF or the BIF, or both. The FDICs claim for damages is superior to claims of stockholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.
Law and regulatory policy impose a number of obligations and restrictions on bank holding companies and their depository institution subsidiaries that are designed to minimize potential loss exposure to the depositors of such depository institutions and to the FDIC insurance funds. Current federal law requires a bank holding company to guarantee the compliance of any insured depository institution subsidiary that may become undercapitalized with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency up to the lesser of (i) an amount equal to 5% of the institutions total assets at the time the institution became undercapitalized, or (ii) the amount that is necessary (or would have been necessary) to bring the institution into compliance with all applicable capital standards as of the time the institution fails to comply with such capital restoration plan. The Federal Reserve requires a bank holding company to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. The Federal Reserve also has the authority under the BHCA to require a bank holding company to terminate any activity or relinquish control of a nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the Federal Reserves determination that such activity or control constitutes a serious risk to the financial soundness or stability of any subsidiary depository institution of the bank holding company. Further, federal law grants federal bank regulatory authorities additional discretion to require a bank holding company to divest itself of any bank or nonbank subsidiary if the agency determines that divestiture may aid the depository institutions financial condition.
The Gramm-Leach-Bliley Act of 1999 (GLB) covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms and insurance companies. GLB also permits bank holding companies to elect to become financial holding companies. A financial holding company may engage in or acquire companies that engage in a broad range of financial services, including securities activities such as underwriting, dealing, investment and merchant banking, insurance underwriting and sales, and brokerage activities. In order to become a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well-managed, and have at least a satisfactory Community Reinvestment Act rating. TSFG became a financial holding company in 2001.
GLB adopts a system of functional regulation under which the Federal Reserve Board is confirmed as the umbrella regulator for bank holding companies, but bank holding company affiliates are to be principally regulated by functional regulators such as the FDIC for state nonmember bank affiliates, the Securities and Exchange Commission for securities affiliates and state insurance regulators for insurance affiliates. GLB repeals the broad exemption of banks from the definitions of broker and dealer for purposes of the Securities Exchange Act of 1934, but identifies a set of specific activities, including traditional bank trust and fiduciary activities, in which a bank may engage without being deemed a broker, and a set of activities in which a bank may engage without being deemed a dealer.
GLB contains extensive customer privacy protection provisions, which require the institution to provide notice of the privacy policies and provide the opportunity to opt-out of many disclosures of personal information. Additionally, GLB limits the disclosure of customer account numbers or other similar account identifiers for marketing purposes.
TSFG, through its banking subsidiaries, is also subject to regulation by the South Carolina and Florida state banking authorities. TSFG must receive the approval of these state authorities prior to engaging in the acquisitions of banking or nonbanking institutions or assets. It also must file periodic reports with these authorities showing its financial condition and operations, management, and intercompany relationships between TSFG and its subsidiaries.
Carolina First Bank and Mercantile Bank. Carolina First Bank and Mercantile Bank are FDIC-insured, state-chartered banking corporations and are subject to various statutory requirements and rules and regulations promulgated and enforced primarily by the FDIC, South Carolina State Board of Financial Institutions in the case of Carolina First Bank, and State of Florida Department of Banking and Finance in the case of Mercantile Bank. These statutes, rules, and regulations relate to insurance of deposits, required reserves, allowable investments, loans, mergers, consolidations, issuance of securities, payment of dividends, establishment of branches and other aspects of the business of Carolina First Bank and Mercantile Bank. The FDIC has broad authority to prohibit Carolina
First Bank or Mercantile Bank from engaging in what it determines to be unsafe or unsound banking practices. In addition, federal law imposes a number of restrictions on state-chartered, FDIC-insured banks, and their subsidiaries. These restrictions range from prohibitions against engaging as a principal in certain activities to the requirement of prior notification of branch closings. Carolina First Bank and Mercantile Bank are not members of the Federal Reserve System.
Carolina First Bank and Mercantile Bank are subject to the requirements of the Community Reinvestment Act (CRA). The CRA requires that financial institutions have an affirmative and ongoing obligation to meet the credit needs of their local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. Each financial institutions efforts in meeting community credit needs are evaluated as part of the examination process pursuant to three assessment factors. These factors are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility.
Other Regulations. Interest and certain other charges collected or contracted for by TSFG subsidiaries are subject to state usury laws and certain federal laws concerning interest rates. TSFGs loan operations are also subject to certain federal laws applicable to credit transactions, such as the federal Truth-In-Lending Act governing disclosures of credit terms to consumer borrowers. The deposit operations of Carolina First Bank and Mercantile Bank are also subject to the Right to Financial Privacy Act, which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records, and the Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve to implement that act, which govern automatic deposits to and withdrawals from deposit accounts and customers rights and liabilities arising from the use of automated teller machines and other electronic services.
The holders of TSFGs common stock are entitled to receive dividends when, as and if declared by the Board of Directors out of funds legally available. As a legal entity separate and distinct from its subsidiaries, TSFG depends on the payment of dividends from its subsidiaries for its revenues. Current federal law prohibits, except under certain circumstances and with prior regulatory approval, an insured depository institution from paying dividends or making any other capital distribution if, after making the payment or distribution, the institution would be considered undercapitalized, as that term is defined in applicable regulations. South Carolina and Florida banking regulations restrict the amount of dividends that the subsidiary banks can pay to TSFG, and may require prior approval before declaration and payment of any excess dividend.
TSFG. The Federal Reserve has adopted risk-based capital guidelines for bank holding companies. Under these guidelines, the minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%. At least half of the total capital is required to be tier 1 capital, principally consisting of common shareholders equity, non-cumulative preferred stock, a limited amount of cumulative perpetual preferred stock, and mandatory redeemable preferred stock, less certain goodwill items. The remainder (tier 2 capital) may consist of a limited amount of subordinated debt and intermediate-term preferred stock, certain hybrid capital instruments and other debt securities, perpetual preferred stock, and a limited amount of the allowance for loan losses. In addition to the risk-based capital guidelines, the Federal Reserve has adopted a minimum tier 1 (leverage) capital ratio under which a bank holding company must maintain a minimum level of tier 1 capital (as determined under applicable rules) to average total consolidated assets of at least 3% in the case of bank holding companies which have the highest regulatory examination ratios and are not contemplating significant growth or expansion. All other bank holding companies, including TSFG, are required to maintain a ratio of at least 4%. At December 31, 2005, TSFGs capital levels exceeded both the risk-based capital guidelines and the applicable minimum leverage capital ratio.
Carolina First Bank and Mercantile Bank. Carolina First Bank and Mercantile Bank are subject to capital requirements imposed by the FDIC. The FDIC requires state-chartered nonmember banks to comply with risk-based capital standards substantially similar to those required by the Federal Reserve, as described above. The FDIC also requires state-chartered nonmember banks to maintain a minimum leverage ratio similar to that adopted by the Federal Reserve. Under the FDICs leverage capital requirement, state nonmember banks that (i) receive the highest rating during the examination process and (ii) are not anticipating or experiencing any significant growth are required to maintain a minimum leverage ratio of 3% of tier 1 capital to average assets; all other banks, including Carolina First Bank and Mercantile Bank, are required to maintain an absolute minimum leverage ratio of not less than 4%. As of December 31, 2005, Carolina First Bank and Mercantile Bank exceeded each of the applicable regulatory capital requirements.
Regulators are considering various revisions to the existing risk-based capital framework. Under Basel 1a, an Advanced Notice of Proposed Rulemaking, agencies are considering:
TSFG will continue to monitor these potential changes to the risk-based capital standards and plans to make the necessary changes to enable its banking subsidiaries to remain well-capitalized.
Deposit Insurance Assessments
Carolina First Bank and Mercantile Bank are subject to insurance assessments imposed by the FDIC. The FDIC has a risk-based assessment schedule where the actual assessment to be paid by each FDIC-insured institution is based on the institutions assessment risk classification. This classification is determined based on whether the institution is considered well capitalized, adequately capitalized or undercapitalized, as such terms have been defined in applicable federal regulations adopted to implement the prompt corrective action provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), and whether such institution is considered by its supervisory agency to be financially sound or to have supervisory concerns. The assessment rate for the first quarter 2006 is 0.0132% (annualized) for both BIF-insured deposits and SAIF-insured deposits. This rate is set quarterly and may change during the year. Carolina First Banks total deposits that were formerly associated with thrift institutions (approximately 30% of total deposits) are subject to SAIF insurance assessments imposed by the FDIC.
Other Safety and Soundness Regulations
Prompt Corrective Action. Current law provides the federal banking agencies with broad powers to take prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon the capitalization of the institutions. Under uniform regulations defining such capital levels issued by each of the federal banking agencies, a bank is considered well capitalized if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a tier 1 risk-based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater, and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure. An adequately capitalized bank is defined as one that has (i) a total risk-based capital ratio of 8% or greater, (ii) a tier 1 risk-based capital ratio of 4% or greater, and (iii) a leverage ratio of 4% or greater. A bank is considered (A) undercapitalized if it has (i) a total risk-based capital ratio of less than 8%, (ii) a tier 1 risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4%; (B) significantly undercapitalized if the bank has (i) a total risk-based capital ratio of less than 6%, (ii) a tier 1 risk-based capital ratio of less than 3%, or (iii) a leverage ratio of less than 3%; and (C) critically undercapitalized if the bank has a ratio of tangible equity to total assets equal to or less than 2%. As of December 31, 2005, Carolina First Bank and Mercantile Bank each met the definition of well capitalized.
Brokered Deposits. Current federal law also regulates the acceptance of brokered deposits by insured depository institutions to permit only a well capitalized depository institution to accept brokered deposits without prior regulatory approval. Under FDIC regulations, well capitalized insured depository institutions may accept brokered deposits without restriction, adequately capitalized insured depository institutions may accept brokered deposits with a waiver from the FDIC (subject to certain restrictions on payments of interest rates) while undercapitalized insured depository institutions may not accept brokered deposits.
Transactions Between TSFG, its Subsidiaries, and Affiliates
TSFGs subsidiaries are subject to certain restrictions on extensions of credit to executive officers, directors, principal shareholders or any related interest of such persons. Extensions of credit (i) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unaffiliated persons; and (ii) must not involve more than the normal risk of repayment or present other unfavorable features. Aggregate limitations on extensions of credit also may apply. TSFGs subsidiaries are also subject to certain lending limits and restrictions on overdrafts to such persons.
Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on extensions of credit to the bank holding company or its nonbank subsidiaries, on investments in their securities and on the use of their securities as collateral for loans to any borrower. Such restrictions may limit TSFGs ability to obtain funds from its bank subsidiaries for its cash needs, including funds for acquisitions, interest, and operating expenses. Certain of these restrictions are not applicable to transactions between a bank and a savings association owned by the same bank holding company, provided that every bank and savings association controlled by such bank holding company complies with all applicable capital requirements without relying on goodwill.
In addition, under the BHCA and certain regulations of the Federal Reserve, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property, or furnishing of services.
Anti-Money Laundering Legislation
TSFGs banking subsidiaries are subject to the Bank Secrecy Act and its implementing regulations and other anti-money laundering laws and regulations, including the USA Patriot Act of 2001. Among other things, these laws and regulations require financial institutions such as TSFG to take steps to prevent the use of its banking subsidiaries for facilitating the flow of illegal or illicit money, to report large currency transactions and to file suspicious activity reports. TSFG is also required to develop and implement a comprehensive anti-money laundering compliance program. TSFG must also have in place appropriate know your customer policies and procedures. Violations of these requirements can result in substantial civil and criminal sanctions. In addition, provisions of the USA Patriot Act require the federal financial institution regulatory agencies to consider the effectiveness of a financial institutions anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.
The Sarbanes-Oxley Act of 2002 addresses, among other issues, corporate governance, auditing and accounting, internal controls, executive compensation, and enhanced and timely disclosure of corporate information. In accordance with Section 302(a) of the Sarbanes-Oxley Act, written certifications by TSFGs Chief Executive Officer and Chief Financial Officer are required. These certifications attest that TSFGs quarterly and annual reports filed with the SEC do not contain any untrue statement of a material fact. TSFG has also implemented a program designed to comply with Section 404 of the Sarbanes-Oxley Act, which includes the identification of significant processes and accounts, documentation of the design of control effectiveness over process and entity level controls, and testing of the operating effectiveness of key controls. See Item 9A Controls and Procedures for TSFGs evaluation of its disclosure controls and procedures.
Changes to the laws and regulations (including changes in interpretation or enforcement) in the states where we do business can affect the operating environment of bank holding companies and their subsidiaries in substantial and unpredictable ways. From time to time, various legislative and regulatory proposals are introduced. These proposals, if codified, may change banking statutes and regulations and our operating environment in substantial and unpredictable ways. If codified, these proposals could increase or decrease the cost of doing business, limit or expand permissible activities or affect the competitive balance among banks, savings associations, credit unions and other financial institutions. We cannot accurately predict whether those changes in laws and regulations will occur, and, if those changes occur, the ultimate effect they would have upon our financial condition or results of operations. It is likely, however, that the current high level of enforcement and compliance-related activities of federal and state authorities will continue and potentially increase.
See Item 7, Critical Accounting Policies and Estimates, Recently Adopted Accounting Pronouncements, and Recently Issued Accounting Pronouncements for discussion of certain accounting matters, which is incorporated herein by reference.
Item 1A. Risk Factors
TSFG is susceptible to certain risk factors that may affect its operations, as well as the market price of its common stock. Some of the specific risk factors include the following items.
TSFG has experienced significant growth in commercial real estate loans, which were 41.7% of total loans at December 31, 2005, compared to 40.0% and 36.0% at December 31, 2004 and 2003, respectively. This concentration is high relative to that of many banks, in particular banks in markets not experiencing strong population growth. Also, the majority of our loans finance properties located on the coast of South Carolina and Florida, regions susceptible to hurricanes. Hence, exposure to potential changes in real estate market conditionsdue to changing economics or catastrophic weatheris relatively high. Risk management and quality control processes designed to manage exposure to these uncertainties are in place; however, a material decline in commercial real estate market conditions in one or more of TSFGs markets could adversely impact the loan portfolios of those markets. (See Tables 2, 3, and 4 under Balance Sheet Review for additional information on loan portfolio concentrations.)
TSFG has a lower level of core deposits and a higher level of wholesale funding, relative to its peer institutions. Over the past several years, TSFG has experienced significant growth in loans, particularly commercial and commercial real estate loans. Because its deposits have not grown at similar rates, TSFG has necessarily had to fund its loan growth with wholesale borrowings. During an environment when interest rates are rising and the related curve is flattening, this causes wholesale borrowing costs to increase disproportionately to loan yields. This results in less net interest income.
TSFG has experienced significant growth through acquisitions, which could, in some circumstances, adversely affect net income. TSFG has experienced significant growth in assets as a result of acquisitions. Moreover, TSFG anticipates engaging in selected acquisitions of financial institutions and assets in the future. There are risks associated with TSFGs acquisition strategy that could adversely impact net income. These risks include, among others, incorrectly assessing the asset quality of a particular institution being acquired, encountering greater than anticipated costs of incorporating acquired businesses into TSFG and being unable to profitably deploy funds acquired in an acquisition. Furthermore, we can give no assurance about the extent that TSFG can continue to grow through acquisitions.
Any future acquisitions would be accounted for using the purchase method of accounting. Acquisitions accounted for by the purchase method of accounting may lower the capital ratios of the entities involved. Consequently, in the event that TSFG engages in significant acquisitions in the future, TSFG may be required to raise additional capital in order to maintain capital levels required by its regulators.
In the future, TSFG may issue capital stock in connection with additional acquisitions. These acquisitions and related issuances of stock may have a dilutive effect on earnings per share and ownership. TSFG does not currently have any definitive understandings or agreements for any acquisitions material to TSFG. However, as noted above, TSFG anticipates that it will continue to expand by acquisition in the future.
TSFG has various anti-takeover measures that could impede the takeover of TSFG. TSFG has various anti-takeover measures in place, some of which are listed below. Any one or more of these measures may impede the takeover of TSFG without the approval of TSFGs board of directors and may prevent shareholders from taking part in a transaction in which shareholders could realize a premium over the current market price of TSFG common stock. The anti-takeover measures include various charter provisions providing for, among other things, a staggered board of directors and supermajority voting requirements in connection with the removal of directors without cause and certain business combinations involving TSFG.
TSFG has certain geographic concentrations. Substantially all of TSFGs loans were to borrowers located in TSFGs market areas in South Carolina, North Carolina, and Florida. Industry concentrations parallel the mix of economic activity in these markets, the most significant of which are the commercial real estate and tourism industries. Commercial construction and development loans represent the largest component of commercial real estate loan product types.
TSFGs ability to maintain its historic performance will depend on the ability to expand the scope of its existing financial services to customers. TSFG competes, and will continue to compete, with well established banks, credit unions, insurance companies and other financial institutions, some of which have greater resources and lending limits than TSFG. Some of these competitors may also provide certain services that TSFG does not provide.
TSFGs controls and procedures may fail or be circumvented. Controls and procedures are particularly important for financial institutions. Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on our business, results of operations and financial condition.
TSFGs information systems may experience an interruption or breach in security. We rely heavily on communications and information systems to conduct our business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in our customer relationship management, general ledger, deposit, loan and other systems. The occurrence of any failures, interruptions or security breaches of our information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations.
TSFG continually encounters technological change. The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. Our future success depends, in part, upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in our operations. Our largest competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on our business and, in turn, our financial condition and results of operations.
TSFG is subject to liquidity risk. Market conditions or other events could negatively affect the level or cost of liquidity, affecting our ongoing ability to accommodate liability maturities and deposit withdrawals, meet contractual obligations, and fund asset growth and new business transactions at a reasonable cost, in a timely manner and without adverse consequences. Any substantial, unexpected and/or prolonged change in the level or cost of liquidity could have a material adverse effect on our financial condition and results of operations. Additional information regarding liquidity risk is included in the section captioned Liquidity.
TSFG is subject to interest rate risk. Our earnings and cash flows are largely dependent upon our net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds, as well as the impact of certain derivative hedging instruments. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, could influence not only the amount of interest we receive on loans and securities and the amount of interest we pay on deposits and borrowings, but such changes could also affect our ability to originate loans and obtain deposits as well as the fair value of our financial assets and liabilities. If the interest we pay on deposits and other borrowings increases at a faster rate than the interest we receive on loans and other investments, our net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest we receive on loans and other investments fall more quickly than the interest we pay on deposits and other borrowings. Additional information regarding interest rate risk is included in the section captioned Enterprise Risk Management Market Risk and Asset/Liability Management.
TSFG has credit and market risk resulting from the use of derivatives. We use derivatives to manage our exposure to interest rate risk, to generate profits from trading and to assist our customers with their risk management objectives. Derivatives used for interest rate risk management include various interest rate swaps, options, and futures contracts. Options and futures contracts typically have indices that relate to the pricing of specific on-balance sheet instruments and forecasted transactions and may be more speculative in nature. By using derivative instruments, TSFG is exposed to credit and market risk. Derivative credit
risk, which is the risk that a counterparty to a derivative instrument will fail to perform, is equal to the extent of the fair value gain in a derivative. Derivative credit risk is created when the fair value of a derivative contract is positive, since this generally indicates that the counterparty owes us. Market risk is the adverse effect on the value of a financial instrument from a change in interest rates or implied volatility of rates.
TSFG is exposed to credit risk in its lending activities. There are inherent risks associated with our lending and trading activities. Loans to individuals and business entities, our single largest asset group, depend for repayment on the willingness and ability of borrowers to perform as contracted. A material adverse change in the ability of a significant portion of our borrowers to meet their obligations to us, due to changes in economic conditions, interest rates, natural disasters, acts of war, or other causes over which we have no control, could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans, and could have a material adverse impact on our earnings and financial condition. We also are subject to various laws and regulations that affect our lending activities. Failure to comply with applicable laws and regulations could subject us to regulatory enforcement action that could result in the assessment against us of civil money or other penalties.
Item 1B. Unresolved Staff Comments
Item 2. Properties
TSFGs principal executive offices are located at 102 South Main Street, Greenville, South Carolina. TSFG leases approximately 111,000 square feet of this location, which also houses Carolina First Banks Greenville main office branch. The majority of TSFGs administrative functions presently reside at this location. TSFG owns a 130,000 square foot building in Lexington, South Carolina which houses the technology and operations departments (formerly known as CF Technology Services Company). TSFG leases the land for the technology building under a 30 year lease. In addition, TSFG leases non-banking office space in 27 locations in South Carolina, North Carolina, and Florida.
At December 31, 2005, TSFG operated 172 branch offices, including 80 in South Carolina, 66 in Florida, and 26 in North Carolina. Of these locations, TSFG or one of its subsidiaries owns 93 locations, which includes 11 locations with land leases, and leases 79 locations. In addition, TSFG or one of its subsidiaries owns 6 stand-alone ATM locations, including five locations with land leases, and leases 12 locations.
TSFG believes that its physical facilities are adequate for its current operations.
Item 3. Legal Proceedings
See Item 8, Legal Proceedings included in Note 24 to the Consolidated Financial Statements for a discussion of legal proceedings, which information is incorporated herein by reference.
Item 4. Submission of Matters to a Vote of Shareholders
No matter was submitted to a vote of security holders by solicitation of proxies or otherwise during the fourth quarter of 2005.
Item 5. Market for the Registrants Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
Market for Common Stock and Related Matters
TSFGs common stock trades on The NASDAQ Stock Market under the symbol TSFG. At March 1, 2006, TSFG had 8,875 shareholders of record and 74,870,033 shares outstanding. See Item 7, Capital Resources and Dividends and Item 8, Notes 27 and 28 to the Consolidated Financial Statements for a discussion of capital stock and dividends, which information is incorporated herein by reference.
Unregistered Sales of Securities
On April 4, 2005, TSFG acquired Koss Olinger group of companies, a wealth management group based in Gainesville, Florida. TSFG issued 56,398 shares of common stock to 6 individuals in connection with this acquisition. The issuance of securities to these individuals was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.
On June 1, 2005, TSFG issued 2,200 shares of common stock to one individual relating to the earnout provisions of the prior acquisition of Summit Title, LLC. The issuance of securities to this individual was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.
On June 6, 2005, TSFG acquired Bowditch Insurance Corporation, an independent insurance agency based in Jacksonville, Florida. TSFG issued 87,339 shares of common stock to 8 individuals in connection with this acquisition. The issuance of securities to these individuals was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.
On December 13, 2005, TSFG issued 1,584 shares of common stock to one individual relating to the earnout provisions of the prior acquisition of Allied Assurance of South Carolina, Inc., an insurance agency based in Columbia, South Carolina. The issuance of securities to this individual was exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
ISSUER PURCHASES OF EQUITY SECURITIES
See Equity Compensation Plan Data in the Registrants Proxy Statement relating to the 2006 Annual Meeting of Shareholders filed with the Securities and Exchange Commission, which information is incorporated herein by reference.
Item 6. Selected Financial Data
See Item 8, Consolidated Financial Statements and the accompanying notes for factors including but not limited to business combinations and accounting changes that affect the comparability of the information presented.
SIX-YEAR SUMMARY OF SELECTED FINANCIAL DATA
(dollars and shares (except per share data) in thousands)
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis are presented to assist in understanding the financial condition, changes in financial condition, results of operations, and cash flows of The South Financial Group, Inc. and its subsidiaries (collectively, TSFG), except where the context requires otherwise. TSFG may also be referred to herein as we, us, or our. This discussion should be read in conjunction with the audited Consolidated Financial Statements and accompanying Notes presented in Item 8 of this report and the supplemental financial data appearing throughout this report. Percentage calculations contained herein have been calculated based upon actual, not rounded, results.
TSFG primarily operates through two wholly-owned subsidiary banks, Carolina First Bank and Mercantile Bank, which are collectively referred to as the Subsidiary Banks.
This report contains certain forward-looking statements (as defined in the Private Securities Litigation Reform Act of 1995) to assist in the understanding of anticipated future operating and financial performance, growth opportunities, growth rates, and other similar forecasts and statements of expectations. These forward-looking statements may be identified by the use of such words as: estimate, anticipate, expect, believe, intend, plan, or words of similar meaning, or future or conditional verbs such as may, intend, could, will, or should. These forward-looking statements reflect current views, but are based on assumptions and are subject to risks, uncertainties, and other factors, which may cause actual results to differ materially from those in such statements. A variety of factors, some of which are discussed in more detail in Item 1A Risk Factors, may affect the operations, performance, business strategy and results of TSFG including, but not limited to, the following:
Such forward-looking statements speak only as of the date on which such statements are made and shall be deemed to be updated by any future filings made by TSFG with the Securities and Exchange Commission (SEC). We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made to reflect the occurrence of unanticipated events. In addition, certain statements in future filings by TSFG with the SEC, in press releases, and in oral and written statements made by or with the approval of TSFG, which are not statements of historical fact, constitute forward-looking statements.
Non-GAAP Financial Information
This report also contains financial information determined by methods other than in accordance with Generally Accepted Accounting Principles (GAAP). TSFGs management uses these non-GAAP measures to analyze TSFGs performance. In particular, TSFG presents certain designated net interest income amounts on a tax-equivalent basis (in accordance with common industry practice). TSFG also presents certain tax-equivalent net interest margin comparisons including the net cash settlements on certain interest rate swaps. Management believes that these presentations of tax-equivalent net interest income aids in the comparability of net interest income arising from both taxable and tax-exempt sources over the periods presented. TSFG also presents loan and deposit growth, excluding loans/deposits acquired net of dispositions (referred to herein as organic growth). In discussing its deposits, TSFG presents customer deposits, which are defined by TSFG as total deposits less brokered deposits. Wholesale borrowings include short-term and long-term borrowings and brokered deposits. These disclosures should not be viewed as a substitute for GAAP measures, and furthermore, TSFGs non-GAAP measures may not necessarily be comparable to non-GAAP performance measures of other companies.
Founded in 1986, TSFG is a financial holding company that operates primarily in select markets in the Southeast area of the United States. TSFG had $14.3 billion in total assets with 172 branch offices in South Carolina, Florida, and North Carolina at December 31, 2005. TSFG operates primarily through two subsidiary banks:
TSFG uses a super-community bank strategy serving small and middle market businesses and retail customers. As a super-community bank, TSFG combines personalized customer service and local decision-making, typical of community banks, with a full range of financial services normally found at larger regional institutions. TSFG focuses on fast-growing banking markets in the Southeast, concentrating its growth in metropolitan statistical areas.
During 2005, TSFG continued to expand in its Southeastern markets. In May 2005, TSFG acquired Pointe Financial Corporation (Pointe), headquartered in Boca Raton, Florida, which had approximately $432 million in assets. In addition, TSFG acquired three Florida-based insurance/financial planning agencies, opened ten de novo branches, and closed two branches.
For 2005, net income totaled $69.8 million, or $0.94 per diluted share, compared with $119.5 million, or $1.80 per diluted share, for 2004. During 2005, in response to the flattening yield curve and lower profitability of our investment securities, we elected to reduce our holdings of investment securities and the associated level of wholesale funding. This balance sheet repositioning contributed to a $55.0 million loss on the sale of investment securities and a $7.1 million loss on early extinguishment of debt. In addition, 2005 net income included a loss of $3.3 million on trading and derivative activities compared to a 2004 gain on trading and derivative activities of $33.3 million, and $10.3 million in employment contract buyouts. For 2005, average diluted shares outstanding increased 12.6%, principally as a result of the July 2004 acquisitions of CNB Florida Bancshares, Inc. (CNB Florida) and Florida Banks, Inc. (Florida Banks) and the May 2005 acquisition of Pointe.
The above mentioned results for 2005 are different from what TSFG reported in its January 19, 2006 earnings release, in which TSFG reported net income of $70.4 million, or $0.94 per diluted share. The difference of $625,000 equals 0.90% of net income for 2005 and relates to additional contract buy-out accruals for early retirement benefits under the Supplementary Executive Retirement Plans.
During 2005, TSFG significantly reduced its level of investment securities and wholesale borrowings. Investment securities declined 26.7% to $3.2 billion at December 31, 2005 from $4.3 billion at December 31, 2004. TSFG also reduced wholesale borrowings 18.6% to $4.7 billion at December 31, 2005 from $5.8 billion a year earlier. At December 31, 2005, TSFGs securities-to-total assets ratio declined to 22.1% of total assets, down from 31.2% at December 31, 2004. TSFGs ratio of wholesale borrowings to total assets declined to 33.1% at December 31, 2005, down from 42.2% at December 31, 2004.
Using period-end balances, our loan and customer deposit balances grew in 2005 as follows:
TSFG increased its emphasis on customer deposit growth during 2005 in an effort to reduce its reliance on wholesale borrowings. In 2005, in contrast to prior years, deposit growth substantially funded all of our loan growth. In addition, our loan yields grew faster than the cost of customer deposits.
For 2005, net interest income, TSFGs primary source of revenue, accounted for 88.1% of total revenues compared to 72.9% for 2004. Net interest income is the difference between the interest earned on assets, primarily loans and securities, and the interest paid for liabilities to support such assets, primarily deposits and borrowed funds. Tax-equivalent net interest income was $415.1 million in 2005, a 22.0% increase over $340.2 million in 2004. This increase was primarily the result of a 19.9% increase in average earning assets, driven by a 28.2% increase in average loans (including growth from acquisitions). The net interest margin totaled 3.12% for 2005 and 3.06% for 2004.
Noninterest income decreased to $55.2 million for 2005 from $124.9 million for 2004, down 55.8%. The decrease was driven primarily by a loss of $55.0 million on the sale of available for sale securities in 2005, compared to a gain of $7.0 million in 2004. Additionally, the change in fair value of interest rate swaps resulted in a loss of $13.3 million in 2005, compared to a gain of $2.6 million for 2004. The net cash settlement of interest rate swaps which did not meet the criteria for hedge accounting treatment declined to $10.4 million in 2005 from $27.6 million in 2004 as a result of the increase in short term interest rates during the period. If the impact of these net cash settlements were included in the net interest margin rather than in noninterest income, the tax-equivalent net interest margin would have declined to 3.20% for 2005 from 3.31% for 2004. Gains on trading and certain other derivative activities decreased to a loss of $335,000 in 2005 from a gain of $3.2 million in 2004. For 2004, noninterest income included a $10.4 million other-than-temporary impairment of Federal National Mortgage Association and Federal Home Loan Mortgage Corporation perpetual preferred stock, and a $2.4 million gain on disposition of land associated with a conservation grant. Customer fee income (service charges on deposit accounts, debit card income, and customer service fee income), wealth management income, bank-owned life insurance, merchant processing income, and mortgage banking income, the primary operating components of noninterest income, increased 22.6% to $104.0 million in 2005 from $84.8 million in 2004.
Noninterest expenses totaled $328.1 million in 2005 compared to $250.2 million for 2004, an increase of 31.1%. Salaries and wages and employee benefits, which account for 49.7% of the total noninterest expenses for 2005, increased 36.4%, growing to $163.0 million in 2005 from $119.5 million in 2004. The increase in personnel expense was primarily attributable to the Pointe acquisition, higher branch and lending incentives, higher incentives and commissions relating to fee based businesses, higher discretionary incentives under TSFGs short-term plan, pay increases, higher health insurance costs, higher contract buyouts, and additional employees. Occupancy costs increased 26.9% for 2005 primarily due to growth initiatives and acquisitions. Professional services increased by 62.7% due to outsourcing certain internal audit functions during the year as well as other outsourced professional services. These fees are expected to decline for 2006. Noninterest expenses also include a loss on early extinguishment of debt of $7.1 million in 2005 compared to $1.4 million in 2004. This loss for 2005 was incurred in connection with the repositioning of the balance sheet discussed earlier.
At December 31, 2005, nonperforming assets as a percentage of loans held for investment and foreclosed property declined to 0.47% from 0.69% at December 31, 2004. Net loan charge-offs as a percentage of average loans held for investment totaled 0.36% for 2005, down from 0.46% for 2004. TSFGs provision for credit losses increased to $40.6 million for 2005 from $35.0 million for 2004, primarily as a result of the increased provision associated with the loan growth.
TSFGs tangible equity to tangible asset ratio decreased to 5.83% at December 31, 2005 from 5.93% at December 31, 2004, primarily due to an increase in the net unrealized loss on available for sale securities.
Critical Accounting Policies and Estimates
TSFGs accounting policies are in accordance with accounting principles generally accepted in the United States and with general practice within the banking industry. TSFG makes a number of judgmental estimates and assumptions relating to reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements and the reported amounts of revenues and expenses during periods presented. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses and reserve for unfunded lending commitments, the accounting for derivatives and other hedging activities, the fair value of certain financial instruments (securities, derivatives, and privately held investments), income tax assets or liabilities, and accounting for acquisitions, including the fair value determinations, the analysis of goodwill impairment and the analysis of valuation allowances in the initial accounting of loans acquired.
To a lesser extent, significant estimates are also associated with the determination of contingent liabilities, stock-based and discretionary compensation, and other employee benefit agreements. Different assumptions in the application of these policies could result in material changes in TSFGs Consolidated Financial Statements. Accordingly, as this information changes, the Consolidated Financial Statements could reflect the use of different estimates, assumptions, and judgments. Certain determinations inherently have a greater reliance on the use of estimates, assumptions, and judgments, and as such have a greater possibility of producing results that could be materially different than originally reported. TSFG has procedures and processes in place to facilitate making these judgements.
Allowance for Loan Losses and Reserve for Unfunded Lending Commitments
The allowance for loan losses (Allowance) represents managements estimate of probable incurred losses in the lending portfolio. See Balance Sheet Review Allowance for Loan Losses for additional discussion, including the methodology for analyzing the adequacy of the Allowance. This methodology relies upon managements judgment in segregating the portfolio into risk-similar segments, computing specific allocations for impaired loans, and setting the amounts within the probable loss range (from 95% to 105% of the adjusted historical loss ratio). Managements judgments evolve from an assessment of various issues, including but not limited to the pace of loan growth, collateral values, borrowers ability and willingness to repay, emerging portfolio concentrations, risk management system, entry into new markets, new product offerings, loan portfolio quality trends, and uncertainty in current economic and business conditions.
Assessing the adequacy of the Allowance is a process that requires considerable judgment. Management considers the year-end Allowance appropriate and adequate to cover probable incurred losses in the loan portfolio. However, managements judgment is based upon a number of assumptions about current events, which are believed to be reasonable, but which may or may not prove valid. Thus, there can be no assurance that loan losses in future periods will not exceed the current Allowance amount or that future increases in the Allowance will not be required. No assurance can be given that managements ongoing evaluation of the loan portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the Allowance, thus adversely affecting the operating results of TSFG.
The Allowance is also subject to examination and adequacy testing by regulatory agencies, which may consider such factors as the methodology used to determine adequacy and the size of the Allowance relative to that of peer institutions, and other adequacy tests. In addition, such regulatory agencies could require TSFG to adjust its Allowance based on information available to them at the time of their examination.
The methodology used to determine the reserve for unfunded lending commitments, which is included in other liabilities, is inherently similar to that used to determine the allowance for loan losses described above, adjusted for factors specific to binding commitments, including the probability of funding and historical loss ratio.
Derivatives and Hedging Activities
TSFG uses derivative financial instruments to reduce exposure to changes in interest rates and market prices for financial instruments. The application of hedge accounting requires judgment in the assessment of hedge effectiveness, identification of similarly hedged item groupings, and measurement of changes in the fair value of derivatives and related hedged items. TSFG believes that its methods for addressing these judgmental areas are reasonable and in accordance with generally accepted accounting principles in the United States. See Derivative Financial Instruments and Fair Value of Certain Financial Instruments for additional information regarding derivatives.
Fair Value of Certain Financial Instruments
Fair value is defined as the amount at which a financial instrument could be liquidated in a transaction between willing, unrelated parties in a normal business transaction. Fair value is based on quoted market prices for the same or similar instruments, adjusted for any differences in terms. If market values are not readily available, then the fair value is estimated. For example, when TSFG has an investment in a privately held company, TSFGs management evaluates the fair value of these investments based on the entitys ability to generate cash through its operations, obtain alternative financing, and subjective factors. Modeling techniques, such as discounted cash flow analyses, which use assumptions for interest rates, credit losses, prepayments, and discount rates, are also used to estimate fair value if market values are not readily available for certain financial instruments.
TSFG carries its available for sale securities, trading securities, and derivatives at fair value. The unrealized gains or losses,
net of income tax effect, on available for sale securities and derivatives qualifying as cash flow hedges are included in accumulated other comprehensive income (loss), a separate component of shareholders equity. The fair value adjustments for trading securities and derivative financial instruments not qualifying as cash flow hedges are included in earnings. In addition, for hedged items in a fair value hedge, changes in the hedged items fair value attributable to the hedged risk are also included in noninterest income. No fair value adjustment is allowed for the related hedged asset or liability in circumstances where the derivatives do not meet the requirements for hedge accounting.
TSFG periodically evaluates its investment securities portfolio for other-than-temporary impairment. If a security is considered to be other-than-temporarily impaired, the related unrealized loss is charged to operations and a new cost basis is established. Factors considered include the reasons for the impairment, the severity and duration of the impairment, changes in value subsequent to period-end, and forecasted performance of the security issuer. Impairment is considered other-than-temporary unless the holder of the security has both the intent and ability to hold the security until the fair value recovers and evidence supporting the recovery outweighs evidence to the contrary. However, for equity securities, which typically do not have a contractual maturity with a specified cash flow on which to rely, the ability to hold an equity security indefinitely, by itself, does not allow for avoidance of other-than-temporary impairment.
The market values of TSFGs investments in privately held limited partnerships, corporations and LLCs are not readily available. These investments are accounted for using either the cost or the equity method of accounting. The accounting treatment depends upon TSFGs percentage ownership and degree of management influence. TSFGs management evaluates its investments in limited partnerships and LLCs quarterly for impairment based on the investees ability to generate cash through its operations, obtain alternative financing, and subjective factors. There are inherent risks associated with TSFGs investments in privately held limited partnerships, corporations and LLCs, which may result in income statement volatility in future periods.
The process for valuing financial instruments, particularly those with little or no liquidity, is subjective and involves a high degree of judgment. Small changes in assumptions can result in significant changes in valuation. Valuations are subject to change as a result of external factors beyond our control that have a substantial degree of uncertainty. The inherent risks associated with determining the fair value of a financial instrument may result in income statement volatility in future periods.
Management uses certain assumptions and estimates in determining income taxes payable or refundable for the current year, deferred income tax liabilities and assets for events recognized differently in its financial statements and income tax returns, and income tax expense. Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations. Management exercises considerable judgment in evaluating the amount and timing of recognition of the resulting income tax liabilities and assets. These judgments and estimates are re-evaluated on a continual basis as regulatory and business factors change.
No assurance can be given that either the tax returns submitted by management or the income tax reported on the Consolidated Financial Statements will not be adjusted by either adverse rulings by the U.S. Tax Court, changes in the tax code, or assessments made by the Internal Revenue Service (IRS). TSFG is subject to potential adverse adjustments, including but not limited to: an increase in the statutory federal or state income tax rates, the permanent nondeductibility of amounts currently considered deductible either now or in future periods, and the dependency on the generation of future taxable income, including capital gains, in order to ultimately realize deferred income tax assets.
During the third quarter 2004, the Internal Revenue Service completed its examination of TSFGs 1999 through 2002 federal income tax returns. TSFG did not receive any adverse rulings or additional tax assessments as a result of these examinations. The IRS is currently reviewing TSFGs 2003 income tax returns.
Accounting for Acquisitions
TSFG has grown its operations, in part, through bank and non-bank acquisitions. Since 2000, and in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, TSFG has used the purchase method of accounting to account for acquisitions. Under this method, TSFG is required to record assets acquired and liabilities assumed at their fair value, which in many instances involves estimates based on third party, internal, or other valuation techniques. These estimates also include the establishment of various accruals for planned facilities dispositions and employee benefit related considerations, among other acquisition-related items. In addition, purchase acquisitions
typically result in goodwill or other intangible assets, which are subject to periodic impairment tests, on an annual basis, or more often, if events or circumstances indicate that there may be impairment. These tests, which TSFG performed annually as of June 30th since 2002, use estimates such as projected cash flows, discount rates, time periods, and comparable market values in their calculations. Furthermore, the determination of which intangible assets have finite lives is subjective, as well as the determination of the amortization period for such intangible assets.
TSFG uses a third-party to test for goodwill impairment by determining the fair value for each reporting unit and comparing it to the carrying amount. If the carrying amount exceeds its fair value, the potential for impairment exists, and a second step of impairment testing is required. In the second step, the implied fair value of the reporting units goodwill is determined by allocating the reporting units fair value to all of its assets (recognized and unrecognized) and liabilities as if the reporting unit had been acquired in a business combination at the date of the impairment test. If the implied fair value of reporting unit goodwill is lower than its carrying amount, goodwill is impaired and is written down to its fair value.
The valuations as of June 30, 2005 indicated that no impairment charges were required as of that test date. There have been no events or circumstances since June 30, 2005 that indicate there may be potential impairment.
For several previous acquisitions, TSFG has agreed to issue earn-out payments based on the achievement of certain performance targets. Upon paying the additional consideration, TSFG would record additional goodwill.
TSFGs other intangible assets have an estimated finite useful life and are amortized over that life in a manner that reflects the estimated decline in the economic value of the identified intangible asset. TSFG periodically reviews its other intangible assets to determine whether there have been any events or circumstances which indicate the recorded amount is not recoverable from projected undiscounted cash flows. If the projected undiscounted net operating cash flows are less than the carrying amount, a loss is recognized to reduce the carrying amount to fair value, and when appropriate, the amortization period is also reduced.
Acquisitions and Sales
The following table summarizes TSFGs acquisitions completed during the past three years. All of the transactions were accounted for using the purchase method of accounting. TSFGs Consolidated Financial Statements include the results of the acquired companys operations since the acquisition date.
Summary of Completed Acquisitions
(dollars in thousands)
For additional information regarding TSFGs acquisitions, please see Item 8, Note 4 to the Consolidated Financial Statements.
In August 2004, Carolina First Bank acquired a branch office (including related loans and deposits) located in Lake Lure, North Carolina from an unrelated financial institution. See Item 1, Note 5 to the Consolidated Financial Statements for additional information.
TSFG had no pending acquisitions as of December 31, 2005.
In the fourth quarter 2004, TSFG made the decision to sell substantially all of the assets and all liabilities of Carolina First Guaranty Reinsurance, Ltd. (CFGRL). CFGRL was a wholly-owned captive reinsurance subsidiary, which provided credit-related insurance services to customers of TSFG. In connection with the sale, which was completed on December 1, 2004, TSFG sold $219,000 in assets, $622,000 in liabilities, and paid cash of $403,000. Since CFGRL was immaterial to TSFGs financial statements, presentation as a discontinued operation was not warranted.
On June 28, 2004, TSFG completed the sale of substantially all of the assets and all liabilities of Community National Bank headquartered in Pulaski, Virginia. TSFG acquired Community National Bank in connection with its October 2003 acquisition of MountainBank Financial Corporation (MBFC), and it was outside TSFGs targeted geographic market. In connection with this disposition, TSFG sold $40.4 million in loans and $60.0 million in deposits, and recorded reductions of goodwill totaling $6.6 million and core deposit intangibles totaling $864,000. This transaction resulted in no book gain or loss. Since Community National Bank was immaterial to TSFGs financial statements, presentation as a discontinued operation was not warranted. For the period from January 1, 2004 to June 28, 2004, Community National Banks net income totaled $91,000.
Balance Sheet Review
TSFG focuses its lending activities on small and middle market businesses and individuals in its geographic markets. At December 31, 2005, outstanding loans totaled $9.5 billion, which equaled 103% of total deposits and 66% of total assets. The major components of the loan portfolio were commercial loans, commercial real estate loans, consumer loans (including both direct and indirect loans), and one-to-four family residential mortgage loans. Substantially all loans were to borrowers located in TSFGs market areas in South Carolina, North Carolina, and Florida. At December 31, 2005, approximately 7% of the portfolio is unsecured.
Loans held for investment increased $1.3 billion, or 16.4%, to $9.4 billion at December 31, 2005 from $8.1 billion at December 31, 2004. This increase included $311.6 million in net acquired loans held for investment from the acquisition of Pointe. Excluding net acquired loans held for investment of $311.6 million, organic loan growth for 2005 was 12.6% (based on period-end balances). Organic loan growth was concentrated primarily in commercial loans.
As part of its portfolio and balance sheet management strategies to reduce exposure to areas of perceived higher risk, TSFG reviews its loans held for investment and determines whether its intent for specific loans or classes of loans has changed. If management changes its intent from held for investment to held for sale, the loans are transferred to the held for sale portfolio and recorded at the lower of cost basis or fair value.
TSFG generally sells a majority of its residential mortgage loans at origination in the secondary market. TSFG also retains certain of its mortgage loans, based on predetermined criteria, in its held for investment portfolio as part of its overall balance sheet management strategy. Loans held for sale increased $15.9 million to $37.2 million at December 31, 2005 from $21.3 million at December 31, 2004, primarily related to higher mortgage originations.
Table 2 summarizes outstanding loans by collateral type for real estate secured loans and by borrower type for all other loans. Collateral type represents the underlying assets securing the loan, rather than the purpose of the loan.
Loan Portfolio Composition
(dollars in thousands)
Loan Portfolio Composition Based on Loan Purpose
(dollars in thousands)
Commercial and industrial loans are loans to finance short-term and intermediate-term cash needs of businesses. Typical needs include the need to finance seasonal or other temporary cash flow imbalances, growth in working assets created by sales growth, and purchases of equipment and vehicles. Credit is extended in the form of short-term single payment loans, lines of credit for periods up to a year, revolving credit facilities for periods up to five years, and amortizing term loans for periods up to ten years.
Owner-occupied real estate loans are loans to finance the purchase or expansion of operating facilities used by businesses not engaged in the real estate business. Typical loans are loans to finance offices, manufacturing plants, warehouse facilities, and retail shops. Depending on the property type and the borrowers cash flows, amortization terms vary from ten years up to 20 years. Although secured by mortgages on the properties financed, these loans are underwritten based on the cash flows generated by operations of the businesses they house.
Commercial real estate loans are loans to finance real properties that are acquired, developed, or constructed for sale or lease to parties unrelated to the borrower. Included are loans to acquire land for development, land development loans, construction loans, mini-perms for cash flow stabilization periods, and permanent loans in situations where access to the secondary market is limited due to loan size.
Indirect sales finance loans are loans to individuals to finance the purchase of motor vehicles. They are closed at the auto dealership but approved in advance by TSFG for immediate purchase. Loans are extended on new and used motor vehicles with terms varying from two to six years.
Direct retail consumer loans are loans to individuals to finance personal, family, or household needs. Typical loans are loans to finance auto purchases, home repairs and additions, and home purchases. TSFG employees located in the subsidiary bank branches originate substantially all of these loans.
Home equity loans are loans to homeowners, secured by junior mortgages on their primary residences, to finance personal, family, or household needs. These loans may be in the form of amortizing loans or lines of credit with terms up to 15 years.
Mortgage loans are loans to individuals, secured by first mortgages on single-family residences, to finance the acquisition of those residences. TSFG generally sells a majority of its residential mortgage loans at origination in the secondary market. TSFG also retains certain of its mortgage loans, based on predetermined criteria, in its held for investment portfolio as part of its overall balance sheet management strategy.
The portfolios most significant concentration is in commercial real estate loans. Real estate development and construction are major components of the economic activity that occurs in TSFGs markets. By product type, commercial construction and development loans represent the largest component of commercial real estate loans, and represent 35.9% of the total commercial real estate loans at December 31, 2005, up from 29.7% at December 31, 2004. The risk attributable to the concentration in commercial real estate loans is managed by focusing our lending on markets we are familiar with and on borrowers who have proven track records and who we believe possess the financial means to weather adverse market conditions. Consequently, although the analysis of reserve adequacy includes an adjustment to account for the risk inherent in this concentration, management believes the risk of loss in its commercial real estate loans is not materially greater than the risk of loss in any other segment of the portfolio.
In addition, management believes that diversification by geography, property type, and borrower partially mitigates the risk of loss in its commercial real estate loan portfolio. Table 4 sorts the commercial real estate portfolio by geography and property type.
Commercial Real Estate Loans
(dollars in thousands)
Table 5 presents maturities of certain loan classifications based on collateral type at December 31, 2005. The table also provides the breakdown between those loans with a predetermined interest rate and those loans with a floating interest rate.
Selected Loan Maturity and Interest Sensitivity
(dollars in thousands)
Table 6 summarizes TSFGs loan relationships, including unused loan commitments, which are greater than $10 million.
Loan Relationships Greater than $10 Million
Portfolio risk is also managed by maintaining a house lending limit at a level significantly lower than the legal lending limit of both Carolina First Bank and Mercantile Bank, and by requiring Board of Director approval to exceed it. At December 31, 2005, TSFGs house lending limit was $35 million, and two credit relationships totaling $86.8 million were in excess of the limit. The 20 largest credit relationships have an aggregate outstanding principal balance of $232.6 million, or 2.5% of total loans held for investment, at December 31, 2005, down from 3.1% of total loans held for investment at December 31, 2004.
TSFG participates in shared national credits (multi-bank credit facilities of $20 million or more), primarily to borrowers who are headquartered or conduct business in or near our markets. At December 31, 2005, the loan portfolio included commitments totaling $646.0 million in shared national credits. Outstanding borrowings under these commitments totaled $222.7 million.
A willingness to take credit risk is inherent in the decision to grant credit. Prudent risk-taking requires a credit risk management system based on sound policies and control processes that ensure compliance with those policies. TSFGs credit risk management system is defined by policies approved by the Board of Directors that govern the risk underwriting, portfolio monitoring, and problem loan administration processes. Adherence to underwriting standards is managed through a multi-layered credit approval process and after-the-fact review by credit risk management of loans approved by lenders. Through daily review by credit risk managers, monthly reviews of exception reports, and ongoing analysis of asset quality trends, compliance with underwriting and loan monitoring policies is closely supervised. The administration of problem loans is driven by policies that require written plans for resolution and quarterly meetings with credit risk management to review progress. Credit risk management activities are monitored by Credit Committees of each banking subsidiarys Board of Directors, which meet monthly to review credit quality trends, new large credits, loans to insiders, large problem credits, credit policy changes, and reports on independent credit audits of branch offices.
Table 7 presents a summary of TSFGs credit quality indicators.
Credit Quality Indicators
(dollars in thousands)
TSFGs nonperforming assets as a percentage of loans held for investment and foreclosed property has improved each year since December 31, 2002 partially due to the resolution of certain identified problem loans purchased from Rock Hill Bank & Trust (the Rock Hill Workout Loans) in October 2002. A substantial majority of the Rock Hill Workout Loans have been resolved so that TSFGs credit quality measures are approaching more normalized levels. At December 31, 2005, the Rock Hill Workout Loans totaled $8.3 million, with nonperforming assets of $3.2 million and an allowance for loan losses of $723,000.
Net loan charge-offs as a percentage of average loans held for investment decreased to 0.36% for 2005 from 0.46% for 2004, primarily due to lower consumer charge-offs.
Allowance for Loan Losses and Reserve for Unfunded Lending Commitments
The allowance for loan losses represents managements estimate of probable incurred losses inherent in the lending portfolio. The adequacy of the allowance for loan losses (the Allowance) is analyzed quarterly. For purposes of this analysis,
adequacy is defined as a level sufficient to absorb probable incurred losses in the portfolio as of the balance sheet date presented. The methodology employed for this analysis is as follows.
The portfolio is segregated into risk-similar segments for which historical loss ratios are calculated and adjusted for identified changes in current portfolio characteristics. Historical loss ratios are calculated by product type for consumer loans (direct installment, indirect installment, revolving, and mortgage) and by credit risk grade for performing commercial loans. Nonperforming commercial loans are reviewed for impairment and impairment is measured in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan, an amendment of FASB Statements No. 5 and 15 (SFAS 114), and assigned specific allocations. To allow for modeling error, a range of probable loss ratios (from 95% to 105% of the adjusted historical loss ratio) is then derived for each segment. The resulting percentages are then applied to the dollar amounts of loans in each segment to arrive at each segments range of probable loss levels.
The Allowance for each portfolio segment is set at an amount within its range that reflects managements best judgment of the extent to which historical loss levels are more or less accurate indicators of current losses in the portfolio. Managements judgments evolve from an assessment of various issues, including but not limited to the pace of loan growth, emerging portfolio concentrations, risk management system changes, entry into new markets, new product offerings, loans acquired from acquisitions, loan portfolio quality trends, and uncertainty in current economic and business conditions.
The Allowance is then segregated into allocated and unallocated components. The allocated component is the sum of the loss estimates at the lower end of the probable loss range for each category. The unallocated component is the sum of the amounts by which final loss estimates exceed the lower end estimates for each category. The unallocated component of the Allowance represents probable incurred losses in the portfolio based on our analysis that are not fully captured in the allocated component. Allocation of the Allowance to respective loan portfolio components is not necessarily indicative of future losses or future allocations. The entire Allowance is available to absorb incurred losses in the loan portfolio.
Assessing the adequacy of the Allowance is a process that requires considerable judgment. Managements judgments are based on numerous assumptions about current events, which we believe to be reasonable, but which may or may not be valid. Thus, there can be no assurance that loan losses in future periods will not exceed the current Allowance amount or that future increases in the Allowance will not be required. No assurance can be given that managements ongoing evaluation of the loan portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the Allowance, thus adversely affecting the operating results of TSFG.
The Allowance is also subject to examination and adequacy testing by regulatory agencies, which may consider such factors as the methodology used to determine adequacy and the size of the Allowance relative to that of peer institutions, and other adequacy tests. In addition, such regulatory agencies could require us to adjust our Allowance based on information available to them at the time of their examination.
The Allowance declined as a percentage of loans held for investment to 1.14% at December 31, 2005 from 1.19% at December 31, 2004. This decline was primarily due to a decrease in nonaccrual and impaired loans, and the related specific allowance. The allowance coverage increased to 3.24 times nonperforming loans at December 31, 2005 from 2.14 times at December 31, 2004. See Credit Quality.
Table 8, which summarizes the changes in the Allowance, and Table 9, which reflects the allocation of the Allowance at the end of each year, provides additional information with respect to the activity in the Allowance.
Summary of Loan Loss Experience
(dollars in thousands)
Composition of Allowance for Loan Losses
(dollars in thousands)
Note: See Table 2 for composition of loan portfolio.
In addition to the allowance for loan losses, TSFG also estimates probable losses related to binding unfunded lending commitments. The methodology to determine such losses is inherently similar to the methodology utilized in calculating the allowance for commercial loans, adjusted for factors specific to binding commitments, including the probability of funding. The reserve for unfunded lending commitments is included in other liabilities on the balance sheet. Changes to the reserve for unfunded lending commitments are made by changes to the provision for credit losses.
TSFG uses the investment securities portfolio for several purposes. It serves as a vehicle to manage interest rate and prepayment risk, to generate interest and dividend income from the investment of funds, to provide liquidity to meet funding requirements, and to provide collateral for pledges on public deposits, securities sold under repurchase agreements, and Federal Home Loan Bank borrowings. In addition, TSFG has engaged in, and expects to continue to engage in, hedging activities designed to reduce interest rate risk associated with the investment securities and other balance sheet items. Table 10 shows the carrying values of the investment securities portfolio at the end of each of the last five years.
Investment Securities Portfolio Composition
(dollars in thousands)
Securities (i.e., trading securities, securities available for sale, and securities held to maturity) excluding the unrealized loss on available for sale securities averaged $4.4 billion in 2005, 5.5% above the average for 2004 of $4.2 billion. During the first quarter of 2005, additional securities of approximately $525 million were purchased, funded with additional leverage from wholesale borrowings. During the remaining three quarters of 2005, TSFG reduced its securities by approximately $1.7 billion in an effort to lower its interest rate risk in a rising rate and flattening yield curve environment and to reduce its reliance on wholesale borrowings. At December 31, 2005, TSFG had a securities-to-total asset ratio of 22%, down from 31% at December 31, 2004.
The average tax-equivalent portfolio yield increased in 2005 to 4.35% from 4.08% in 2004. The securities yield increased primarily due to a $8.5 million decrease in mortgage-backed securities (MBS) premium amortization for 2005 compared to 2004.
TSFG strives to keep the duration of its securities portfolio relatively short to provide adequate flexibility to proactively manage cash flow as market conditions change. Cash flow may be used to pay-off borrowings, to fund loan growth, or to reinvest
in securities at then current market rates.
The expected duration of the debt securities portfolio increased to approximately 3.8 years at December 31, 2005 from approximately 3.2 years at December 31, 2004. The increase was due to the impact of rising interest rates. If interest rates continue to rise, the duration of the debt securities portfolio may extend.
The available for sale portfolio constituted 98.0% of total securities at December 31, 2005. Management believes that maintaining most of its securities in the available for sale category provides greater flexibility in the management of the overall investment portfolio. Nearly all of these securities are rated AAA so the credit risk is minimal. Approximately 72% of MBS are collateralized mortgage obligations (CMOs) with a total expected duration of 4.9 years. TSFG manages the MBS portfolio to maintain a short duration and repricing horizon. At December 31, 2005, approximately 20% of the MBS portfolio was variable rate or hybrid variable rate, where the rate adjusts on an annual basis after a specified fixed rate period, generally ranging from three to ten years. Many of these adjustable rate MBS are still in the fixed rate period, and are therefore anticipated to behave more like a fixed rate instrument over the next twelve months or more.
Changes in interest rates and related prepayment activity impact yields and fair values of TSFGs securities, specifically MBS. Based on the current investment portfolio composition, in a rising interest rate environment, related prepayment activity should decrease. Decreasing prepayment activity extends the premium amortization period, thereby improving yields.
The net unrealized loss on available for sale securities (pre-tax) totaled $73.6 million at December 31, 2005, compared with a $29.5 million loss at December 31, 2004. This increase in unrealized loss was primarily due to increases in interest rates, with the most significant increase in unrealized loss relating to MBS, which increased $28.6 million. If interest rates continue to increase, TSFG expects its net unrealized loss on available for sale securities as a percentage of the portfolio to increase. See Item 1, Note 9 to the Consolidated Financial Statements for information about TSFGs securities in unrealized loss positions.
Table 11 shows the contractual maturity schedule for securities held to maturity and securities available for sale at December 31, 2005. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations. The table also reflects the weighted average yield of the investment securities.
Investment Securities Maturity Schedule
(dollars in thousands)
Available for Sale Fair Value
Community Bank Stocks. At December 31, 2005, TSFG had equity investments in nine community banks located in the Southeast with a cost basis of $8.1 million and a market value of $10.1 million. In each case, TSFG owns less than 5% of the community banks outstanding common stock. TSFG made these investments to develop correspondent banking relationships and to promote community banking in the Southeast. These investments in community banks are included in securities available for sale.
Intangible assets totaled $691.8 million at December 31, 2005, up from $611.5 million at December 31, 2004, principally due to the Pointe acquisition. See Item 1, Notes 14 and 15 to the Consolidated Financial Statements for the types and balances of intangible assets.
Derivative Financial Instruments
Derivative financial instruments used by TSFG may include interest rate swaps, caps, collars, floors, options, futures and forward contracts. Derivative contracts are primarily used to hedge identified on-balance sheet risks and also to provide risk-
management products to customers. TSFG has derivatives that qualify for hedge accounting under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), trading derivatives, derivatives that do not qualify for hedge accounting under SFAS 133 but otherwise achieve economic hedging goals (economic hedges), and customer hedging programs. Table 12 shows the fair value of TSFGs derivative assets and liabilities and their related notional amounts. TSFGs trading derivatives, economic hedges, and customer hedging programs are included in Other Derivatives in Table 12.
Summary of Derivative Assets and Liabilities
(dollars in thousands)
Customer Hedging Programs. TSFG offers programs that permit its customers to hedge various risks, including fluctuations in interest rates and foreign exchange rates. Through these programs, derivative contracts are executed between the customers and TSFG. Offsetting contracts are executed between TSFG and selected third parties to hedge the risk created through the customer contracts. The third party interest rate contracts are identical to the customer contracts, except for a fixed pricing spread or a fee paid to TSFG as compensation for administrative costs, credit risk and profit. As a result, the change in fair value of the customer contracts will generally be offset by the change in fair value of the related third-party contracts. These customer contracts generally take the form of interest rate swaps to hedge fixed rate loans made by TSFG to the customer and foreign exchange forward contracts to manage currency risk associated with non-dollar denominated transactions.
All derivative contracts associated with these programs are carried at fair value and are not considered hedges under SFAS 133. At December 31, 2005, the largest fair value adjustment to any single customer or counterparty totaled $56,000.
Fair Value Hedges. TSFG enters into interest rate swaps to effectively convert its fixed rate brokered CDs to floating rates. The interest rate swaps are structured such that the notional amount, termination date, fixed rate and other relevant terms match those of the brokered CD it is hedging. As a result of not having the proper hedge documentation in place upon inception of the hedging relationship, TSFG was not able to apply hedge accounting under SFAS 133 in prior periods. As a result, the derivative instruments gain or loss has been included in noninterest income in derivative gains or losses, with no offsetting fair value adjustment for the hedged item for the first nine months of 2005 and prior periods. These interest rate swaps were redesignated using the long-haul method and qualified as fair value hedges under SFAS 133 beginning in October 2005. The fair value adjustment recorded for the year ended December 31, 2005 and 2004 was a loss of $9.3 million and a gain of $3.7 million, respectively. TSFG received net cash settlements on its brokered CD swaps of $10.9 million and $25.0 million (included in noninterest income in derivative gains (losses)) for the year ended December 31, 2005 and 2004, respectively, related to these interest rate swaps. Amortization of the prepaid fees on the brokered CDs included in interest expense was $3.4 million and $3.3 million for the year ended December 31, 2005 and 2004, respectively.
TSFG has entered into interest rate swaps relating to certain indexed CD products, including equity-linked CDs and inflation-indexed CDs. These interest rate swaps are designated as fair value hedges under SFAS 133 using the long-haul method.
TSFG enters into receive-fixed interest rate swaps to hedge certain fixed rate Federal Home Loan Bank borrowings. The interest rate swaps are intended to be fair value hedges of the benchmark interest rate risk inherent in these liabilities. As a result of not having the proper hedge documentation in place upon inception of the hedging relationship for these interest rate swaps, TSFG was not able to apply hedge accounting under SFAS 133. As a result, the related derivative instruments gain or loss has been included in noninterest income in derivative gains or losses, with no offsetting fair value adjustment for the hedged item. The fair value adjustment recorded for the year ended December 31, 2005 and 2004 was a loss of $5.5 million and $1.2 million, respectively. For the year ended December 31, 2005 and 2004, TSFG paid net cash settlements of $547,000 and received net cash settlements of $2.6 million, respectively, related to these interest rate swaps (included in noninterest income). These interest rate swaps were terminated in November 2005.
Cash Flow Hedges. TSFG uses interest rate swaps to hedge the repricing characteristics of certain floating rate assets and liabilities. The initial assessment of expected hedge effectiveness and the ongoing periodic measures of hedge ineffectiveness are based on the expected change in cash flows of the hedged item caused by changes in the benchmark interest rate. TSFG entered into pay-fixed interest rate swaps to convert a portion of its variable rate structured repurchase agreement portfolio and FHLB advances to fixed rates in 2005. In addition, during the third quarter 2005, TSFG entered into receive-fixed interest rate swaps to hedge the forecasted interest income from prime-based commercial loans through 2008 and expects to enter into additional interest rate swaps on its prime-based commercial loans. There were no significant cash flow hedging gains or losses, as a result of hedge ineffectiveness, recognized for the year ended December 31, 2005.
TSFG entered into pay-fixed interest rate swaps to convert certain of its subordinated notes associated with trust preferred securities to fixed rates. As a result of not having the proper hedge documentation in place upon inception of the hedging relationship for these interest rate swaps, TSFG was not able to apply hedge accounting under SFAS 133. As a result, the derivative instruments gain or loss has been included in noninterest income in derivative gains or losses. The fair value adjustment recorded for the year ended December 31, 2005 and 2004 was a gain of $1.5 million and a gain of $66,000, respectively. TSFG paid net cash settlements of $18,000 and received net cash settlements of $9,000 for the year ended December 31, 2005 and 2004, respectively, related to these interest rate swaps (included in noninterest income). TSFG terminated the interest rate swaps hedging the subordinated debt in November 2005.
Trading. From time to time, TSFG enters into derivative financial contracts that are not designed to hedge specific transactions or identified assets or liabilities and therefore do not qualify for hedge accounting, but are rather part of the Companys overall risk management strategy. Such contracts include interest rate futures, option contracts on certain U.S. agency debt securities, and certain other interest rate swaps which are not designated as hedges. The futures contracts are exchange-traded, while the option contracts are over-the-counter instruments with money center and super-regional financial institution counterparties. These contracts are marked to market through earnings each period and are generally short-term in nature. At December 31, 2005 there were no such contracts outstanding. For the year ended December 31, 2005, TSFG recognized a gain of $371,000 relating to these activities, compared to a gain of $3.1 million for the year ended December 31, 2004.
Mortgage Loan Commitments and Forward Sales Commitments. As part of its mortgage lending activities, TSFG originates certain residential loans and commits these loans for sale. The commitments to originate residential loans (rate locks) and the sales commitments are freestanding derivative instruments and are generally funded within 90 days. During the third quarter 2005, TSFG expanded its strategy to include selling mortgage loans on a pooled basis in addition to individual loan sales. As a result, the amount of time between origination date and sale date has increased, which has increased the amount of interest rate risk associated with these loans. At December 31, 2005, the fair value of the rate locks was a liability of $50,000.
The Company enters into forward sales commitments of closed mortgage loans to third parties at a specified price. The forward sales commitments are entered into to economically hedge the change in fair value of the underlying mortgage loans. The change in the value of the forward sales commitments is recognized through current period earnings. The loans are accounted for on the basis of the lower of cost or market guidelines. Fair value hedging gains or losses related to the forward sales commitments were not material for the year ended December 31, 2005. The fair value of forward sales commitments was an asset of $11,000 and a liability of $86,000 at December 31, 2005.
Credit Risk of Derivative Financial Instruments. Entering into derivative financial contracts creates credit risk for potential amounts contractually due to TSFG from the derivative counterparties. Derivative credit risk is generally measured as the net replacement cost to TSFG in the event that a counterparty to a contract in a gain position to TSFG completely fails to perform under the terms of the contract. Derivative credit risk related to existing bank customers (in the case of customer loan swaps and foreign exchange contracts) is monitored through existing credit policies and procedures. The effects of changes in interest
rates or foreign exchange rates are evaluated across a range of possible options to limit the maximum exposures to individual customers. Customer loan swaps are generally cross-collateralized with the related loan. In addition, customers may also be required to provide margin collateral to further limit TSFGs derivative credit risk.
Counterparty credit risk with other derivative counterparties (generally money-center and super-regional financial institutions) is evaluated through existing policies and procedures. This evaluation considers the total relationship between TSFG and each of the counterparties. Individual limits are established by management and approved by the credit department. Margin collateral in the form of cash or marketable securities is required if the exposure between TSFG and any counterparty exceeds established limits. Based on declines in the counterparties credit rating, these limits are reduced and additional margin collateral is required.
A deterioration of the credit standing of one or more of the counterparties to these contracts may result in the related hedging relationships being deemed ineffective or in TSFG not achieving its desired economic hedging outcome. This could occur if the credit standing of the counterparty deteriorated such that either the fair value of underlying collateral no longer supported the contract or the counterpartys ability to provide margin collateral was impaired.
Please see Item 8, Note 1 to the Consolidated Financial Statements for a description of TSFGs significant accounting policies.
Deposits remain TSFGs primary source of funds for loans and investments. Average deposits provided funding for 64.9% of average earning assets in 2005 and 62.1% in 2004. Carolina First Bank and Mercantile Bank face strong competition from other banking and financial services companies in gathering deposits. TSFG has developed other sources, such as brokered CDs, FHLB advances, short-term borrowings, and long-term structured repurchase agreements to fund a portion of loan demand and, if appropriate, any increases in investment securities.
Table 13 shows the breakdown of total deposits by type of deposit and the respective percentage of total deposits.
Types of Deposits
(dollars in thousands)
At December 31, 2005, customer deposits increased $1.4 billion from December 31, 2004. Approximately 23% of this increase was attributable to $328.6 million in net acquired deposits from the acquisition of Pointe. Excluding net acquired deposits, organic growth in customer deposits totaled 17.2%. TSFGs deposit growth was not concentrated in any particular market.
TSFG uses brokered deposits as an alternative funding source while continuing its efforts to maintain and grow its local customer deposit base. Although brokered deposits increased during the past year, these balances declined as a percentage of total deposits.
Table 18 in Results of Operations Net Interest Income details average balances for the deposit portfolio for both 2005 and 2004. Comparing December 31, 2005 and 2004, average interest-bearing transaction accounts (checking, savings, and money market) increased $342.4 million, or 10.0%, and average noninterest-bearing deposits increased $347.0 million, or 33.4%. In 2005, average time deposits, excluding average brokered deposits, increased $680.2 million, or 47.1%, and average brokered deposits increased $362.8 million, or 36.9%.
As part of its overall funding strategy, TSFG expects to continue its focus on growing customer deposits. TSFG attempts to enhance its deposit mix by working to attract lower-cost transaction accounts. TSFGs customer-centered sales process, Elevate, and deposit campaigns are expected to play an integral part in achieving this longer-term goal. Despite this focus, growth in time deposits outpaced the growth in transaction accounts during 2005, in response to increased customer demand for CDs. However, noninterest-bearing deposit growth increased at a 22.2% rate (based on period-end balances) for 2005, and increased at a 13.0% organic growth rate (which excludes the noninterest-bearing deposits acquired from Pointe). Deposit pricing is very competitive, and we expect this pricing environment to continue.
Time deposits of $100,000 or more are generally from customers within our local markets and include public deposits. During 2005, time deposits of $100,000 or more increased $729.4 million, or 109.6%, to $1.4 billion. This increase included $143.4
million in public deposits. TSFG utilizes these deposits to provide long-term fixed rate funding for the company at a price that is favorable relative to expected changes in the yield curve.
Table 14 shows a maturity schedule for time deposits of $100,000 or more at December 31, 2005.
Maturity Distribution of Time Deposits of $100,000 or More
(dollars in thousands)
Table 15 shows the breakdown of total borrowings by type.
Types of Borrowings
(dollars in thousands)
TSFG uses both short-term and long-term borrowings to fund growth of earning assets in excess of deposit growth. In 2005, average borrowings totaled $4.5 billion, compared with $4.0 billion in 2004. This increase was primarily attributable to an increased reliance on short-term borrowings to support earning asset growth, including increases in investment securities. TSFG has and may continue to enter into interest rate swap agreements to hedge interest rate risk related to borrowings.
Table 16 shows balance and interest rate information on TSFGs short-term borrowings.
(dollars in thousands)
Federal funds purchased and repurchase agreements are used to satisfy daily funding needs. The increases in both the short-term and long-term balances are primarily to support earning asset growth. Balances in these accounts can fluctuate on a day-to-day basis.
FHLB advances are a source of funding which TSFG uses depending on the current level of deposits, its ability to raise deposits through market promotions, the Subsidiary Banks unused FHLB borrowing capacity, and the availability of collateral to secure FHLB borrowings.
During 2005, TSFG recognized a loss on early extinguishment of debt of $7.1 million, which reflects the costs to terminate certain structured repurchase agreement borrowings totaling $1.5 billion, with interest rates ranging from 2.12% to 3.74%. The losses were offset by a gain related to prepayment discounts on Federal Home Loan Bank advances totaling $345.0 million with fixed interest rates ranging from 1.84% to 3.57%.
In March 2004, TSFG recorded a loss on early extinguishment of debt totaling $1.4 million for prepayment penalties for repurchase agreement borrowings totaling $185.0 million with interest rates ranging from 1.54% to 2.99%. Due to a change in estimates related to step-up and callable repurchase agreements (including the retired debt), TSFG reversed $900,000 in interest expense accrued at December 31, 2003. In August 2003, TSFG recorded a loss on early extinguishment of debt totaling $2.7 million for prepayment penalties for FHLB advances totaling $40.0 million with a fixed interest rate of 6.27%.
Capital Resources and Dividends
Total shareholders equity amounted to $1.5 billion, or 10.4% of total assets, compared with $1.4 billion, or 10.1% of total assets, at December 31, 2004. Shareholders equity increased during 2005 primarily from the issuance of common stock for the Pointe acquisition, as well as the retention of earnings. Cash dividends paid and the increase in unrealized loss in the available for sale investment portfolio partially offset these increases. TSFG has approximately 1.3 million shares remaining under its stock repurchase authorization, but at this time has no plans to repurchase any significant number of shares.
TSFGs unrealized loss on securities, net of tax, which is included in accumulated other comprehensive loss, was $46.4 million as of December 31, 2005 compared with $18.5 million at December 31, 2004. For discussion on the primary reasons for the unrealized decline in the market value of available for sale securities, see Securities.
Book value per share at December 31, 2005 and 2004 was $19.90 and $19.56, respectively. Tangible book value per share at December 31, 2005 and 2004 was $10.64 and $10.98, respectively. Tangible book value was below book value as a result of the purchase premiums associated with acquisitions of entities and assets accounted for as purchases.
TSFG is subject to the risk based capital guidelines administered by bank regulatory agencies. The guidelines are designed to make regulatory capital requirements more sensitive to differences in risk profiles among banks and bank holding companies, to account for off-balance sheet exposure and to minimize disincentives for holding liquid assets. Under these guidelines, assets and certain off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and certain off-balance sheet items. TSFG and its Subsidiary Banks exceeded the well-capitalized regulatory requirements at December 31, 2005. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators, that, if undertaken, could have a direct material effect on our Consolidated Financial Statements.
Regulators are considering various revisions to the existing risk-based capital framework. Under Basel 1a, an Advanced Notice of Proposed Rulemaking, agencies are considering:
TSFG will continue to monitor these potential changes to the risk-based capital standards and plans to make the necessary changes to enable it to remain well-capitalized.
Table 17 sets forth various capital ratios for TSFG and its Subsidiary Banks. Under current regulatory guidelines, debt associated with trust preferred securities qualifies for tier 1 capital treatment. At December 31, 2005, trust preferred securities included in tier 1 capital totaled $135.5 million. For further information regarding the regulatory capital of TSFG and its Subsidiary Banks, see Item 8, Note 26 to the Consolidated Financial Statements.
On November 10, 2004, TSFG filed a universal shelf registration statement registering up to $750.0 million of securities to provide additional flexibility in managing capital levels, both in terms of debt and equity. No securities have been offered or sold under this shelf registration to date.
At December 31, 2005, TSFGs tangible equity to tangible asset ratio was at 5.83%, a decline from 5.93% at December 31, 2004, due to the increase in the unrealized loss on available for sale securities. If interest rates continue to increase, TSFG expects its unrealized loss on available for sale securities to increase, leading to a lower tangible equity to tangible asset ratio. Additionally, TSFGs acquisitions of Pointe, Koss Olinger, Bowditch, and Lossing lowered TSFGs tangible equity to tangible asset ratio as a result of the goodwill recorded, as well as the use of cash as partial consideration for these acquisitions.
TSFGs Subsidiary Banks are subject to certain regulatory restrictions on the amount of dividends they are permitted to pay. TSFG has paid a cash dividend each quarter since the initiation of cash dividends on February 1, 1994. TSFG presently intends to pay a quarterly cash dividend on its common stock; however, future dividends will depend upon TSFGs financial performance and capital requirements.
TSFG, through a real estate investment trust subsidiary, had 898 mandatory redeemable preferred shares outstanding at December 31, 2005 with a stated value of $100,000 per share. At December 31, 2005, these preferred shares, which are reported as long-term debt on the consolidated balance sheet, totaled $89.9 million. Under Federal Reserve Board guidelines, $25.2 million, net of issuance costs, qualified as tier 1 capital, and $62.1 million, net of issuance costs, qualified as tier 2 capital. The terms for the preferred shares include certain asset coverage and cash flow tests, which if triggered, may prohibit TSFGs real estate trust subsidiary from paying dividends to Carolina First Bank, which in turn may limit its ability to pay dividends to TSFG.
Results of Operations
Net Interest Income
Net interest income is TSFGs primary source of revenue. Net interest income is the difference between the interest earned on assets, including loan fees and dividends on investment securities, and the interest incurred for the liabilities to support such assets. The net interest margin measures how effectively a company manages the difference between the yield on earning assets and the rate paid on funds used to support those assets. Fully tax-equivalent net interest income adjusts the yield for assets earning tax-exempt income to a comparable yield on a taxable basis based on a 35% marginal federal income tax rate. Table 18 presents average balance sheets and a net interest income analysis on a tax equivalent basis for each of the years in the three-year period ended December 31, 2005. Table 19 provides additional analysis of the effects of volume and rate on net interest income.
Comparative Average Balances Yields and Costs
(dollars in thousands)
Rate/Volume Variance Analysis
(dollars in thousands)
Fully tax-equivalent net interest income increased by $74.9 million, or 22.0%, in 2005 compared to 2004. Net interest income increased as a result of the 19.9% growth in average earning assets, principally from organic loan growth and growth from acquisitions. The Pointe acquisition, which closed May 6, 2005, added approximately $312 million in earning assets, all of which were loans, while the CNB and Florida Banks acquisitions, which closed July 16, 2004, added approximately $1.7 billion in earning assets, including $1.5 billion in loans.
Comparing 2005 to 2004, average loans increased $2.0 billion, or 28.2%, resulting from both internally-generated loans as well as loans that were added from the acquisitions noted in the preceding paragraph. At December 31, 2005, approximately 63% of TSFGs accruing loans were variable rate loans, the majority of which are tied to the prime rate.
Average securities declined as a percentage of average earning assets to 33.0% for 2005, down from 37.5% for 2004. Accordingly, for 2005, interest income from securities represented approximately 25% of TSFGs total interest income, down from 31% for 2004. During the second quarter 2005, TSFG began repositioning its balance sheet, by reducing investment securities (see Securities) and wholesale borrowings. This strategy continued during the third and fourth quarters of 2005. Investment securities at December 31, 2005 totaled $3.2 billion, down from $4.3 billion at December 31, 2004.
The net interest margin for 2005 was 3.12%, compared with 3.06% for 2004. The net interest margin benefited from a 79 basis point increase in the yield on average earning assets, while the average cost of customer deposits increased by 56 basis points. Growth in average noninterest-bearing deposits, which increased to $1.4 billion at December 31, 2005 from $1.0 billion at December 31, 2004, or an increase of 33.4%, also contributed to the net interest margin increase. This improved spread was partially offset by higher costs on wholesale borrowing, which increased 99 basis points. Due to the level of variable rate wholesale borrowings, the net interest margin is expected to decline over the near term if interest rates continue to increase. TSFG continues to evaluate its balance sheet positioning due to changes in interest rates, pricing competition, and customer preferences.
The Federal Reserve has increased the federal funds target rate 13 times, by 25 basis points each time, since June 30, 2004, following a three-year period of declining rates. Furthermore, over the past year, short-term rates have increased more quickly than long-term rates, leading to a flattened yield curve.
Provision for Credit Losses
The provision for credit losses is recorded in amounts sufficient to bring the allowance for loan losses and the reserve for unfunded lending commitments to a level deemed appropriate by management. Management determines this amount based upon many factors, including its assessment of loan portfolio quality, loan growth, changes in loan portfolio composition, net loan charge-off levels, and expected economic conditions. The provision for credit losses was $40.6 million, $35.0 million, and $20.6 million in 2005, 2004, and 2003, respectively. The higher provision for credit losses was primarily attributable to loan growth.
Net loan charge-offs were $31.9 million, or 0.36% of average loans held for investment in 2005, compared with $31.5 million, or 0.46% of average loans held for investment in 2004. The allowance for loan losses equaled 1.14% and 1.19% of loans held for investment as of December 31, 2005 and 2004, respectively. See Loans, Credit Quality, and Allowance for Loan Losses.
Table 20 shows the components of noninterest income during the three years ended December 31, 2005.
Components of Noninterest Income
(dollars in thousands)
Total customer fee income rose $9.7 million, or 22.4% in 2005, compared with 2004. Service charges on deposit accounts, the largest contributor to noninterest income, rose $6.3 million, or 17.4% for the same period due to acquisitions, higher nonsufficient funds charges, improved collections, increased numbers of accounts, and higher fees. Average balances for deposit transaction accounts, which impact service charges, increased $689.4 million, or 15.4% for the same period.
In 2005, wealth management income increased $6.5 million, or 42.7%. Wealth management income includes retail investment services, insurance income, trust and investment management income, and benefit administration fees. The increase in wealth management income was the result of increases throughout each of these categories, driven primarily by acquisitions, increased focus and additions to the sales force. Retail investment services increased $2.2 million, or 46.2%, in 2005 compared with 2004 due in part from hiring two additional brokers (an increase of 9.5%) and in part from the acquisition of a wealth management group. Insurance income increased $2.9 million, or 64.8%, due primarily to the acquisition of several insurance agencies in 2005, as well as efforts to leverage TSFGs existing customer base. TSFG continues to search for additional potential acquisitions to assist in growing its insurance agency operations. Trust and investment management income increased $1.0 million, or 27.5%, for the same period. At December 31, 2005 and 2004, the market value of assets administered by the trust department totaled $1.9 billion and $1.8 billion, respectively. Benefit administration fees are generated by TSFGs wholly-owned subsidiary, American Pensions, Inc., which was acquired in April 2003. Additional sales efforts resulted in increased fees for 2005 compared to 2004.
In 2005, noninterest income included a loss on the sale of securities of $52.1 million as a result of the balance sheet repositioning undertaken in an effort to lower TSFGs interest rate risk in a rising rate environment and its reliance on wholesale borrowings, compared with a gain on the sale of securities of $11.7 million in 2004. The 2004 gain on sale of securities was offset by $10.4 million impairment recognized on TSFGs perpetual preferred stock investments in Federal National Mortgage Association and Federal Home Loan Mortgage Corporation. TSFG periodically evaluates its available for sale securities portfolio for other-than-temporary impairment. As discussed in Note 9 to the Consolidated Financial Statements, TSFGs unrealized losses were primarily attributable to increases in interest rates. For additional details, see Critical Accounting Policies and Estimates Fair Value of Certain Financial Instruments and Securities.
Noninterest income also included a loss in fair value of interest rate swaps of $13.3 million in 2005, compared with a gain of $2.6 million in 2004. The net cash receipts for settlement of interest rate swaps declined to $10.4 million in 2005, compared with $27.6 million in 2004 as a result of the increase in interest rates. If interest rates continue to increase, the net cash settlement on the CD swap derivatives will continue to decline, and could result in net cash payments owed. In October 2005, these CD swap derivatives were redesignated under the long-haul method and the net cash settlements are included in net interest income (and the net interest margin) rather than in noninterest income. The gain on trading and certain other derivative activities declined to $335,000 in 2005, compared with $3.2 million in 2004. See Risk Management - Market Risk and Asset/Liability Management Derivatives and Hedging Activities.
Merchant processing income increased $1.2 million, or 13.5%, in 2005 compared with 2004 as a result of increased transactions.
In 2005, mortgage banking income increased $1.3 million, or 21.7%, compared with 2004. Mortgage loans originated by TSFG originators totaled $827.4 million, $513.1 million, and $689.5 million in 2005, 2004 and 2003, respectively. The increase in mortgage banking income was principally the result of higher loan volume and higher gains on sale to the secondary market. TSFG had 79 originators at December 31, 2005, up from 59 at December 31, 2004.
Table 21 shows the components of mortgage banking income for the three years ended December 31, 2005
Components of Mortgage Banking Income
(dollars in thousands)
TSFGs mortgage banking strategy is to sell most of the loans it originates in the secondary market with servicing rights released. However, during 2005 TSFG retained approximately $207.3 million of its mortgage loans in loans held for investment. At December 31, 2005, TSFGs servicing portfolio had an aggregate principal balance of $118.3 million, down from $155.2 million at December 31, 2004. The servicing portfolio decreased in 2005 due to prepayments and scheduled amortization.
Fees related to servicing other loans, for which Carolina First Bank owns the rights to service, are offset by the related amortization of mortgage servicing rights. In 2005, TSFG net mortgage servicing loss improved due to lower amortization of mortgage servicing rights as prepayments slowed. Mortgage servicing rights totaled $415,000 and $1.1 million at December 31, 2005 and 2004, respectively.
During 2004, the gain on disposition of assets and liabilities resulted from the contribution of land at fair value associated with a conservation grant in North Carolina.
Other noninterest income includes income related to international banking services, wire transfer fees, overdraft protection fee income, internet banking fees, and gains/losses on disposition of other real estate owned/fixed assets.
TSFG is expanding in new and existing markets within its targeted geographic footprint in the Southeast, both through organic growth and acquisitions. TSFG also makes strategic investments in its products and services, and technology systems. These factors contributed to TSFGs increases in noninterest expense, which increased 31.1% in 2005 over 2004. TSFGs market expansion included the May acquisition of Pointe. Additionally, during 2005, TSFG opened ten de novo branches. Non-banking acquisitions during 2005 included the Koss Olinger group of companies, a wealth management advisory firm operating in North Florida, Bowditch Insurance Corporation, a property and casualty company operating in Jacksonville, Florida, and Lossing Insurance Agency, a property and casualty company operating in Ocala, Florida.
Table 22 shows the components of noninterest expenses and TSFGs efficiency ratio, a measure of TSFGs expenses relative to total revenues.
Components of Noninterest Expense
(dollars in thousands)
Salaries, wages, and employee benefits rose $34.2 million, or 28.9%, in 2005 after rising 17.5% in 2004. Full-time equivalent employees as of December 31, 2005 increased to 2,607 from 2,308 and 1,918 at December 31, 2004 and 2003, respectively. The increase in personnel expense was primarily attributable to the Pointe acquisition, higher branch and lending incentives, higher incentives and commissions relating to fee based businesses, higher discretionary incentives under TSFGs short-term plan, pay increases, higher health insurance costs, and additional employees. This increase was partially offset by lower long-term discretionary incentive accruals. The structure of TSFGs incentive plans may result in increased volatility in personnel expense in future periods.
Occupancy and furniture and equipment expense increased $8.2 million, or 19.3%, in 2005 primarily from the addition of branch offices from TSFGs acquisition of Pointe and additional de novo branches. The increase in professional services of $8.8 million, or 62.7%, was partially related to outsourcing costs for various fee initiatives and internal audit projects, as well as the costs associated with the restatement of prior period financial statements and other professional services. The increase in merchant processing expense of $1.1 million, or 16.6%, was in line with the increase in merchant processing income of $1.2 million.
Advertising and business development increased $2.3 million, or 36.5%, due to direct mail campaigns designed to increase deposits.
Amortization of intangibles increased $2.6 million in 2005, primarily due to the addition of core deposit intangibles from bank acquisitions, as well as identifiable amortizable intangibles acquired in connection with the insurance agency acquisitions.
TSFG incurred pre-tax merger-related costs, in connection with TSFGs acquisitions in 2005, 2004 and 2003. See Item 8, Note 31 to the Consolidated Financial Statements.
Employment contract buyouts increased by $9.2 million as TSFG terminated contracts with certain existing managers and accrued the related severance payments.
During 2005, TSFG contributed an equity investment to its charitable foundation and expensed the fair value of the contribution of $683,000. During 2004, TSFG executed a conservation grant of land in North Carolina and expensed the fair value of the contribution of $3.4 million.
During 2005, TSFG recognized a loss on early extinguishment of debt of $7.1 million, primarily attributable to costs incurred to terminate certain structured repurchase agreement borrowings. In 2004, TSFG recorded a loss on early extinguishment of debt totaling $1.4 million for prepayment penalties for repurchase agreement borrowings. In 2003, TSFG recorded a loss on early extinguishment of debt for prepayment penalties for FHLB advances. See Borrowed Funds.
Other noninterest expenses rose 26.5% in 2005 after an increase of 19.0% in 2004. The overall increase in other noninterest expenses was principally attributable to increases in staff recruitment, travel, debit card expenses, and growth from acquisitions.
The effective income tax rate as a percentage of pretax income was 26.6% in 2005, 31.6% in 2004, and 30.9% in 2003. The blended statutory federal and state income tax rate was approximately 37.0% during all three periods. TSFG anticipates the effective income tax rate to increase to between 34% and 35% for 2006.
For further information concerning income tax expense, refer to Item 8, Note 19 to the Consolidated Financial Statements.
Fourth Quarter Summary
In the fourth quarter 2005, TSFG reported a net loss of $16.4 million, or $(0.22) per diluted share compared to net income of $23.4 million, or $0.33 per diluted share for the fourth quarter 2004. During the fourth quarter 2005, TSFG repositioned its balance sheet, realizing losses of $52.5 million on the sale of securities and a loss of $5.1 million on the early extinguishment of debt. Securities were reduced to $3.2 billion at December 31, 2005 from $4.0 billion at September 30, 2005, a reduction of $874.0 million, or 21.7%. Long-term debt was reduced to $1.9 billion at December 31, 2005 from $2.8 billion at September 30, 2005, a reduction of $829.1 million, or 30.1%. This balance sheet repositioning reduced the ratio of securities to assets to 22.1% at December 31, 2005 from 27.0% at September 30, 2005 and the ratio of wholesale borrowings to total assets to 33.1% from 36.7% over the same period.
Net interest income was $104.9 million and $97.1 million for the quarter ended December 31, 2005 and 2004, respectively. The net interest margin was 3.16% for the fourth quarter of 2005 compared to 3.15% for the fourth quarter of 2004. The total yield on earning assets improved to 6.11% in the fourth quarter 2005 from 5.16% in the fourth quarter 2004. The cost of interest bearing deposits increased to 3.05% in the fourth quarter 2005 from 2.24% in the fourth quarter 2004. The cost of borrowings increased to 3.98% in the fourth quarter 2005 from 2.33% in the fourth quarter 2004.
TSFGs provision for credit losses was $10.8 million in both the fourth quarter 2005 and the fourth quarter 2004. The allowance for loan losses as a percentage of loans held for investment decreased to 1.14% at December 31, 2005 from 1.19% at December 31, 2004. Nonperforming loans improved to $33.3 million at December 31, 2005, down from $45.1 million at December 31, 2004. Nonperforming loans as a percentage of loans held for investment improved to 0.35% at December 31, 2005 from 0.56% at December 31, 2004. Net loan charge-offs, annualized, as a percentage of average loans held for investment improved to 0.38% for the fourth quarter 2005 from 0.50% for the fourth quarter 2004.
During the fourth quarter of 2005, TSFGs noninterest income was a negative $25.0 million as a result of the $52.5 million loss on sale of securities. For the fourth quarter of 2004, TSFGs noninterest income totaled $19.1 million, which was net of a $10.4 million other-than-temporary impairment of perpetual preferred stock. Excluding the loss on sale of securities and the impairment on the perpetual preferred stock, TSFGs noninterest income totaled $27.5 million in the fourth quarter 2005 compared to $27.7 million in the fourth quarter 2004. Total customer fee income improved to $14.5 million for the fourth quarter 2005, up $2.8 million or 23.9%, from $11.7 million for the fourth quarter 2004. The increase in customer fee income was driven by higher service charges on deposit accounts. Total wealth management income improved to $6.7 million for the fourth quarter 2005, up $2.8 million, or 72.0%, from $3.9 million for the fourth quarter 2004. The increase in wealth management income was driven by higher retail investment services and insurance income from the acquisitions completed during 2005. The total gain or loss on trading and derivative activities decreased to a loss of $3.0 million in the fourth quarter 2005 compared to a gain of $4.8 million in the fourth quarter 2004.
Noninterest expenses increased to $101.0 million for the fourth quarter of 2005 compared to $68.6 million for the fourth quarter of 2004. Salaries, wages and benefits increased to $53.5 million for the fourth quarter of 2005, up from $34.6 million for the fourth quarter of 2004, an increase of $18.8 million, or 54.5%. The increase in personnel costs was partially due to $10.0 million in employment contract buy-outs during the fourth quarter of 2005 compared to $1.0 million in employment contract buyouts in the fourth quarter of 2004. Personnel costs also increased due to expanding the risk management and internal audit departments, completing one bank acquisition and three insurance company acquisitions during 2005 and opening additional branch locations. Occupancy costs increased to $13.4 million in the fourth quarter 2005 compared to $11.5 million in the fourth quarter 2004, an increase of $1.9 million, or 16.3%. The increased occupancy costs were a result of the acquisitions and de novo branch expansions during 2005. Professional services increased to $7.1 million in the fourth quarter 2005 from $3.8 million in the fourth quarter 2004 as a result of outsourcing some of the internal audit procedures, additional costs in connection with the restatement of the financial statements during the fourth quarter 2005 relating to the accounting for derivatives, and other professional services incurred.
In the fourth quarter of 2005, the effective income tax rate was a benefit of 48.5% as a result of the fourth quarter loss. For the fourth quarter of 2004, the effective income tax rate was 35.4%.
The above mentioned results for the fourth quarter of 2005 are different from what TSFG reported in its January 19, 2006 earnings release, in which TSFG reported a net loss of $15.8 million, or $(0.21) per diluted share. The difference of $625,000 relates to additional contract buy-out accruals for early retirement benefits under the Supplementary Executive Retirement Plans.
Enterprise Risk Management
Risk, to varying degrees and in different forms, is present in virtually all business activities of a financial services organization. In certain activities, the bank proactively assumes risk as a means of generating revenue, while in other activities risk arises by virtue of engaging in that activity. The primary goals of risk management are to ensure that (1) the outcomes of risk-taking activities are within TSFGs risk tolerance, and (2) that there is an appropriate balance between risk and reward to maximize shareholder returns.
Several key principles guide risk and capital management on an enterprise-wide basis. TSFGs Enterprise Risk and Capital Management Group utilizes these principles to develop a measurement framework that identifies and reports risks in TSFGs diverse activities. The Group expects to integrate the framework within the companys strategy and business planning processes. The active participation of executive and business line management in the risk management process ensures consistency with risk-taking activities and integrity with the risk measurement framework. In varying forms, these principles apply to all business and risk types:
Management optimizes risks within the policies and parameters approved by the Board of Directors and in accordance with a robust and comprehensive governance structure. Enterprise Risk and Capital Management is responsible for measuring and monitoring all risks within the policies and limits set by the Board of Directors.
Our Corporate Governance Guidelines, Code of Conduct, Code of Ethics for Senior Executive and Financial Officers, Whistleblower Policy, and charters for Board Committees are accessible at no cost on TSFGs web site, www.thesouthgroup.com, through the Investor Relations link.
Market Risk and Asset/Liability Management
Market Risk Management. We refer to market risk as the risk of loss from adverse changes in market prices of fixed income securities, equity securities, other earning assets, interest-bearing liabilities, and derivative financial instruments as a result of changes in interest rates or other factors. TSFGs market risk arises principally from interest rate risk inherent in its core banking activities. Interest rate risk is the risk of decline in earnings or equity represented by the impact of potential changes in market interest rates, both short-term and long-term, and includes, but is not limited to, the following:
TSFG has risk management policies and systems which attempt to monitor and limit exposure to interest rate risk. Specifically, TSFG manages its exposure to fluctuations in interest rates through policies established by our Subsidiary Banks Joint Asset/Liability Committee (ALCO), reviewed by the Subsidiary Banks Joint Investment Committee, and approved by the Subsidiary Banks Board of Directors. The primary goal of the ALCO is to monitor and limit exposure to interest rate risk through implementation of various strategies. These strategies include positioning the balance sheet to minimize fluctuations in income associated with interest rate risk, while maintaining adequate liquidity and capital. As of December 31, 2005, the overall interest rate risk position of TSFG and its Subsidiary Banks fell within risk guidelines established by ALCO.
In evaluating interest rate risk, TSFG uses a simulation model to analyze various interest rate scenarios, which take into account changes in the shape of the yield curve, forecasts by groups of economists, projections based on movements in the futures markets, and instantaneous interest rate shocks. ALCO assesses interest rate risk by comparing our static balance sheet and flat interest rate environment results to the various interest rate scenarios. The variations of net interest income, economic value of equity (EVE), and duration in the varying interest rate scenarios as compared to our base case, provide insight into the inherent risk in our balance sheet.
In addition to evaluating interest rate risk, the model is also used to prepare forecasts for management. The forecast utilizes
managements projections regarding changes in the balance sheet, including volume, mix, spread, and other assumptions to gauge the impact of changes in interest rates and/or balance sheet items on the earnings of TSFG compared to the base forecast. Strategies can be formulated based on the information provided by the earnings simulation if either a scenario seems likely to occur or we choose to undertake the proposed transaction. ALCO updates its base forecast quarterly based on economic changes that occurred during the past quarter as well as changes in the economic outlook for the coming year. Based on the circumstances and our modeling, we may choose to extend or shorten the maturities of our funding sources. We may choose to redirect cash flows into assets with shorter or longer expected durations, or repay borrowings. Derivative instruments may be used to reduce repricing mismatches between assets and liabilities.
The assumptions used in this process are inherently uncertain and, as a result, we cannot precisely predict the impact of changes in interest rates on net interest income or the fair value of net assets. Actual results may differ significantly from our projections, due to, but not limited to the following:
Interest Sensitivity Analysis. The information presented in Tables 23 and 24 are not projections, and are presented with static balance sheet positions. This methodology allows for an analysis of our inherent risk associated with changes in interest rates. There are some similar assumptions used in both Table 23 and 24. These include, but are not limited to, the following:
Table 23 reflects the sensitivity of net interest income to changes in interest rates. It shows the effect that the indicated changes in interest rates would have on net interest income over the next twelve months compared with the base case or flat interest rate scenario. The base case or flat scenario assumes interest rates stay at December 31, 2005 and 2004 levels, respectively.
Net Interest Income at Risk Analysis
Table 24 reflects the sensitivity of the EVE to changes in interest rates. EVE is a measurement of the inherent, long-term economic value of TSFG (defined as the fair value of all assets minus the fair value of all liabilities and their associated off balance sheet amounts) at a given point in time. Table 24 shows the effect that the indicated changes in interest rates would have on the fair value of net assets at December 31, 2005 and 2004, respectively, compared with the base case or flat interest rate scenario. The base case scenario assumes interest rates stay at December 31, 2005 and 2004 levels, respectively.
Economic Value of Equity Risk Analysis
Changes from the December 31, 2004 scenario results were due primarily to the reduction in investment securities and wholesale borrowings that occurred during the year and the resulting new balance sheet mix. Another component of the change in sensitivity for December 31, 2005 was the change in the absolute level of interest rate as compared to December 31, 2004. In addition, TSFG continually refines the modeling process through the use of more precise model assumptions. Specific model assumption refinements for the year ended December 31, 2005 include the following:
There are material limitations with TSFGs models presented in Tables 23 and 24, which include, but are not limited to, the following:
Derivatives and Hedging Activities. TSFG uses derivative instruments as part of its interest rate risk management activities to reduce risks associated with its lending, investment, deposit taking, and borrowing activities. Derivatives used for interest rate risk management include various interest rate swaps, options, and futures contracts. Options and futures contracts typically have indices that relate to the pricing of specific on-balance sheet instruments and forecasted transactions and may be more speculative in nature.
By using derivative instruments, TSFG is exposed to credit and market risk. Derivative credit risk, which is the risk that a counterparty to a derivative instrument will fail to perform, is equal to the extent of the fair value gain in a derivative. Derivative credit risk is created when the fair value of a derivative contract is positive, since this generally indicates that the counterparty owes us. When the fair value of a derivative is negative, no credit risk exists since TSFG would owe the counterparty. TSFG minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties as evaluated by
management. In addition, many derivative contracts include a Credit Support Annex, which can require that securities be pledged to mitigate this credit risk. Market risk is the adverse effect on the value of a financial instrument from a change in interest rates, or implied volatility of rates. TSFG manages the market risk associated with derivative contracts by establishing and monitoring limits as to the types and degree of risk that may be undertaken. The market risk associated with derivatives used for interest rate risk management activity is fully incorporated into our market risk sensitivity analysis.
In accordance with SFAS 133, TSFG records derivatives at fair value, as either assets or liabilities, on the consolidated balance sheets, included in other assets or other liabilities. See Table 12 for the fair value of TSFGs derivative assets and liabilities and their related notional amounts. Derivative transactions are measured in terms of the notional amount, but this amount is not recorded on the balance sheets and is not, when viewed in isolation, a meaningful measure of the risk profile of the instrument. The notional amount is not exchanged, but is used only as the basis upon which interest and other payments are calculated.
TSFGs performance is impacted by U.S. and particularly Southeastern economic conditions, including the level of interest rates, price compression, competition, bankruptcy filings and unemployment rates, as well as political policies, regulatory guidelines and general developments. TSFG remains diversified in its products and customers and continues to monitor the economic situations in all areas of operations to achieve growth and limit risk.
Credit risk is the potential for financial loss resulting from the failure of a borrower or counterparty to honor its financial or contractual obligation. Credit risk arises in many of TSFGs business activities, most prominently in its lending activities, derivative activities, ownership of debt securities, and when TSFG acts as an intermediary on behalf of its customers and other third parties. TSFG has a risk management system designed to help ensure compliance with its policies and control processes. See Critical Accounting Policies and Estimates Allowance for Loan Losses and Reserve for Unfunded Lending Commitments and Credit Quality.
TSFGs business is also subject to liquidity risk, which arises in the normal course of business. TSFGs liquidity risk is that we will be unable to meet a financial commitment to a customer, creditor, or investor when due. See Liquidity.
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people or systems, or external events. It includes reputation and franchise risks associated with business practices or market conduct that TSFG may undertake. TSFG has an operational risk management system with policies and procedures designed to help limit our operational risks. These policies and control processes comply with the Gramm-Leach-Bliley Act and other regulatory guidance.
Managing merger integration risk is a key component of TSFGs operational risk. To manage the integration risk inherent in TSFG a significant resource commitment is made. For each significant acquisition, TSFG establishes a steering committee, which includes the bank president, key members of finance, and key members of technology, for oversight of the integration process. In addition, an integration team is comprised of managers from all affected departments. Finally, a project team of dedicated resources is established to manage our merger-task list, monitor risks, host regular meetings, coordinate information-sharing, and make on-site visits to the acquiree.
Compliance and Litigation Risks
TSFG is a public company in a heavily regulated industry. Failure to comply with applicable laws and regulations can result in monetary penalties and/or prohibition from conducting certain types of activities. Furthermore, TSFGs conduct of business may result in litigation associated with contractual disputes or other alleged liability to third parties.
TSFGs regulatory compliance risk is managed by our compliance group. This group works with our business lines regularly monitoring activities and evaluating policies and procedures. See Item 1, Supervision and Regulation for some of the laws and regulations which impact TSFG and its subsidiaries. TSFG has policies and control processes that are designed to help
ensure compliance with applicable laws and regulations and limit litigation.
TSFGs Audit Committee and Disclosure Committee help to ensure compliance with financial reporting matters. TSFGs Audit Committee is involved in the following: selecting the independent auditor, communicating with the independent auditor, reviewing the financial statements and the results of the financial statement audit, monitoring the performance of the independent auditor, and monitoring the work of the internal audit function. The Audit Committee has chartered a Disclosure Committee to help ensure that TSFGs internal controls and reporting systems are sufficient to satisfy compliance with disclosure requirements related to TSFGs Annual Report on Form 10-K and Quarterly Reports on Form 10-Q.
Off-Balance Sheet Arrangements
In the normal course of operations, TSFG engages in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in the financial statements, or are recorded in amounts that differ from the notional amounts. These transactions involve, to varying degrees, elements of credit, interest rate, and liquidity risk. Such transactions are used by TSFG for general corporate purposes or for customer needs. Corporate purpose transactions are used to help manage credit, interest rate, and liquidity risk or to optimize capital. Customer transactions are used to manage customers requests for funding.
Lending Commitments. Lending commitments include loan commitments, standby letters of credit, unused business credit card lines, and documentary letters of credit. These instruments are not recorded in the consolidated balance sheet until funds are advanced under the commitments. TSFG provides these lending commitments to customers in the normal course of business. TSFG estimates probable losses related to binding unfunded lending commitments and records a reserve for unfunded lending commitments in other liabilities on the consolidated balance sheet.
For commercial customers, loan commitments generally take the form of revolving credit arrangements to finance customers working capital requirements. For retail customers, loan commitments are generally lines of credit secured by residential property. At December 31, 2005, commercial and retail loan commitments totaled $2.2 billion. Documentary letters of credit are typically issued in connection with customers trade financing requirements and totaled $776,000 at December 31, 2005. Unused business credit card lines, which totaled $19.2 million at December 31, 2005, are generally for short-term borrowings.
Standby letters of credit represent an obligation of TSFG to a third party contingent upon the failure of TSFGs customer to perform under the terms of an underlying contract with the third party. The underlying contract may entail either financial or nonfinancial obligations and may involve such things as the customers delivery of merchandise, completion of a construction contract, release of a lien, or repayment of an obligation. Under the terms of a standby letter, drafts will be generally drawn only when the underlying event fails to occur as intended. TSFG has legal recourse to its customers for amounts paid, and these obligations are secured or unsecured, depending on the customers creditworthiness. Commitments under standby letters of credit are usually for one year or less. TSFG evaluates its obligation to perform as a guarantor and records reserves as deemed necessary. The maximum potential amount of undiscounted future payments related to standby letters of credit at December 31, 2005 was $192.6 million.
TSFG applies essentially the same credit policies and standards as it does in the lending process when making these commitments. See Item 8, Note 24 to the Consolidated Financial Statements for additional information regarding lending commitments.
Derivatives. In accordance with SFAS 133, TSFG records derivatives at fair value, as either assets or liabilities, on the consolidated balance sheets. Derivative transactions are measured in terms of the notional amount, but this amount is not recorded on the balance sheets and is not, when viewed in isolation, a meaningful measure of the risk profile of the instrument. The notional amount is not exchanged, but is used only as the basis upon which interest and other payments are calculated.
See Derivative Financial Instruments under Balance Sheet Review for additional information regarding derivatives.
Liquidity management ensures that adequate funds are available to meet deposit withdrawals, fund loan and capital expenditure commitments, maintain reserve requirements, pay operating expenses, provide funds for dividends and debt service, manage operations on an ongoing basis, and capitalize on new business opportunities. Funds are primarily provided by the Subsidiary Banks through customers deposits, wholesale money market borrowings, principal and interest payments on loans, loan sales, sales of
securities available for sale, maturities and paydowns of securities, and earnings. Securities classified as available for sale, which are not pledged, may be sold in response to changes in interest rates or liquidity needs. A significant portion of TSFGs securities are pledged as collateral for FHLB borrowings, repurchase agreements and public funds deposits. The projected cash flows from the securities portfolio, under different interest rate scenarios, including a rising rate scenario, are expected to provide some of the funding needs for 2006. Management believes that cash flows from investments and its loan portfolio, in addition to its available borrowing capacity and anticipated growth in deposits, are sufficient to provide the necessary funding for 2006.
In managing its liquidity needs, TSFG focuses on its existing assets and liabilities, as well as its ability to enter into additional borrowings, and on the manner in which they combine to provide adequate liquidity to meet our needs. Table 25 summarizes future contractual obligations as of December 31, 2005. Table 25 does not include payments, which may be required under employment and deferred compensation agreements (see Item 8, Note 30 of the Consolidated Financial Statements). In addition, Table 25 does not include payments required for interest and income taxes (see Item 8, Consolidated Statements of Cash Flows for details on interest and income taxes paid for 2005).
(dollars in thousands)
Net cash provided by operations and deposits from customers have been the primary sources of liquidity for TSFG. TSFG is focusing additional efforts aimed at acquiring new deposits through the Subsidiary Banks established branch network to enhance liquidity and reduce reliance on wholesale borrowing. Liquidity needs are a factor in developing the Subsidiary Banks deposit pricing structure, which may be altered to retain or grow deposits if deemed necessary.
The Subsidiary Banks currently have the ability to borrow from the FHLB and maintain short-term lines of credit from unrelated banks. FHLB advances outstanding as of December 31, 2005, totaled $852.1 million. At December 31, 2005, the Subsidiary Banks had $2.1 billion of unused borrowing capacity from the FHLB. This capacity may be used when the Subsidiary Banks have available collateral to pledge. Until the Subsidiary Banks make collateral available (other than cash) to secure additional FHLB advances, TSFG will fund its short-term needs principally with deposits, including brokered deposits, federal funds purchased, repurchase agreements, and the sale of securities available for sale. In addition, the Subsidiary Banks may purchase securities or may repay repurchase agreements to provide additional FHLB-qualifying collateral. At December 31, 2005, the Subsidiary Banks had unused short-term lines of credit totaling $1.3 billion (which may be canceled at the lenders option).
The Subsidiary Banks also use repurchase agreements as a source of funding. These borrowings are collateralized by investment securities and range in term from overnight to several years. Repurchase agreements with final maturities in excess of one year generally allow the lender to call the borrowing prior to its stated maturity.
The Federal Reserve Bank provides back-up funding for commercial banks. Collateralized borrowing relationships with the Federal Reserve Banks of Richmond and Atlanta are in place for the Subsidiary Banks to meet emergency funding needs. At December 31, 2005, the Subsidiary Banks had qualifying collateral to secure advances up to $1.1 billion, of which none was outstanding.
At December 31, 2005, the parent company had three short-term lines of credit totaling $35.0 million. These lines of credit may be canceled at the lenders option and mature May 14, 2006 for $15.0 million, June 30, 2006 for $10.0 million, and November 15, 2006 for $10.0 million. There were no amounts outstanding under these lines of credit at December 31, 2005 or during the year then ended.
TSFG, principally through the Subsidiary Banks, enters into agreements in the normal course of business to extend credit to meet the financial needs of its customers. For amounts and types of such agreements at December 31, 2005, see Off-Balance Sheet Arrangements. Increased demand for funds under these agreements would reduce TSFGs available liquidity and could require additional sources of liquidity.
Recently Adopted Accounting Pronouncements
Accounting for Certain Loans or Debt Securities Acquired in a Transfer
Effective January 1, 2005, TSFG adopted American Institute of Certified Public Accountants Statement of Position (SOP) No. 03-3 (SOP 03-3), Accounting for Certain Loans or Debt Securities Acquired in a Transfer, which prohibits carry over or creation of valuation allowances in the initial accounting of all loans acquired in a transfer that are within the scope of this SOP. The prohibition of the valuation allowance carryover applies to the purchase of loans (including loans acquired in a business combination) with evidence of deterioration of credit quality since origination, for which its probable, at acquisition, that the investor will be unable to collect all contractually required payments. The initial adoption of this issue did not have an impact on the financial condition or results of operations of TSFG. See Item 8, Note 4 to the Consolidated Financial Statements for information on the acquisition of Pointe.
Meaning of Other-Than-Temporary Impairment
Financial Accounting Standards Board (FASB) Staff Position (FSP) FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments codified the guidance set forth in Emerging Issues Task Force (EITF) Topic D-44 and clarified that an investor should recognize an impairment loss no later than when the impairment is deemed other than temporary, even if a decision to sell has not been made. FSP FAS 115-1 was effective for other-than-temporary impairment analysis conducted in periods beginning after September 15, 2005. Adoption of this standard did not have a significant impact on TSFGs shareholders equity or results of operations.
Accounting Changes and Error Corrections
In May 2005, the FASB issued SFAS No. 154 (SFAS 154), Accounting Changes and Error Corrections a replacement of Accounting Principles Board (APB) Opinion No. 20 and FASB Statement No. 3, which eliminates the requirement to reflect changes in accounting principles as cumulative adjustments to net income in the period of the change and requires retrospective application to prior periods financial statements for voluntary changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. If it is impracticable to determine the cumulative effect of the change to all prior periods, SFAS 154 requires that the new accounting principle be adopted prospectively. For new accounting pronouncements, the transition guidance in the pronouncement should be followed. Retrospective application refers to the application of a different accounting principle to previously issued financial statements as if that principle had always been used.
SFAS 154 did not change the guidance for reporting corrections of errors, changes in estimates or for justification of a change in accounting principle on the basis of preferability. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. TSFG adopted the provisions of SFAS 154 on January 1, 2006. The adoption of this Statement did not impact TSFGs financial position or results of operations.
In December 2004, the FASB issued SFAS No. 123R (SFAS 123R), Share-Based Payment, which requires companies to recognize in the income statement the grant-date fair value of stock options and other equity-based compensation issued to employees. SFAS 123R is an amendment of SFAS No. 123 (SFAS 123), Accounting for Stock-Based Compensation, and its related implementation guidance. SFAS 123R does not change the accounting guidance for share-based payment transactions with parties other than employees provided in SFAS 123. Under SFAS 123R, the way an award is classified will affect the measurement of compensation cost. Liability-classified awards are remeasured to fair value at each balance-sheet date until the award is settled. Liability-classified awards include the following:
Equity-classified awards are measured at grant-date fair value, amortized over the subsequent vesting period, and are not subsequently remeasured. Equity-classified awards include the following:
TSFG adopted this standard on January 1, 2006 using the modified prospective method for transition to the new rules whereby grants after January 1, 2006 are measured and accounted for under SFAS 123R, as are unvested awards granted prior to January 1, 2006. The adoption of this standard did not differ materially from the pro-forma disclosures in Item 8, Note 1 General to the Consolidated Financial Statements.
Accounting for Nonmonetary Transactions
In December 2004, the FASB issued SFAS No. 153 (SFAS 153), Exchanges of Nonmonetary Assets-an amendment of APB Opinion No. 29, which eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for nonmonetary transactions occurring in fiscal years beginning after June 15, 2005. TSFG adopted this standard on January 1, 2006. The adoption of this standard did not have a significant impact on TSFGs shareholders equity or results of operations.
Consolidation of Limited Partnerships
In June 2005, the FASB ratified EITF Issue No. 04-5, Determining Whether a General Partner, or the General Partners of a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights. Issue No. 04-5 is effective for all limited partnerships created or modified after June 29, 2005, and will become effective for all other limited partnerships at the beginning of the first interim period in fiscal years beginning after December 15, 2005 (effective January 1, 2006, for TSFG). The adoption of this guidance had no material effect on TSFGs financial condition or results of operations.
Concentration of Credit Risk
In December 2005, the FASB issued FSP No. SOP 94-6-1, Terms of Loan Products That May Give Rise to a Concentration of Credit Risk. FSP No. SOP 94-6-1 requires additional disclosures for certain loan products that expose entities to higher risks than traditional loan products. The FSP requires the Company to disclose additional information such as significant concentrations of credit risks resulting from these products, quantitative information about the market risks of financial instruments that is consistent with the way the Company manages or adjusts those risks, concentrations in revenue from particular products if certain conditions are met, and the factors that influenced managements judgment as it relates to the accounting policy for credit losses and doubtful accounts. This FSP is effective for the reporting period ended December 31, 2005. The required disclosures related to the Companys loan products that are within the scope of this FSP are included in Item 8, Note 10 to the Consolidated Financial Statements.
Proposed Accounting Pronouncements
The FASB has issued a proposed FASB Interpretation, Uncertain Tax Positions, to clarify the criteria for recognition of income tax benefits in accordance with SFAS No. 109, Accounting for Income Taxes. Under the proposed Interpretation, a company would recognize in its financial statements its best estimate of the benefit associated with a tax position only if it is
considered probable, as defined in SFAS No. 5, Accounting for Contingencies, of being sustained on audit based solely on the technical merits of the tax position. The effective date in the proposed Interpretation is December 31, 2005, although the FASB has since indicated the effective date will be January 1, 2007. Implementation of the final Interpretation will occur through a cumulative effect of a change in accounting principle to be recorded upon the initial adoption. Under the proposed Interpretation, only tax positions that meet the probable threshold at the effective date would continue to be recognized; however, the FASB has indicated the threshold will be changed to more likely than not in the final Interpretation. We are currently analyzing the proposed Interpretation and have not determined its potential impact on our consolidated financial position or results of operations. The proposed Interpretation was subject to a comment period, is currently being deliberated by the FASB, and is subject to change. We cannot predict with certainty what the final Interpretation will provide.
The FASB has issued three separate exposure drafts that address accounting for the transfer and holding of financial instruments. These proposals would amend SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, and one would also amend SFAS No. 133, Accounting for Derivative Instruments. The proposals would (i) revise or clarify the criteria for derecognition of financial assets after a transfer; (ii) change the recognition method at the date of transfer for certain retained positions, including servicing assets, to fair value from an allocated carrying amount; (iii) provide an option to elect recognition of servicing assets at fair value, with changes in fair value recorded in income; (iv) provide an option to elect recognition of hybrid financial instruments at fair value as one financial instrument, with changes in fair value recorded in income (currently, hybrid financial instruments are required to be separated into two instruments, a derivative and a host, and generally only the derivative instrument is recorded at fair value); and (v) require that beneficial interests in securitized assets be evaluated for derivatives, either freestanding or embedded, under SFAS 133 (currently, this is not required). These proposals have effective dates for transfers after July 1, 2006, and additional transition provisions that depend on the types of financial transfers involved. The FASB has indicated in its final deliberations that the proposals regarding servicing assets and hybrid financial instruments will be finalized and issued in the first quarter of 2006, while the proposals related to the transfers of financial assets are not expected to be finalized and issued until later in 2006. We cannot predict with certainty what the final amendments will provide. We are currently assessing the impact of these proposed amendments on our consolidated financial position and results of operations.
The FASB issued a Proposed Statement, Business Combinations, which would replace SFAS No. 141, Business Combinations, in June 2005. While the Proposed Statement retains many of the current fundamental concepts, including the purchase method of accounting, it proposes changes in several areas. Under the Proposed Statement, consideration paid in a business combination would be measured at fair value, with fair value determined on the consummation date, rather than on announcement date, as is the current practice. Additionally, fair value would include obligations for contingent consideration and would exclude transaction costs, which would be recorded as expenses when incurred. Currently, contingent consideration is not recorded until payment is probable and transaction costs are included in determination of the purchase price. Also, loans would be recorded at fair value, reflecting both interest rate and credit factors, and the acquirees allowance for loan losses would no longer be carried forward. The Proposed Statement would be effective for business combinations that consummate beginning in 2007. The Proposed Statement was subject to a 120-day comment period and will be followed by final deliberations by the FASB, and therefore, is subject to change. We cannot predict with certainty what the final Statement will provide.
Various legislative and regulatory proposals concerning the financial services industry are pending in Congress, the legislatures in states in which we conduct operations and before various regulatory agencies that supervise our operations. Given the uncertainty of the legislative and regulatory process, we cannot assess the impact of any such legislation or regulations on our consolidated financial position or results of operations.
In June 2004, the Basel Committee on Bank Supervision published new international guidelines for determining regulatory capital. The U.S. regulators have published a draft containing certain guidance on their interpretation of the new Basel guidelines. Under the proposed regulations, we will be required to determine regulatory capital under new methodologies, in parallel with the existing capital rules, beginning in 2008. In 2009, we will determine regulatory capital solely under the new rules, which include certain required minimum levels in 2009 through 2011. The new regulations will result in regulatory capital that would be more risk sensitive than under the current framework, and represent a significant implementation effort.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
See Risk Management in Item 7, and Item 8, Notes 9, 17, and 33, for quantitative and qualitative disclosures about market risk, which information is incorporated herein by reference.
Item 8. Financial Statements and Supplementary Data
MANAGEMENTS STATEMENT OF FINANCIAL RESPONSIBILITY
Management of The South Financial Group, Inc. (TSFG) and subsidiaries is committed to quality customer service, enhanced shareholder value, financial stability, and integrity in all dealings. Management has prepared the accompanying Consolidated Financial Statements in conformity with U.S. generally accepted accounting principles. The statements include amounts that are based on managements best estimates and judgments. Other financial information in this report is consistent with the Consolidated Financial Statements. Both the Chief Executive Officer and the Chief Financial Officer have certified that TSFGs 2005 Annual Report on Form 10-K fully complies with the applicable sections of the Securities Exchange Act of 1934 and that the information reported therein fairly represents, in all material respects, the financial position and results of operations of TSFG.
In meeting its responsibility, management relies on its internal control structure that is supplemented by a program of internal audits. The internal control structure is designed to provide reasonable assurance that financial records are reliable for preparing financial statements and maintaining accountability for assets, and that assets are safeguarded against unauthorized use or disposition. See Managements Report on Internal Control over Financial Reporting that follows for additional discussion.
KPMG LLP, an independent registered public accounting firm, audited TSFGs Consolidated Financial Statements and managements assessment of the effectiveness of TSFGs internal control over financial reporting in accordance with standards of the Public Company Accounting Oversight Board (United States). KPMG LLP reviews the results of its audit with both management and the Audit Committee of the Board of Directors of TSFG. The Consolidated Financial Statements have not been reviewed, or confirmed for accuracy or relevance, by the Federal Deposit Insurance Corporation.
The Audit Committee, composed entirely of independent directors, meets periodically with management, TSFGs internal auditors and KPMG LLP (separately and jointly) to discuss audit, financial reporting and related matters. KPMG LLP and the internal auditors have direct access to the Audit Committee.
MANAGEMENTS REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of The South Financial Group, Inc. and subsidiaries (TSFG) is responsible for establishing and maintaining adequate internal control over financial reporting. TSFGs internal control system was designed to provide reasonable assurance to TSFGs management and board of directors regarding the preparation and fair presentation of published financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
TSFGs management assessed the effectiveness of TSFGs internal control over financial reporting as of December 31, 2005. In making this assessment, management used the criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management identified the following material weakness in internal control over financial reporting as of December 31, 2005:
TSFG had ineffective policies and procedures related to the accounting for certain derivative financial instruments in accordance with Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). Specifically, TSFG did not have personnel possessing sufficient technical expertise related to the application of the provisions of SFAS 133 or with sufficient understanding of derivative instruments. This deficiency resulted in errors in the Companys accounting for derivatives. This deficiency results in more than a remote likelihood that a material misstatement of the Companys annual or interim financial statements would not be prevented or detected.
As a result of this material weakness, our management has concluded that our internal control over financial reporting was not effective as of December 31, 2005.
TSFGs independent auditor, KPMG LLP, an independent registered public accounting firm, has issued an attestation report on our assessment of our internal control over financial reporting as of December 31, 2005. This attestation report Report of Independent Registered Public Accounting Firm appears on pages 61 and 62.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
The South Financial Group, Inc.:
We have audited managements assessment, included in the accompanying Managements Report on Internal Control over Financial Reporting, that The South Financial Group, Inc. (TSFG, the Company) did not maintain effective internal control over financial reporting as of December 31, 2005, because of the effect of the material weakness identified in managements assessment, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). TSFGs management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the Companys internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in managements assessment: As of December 31, 2005, TSFG had ineffective policies and procedures to account for certain derivative financial instruments under Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133). Specifically, TSFG did not have personnel possessing sufficient technical expertise related to the application of the provisions of SFAS 133 or with sufficient understanding of derivative instruments. This deficiency resulted in errors in the Companys accounting for derivatives. This deficiency results in more than a remote likelihood that a material misstatement of the Companys annual or interim financial statements would not be prevented or detected.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of The South Financial Group, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in shareholders equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2005. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2005 Consolidated Financial Statements, and this report does not affect our report dated March 10, 2006, which expressed an unqualified opinion on those Consolidated Financial Statements.
In our opinion, managements assessment that TSFG did not maintain effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, TSFG has not maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Greenville, South Carolina
March 10, 2006
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
The South Financial Group, Inc.:
We have audited the accompanying consolidated balance sheets of The South Financial Group, Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in shareholders equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2005. These Consolidated Financial Statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these Consolidated Financial Statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the Consolidated Financial Statements referred to above present fairly, in all material respects, the financial position of The South Financial Group. Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Companys internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 10, 2006, expressed an unqualified opinion on managements assessment of, and an adverse opinion on the effective operation of, internal control over financial reporting.
Greenville, South Carolina
March 10, 2006
THE SOUTH FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
See Notes to Consolidated Financial Statements, which are an integral part of these statements.
THE SOUTH FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data)
See Notes to Consolidated Financial Statements, which are an integral part of these statements.
THE SOUTH FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES
IN SHAREHOLDERS EQUITY AND COMPREHENSIVE INCOME
(dollars in thousands, except per share data)