Net revenues from mortgage banking were $4.6 million during the first six months of 2007, compared with $6.4 million in the first six months of 2006. As shown in the accompanying table, net mortgage servicing income has increased $382 thousand, or 5.8% when the first six months of 2007 is compared with the same time period in 2006. This increase coincides with growth in the balance of the mortgage servicing portfolio. Loans serviced for others totaled $4.2 billion at June 30, 2007 compared with $3.9 billion at June 30, 2006.
Trustmark utilizes derivative instruments to offset changes in the fair value of mortgage servicing rights (MSR) attributable to changes in interest rates. Changes in the fair value of these derivative instruments are recorded in mortgage banking income and are offset by the changes in the fair value of MSR, as shown in the accompanying table. MSR fair values represent the effect of present value decay and the effect of changes in interest rates. Ineffectiveness of hedging MSR fair value is measured by comparing total hedge cost to the fair value of the MSR asset attributable to interest rate changes. During the first six months of 2007, the impact of implementing this strategy resulted in a net negative ineffectiveness of $0.8 million compared with $0.6 million in net positive ineffectiveness during the first six months of 2006. The decrease in hedging ineffectiveness is primarily due to the increase in volatility in long-term interest rates during the second quarter of 2007. In addition, for the first half of 2006, the fair value change in MSR attributable to the change in interest rates included approximately $1.0 million in fair value adjustments that occurred prior to the utilization of Trustmark’s strategy to use derivative instruments to offset changes in the fair value of MSR attributable to changes in interest rates. Changes in the fair value of MSR from present value decay, also referred to as “runoff,” reduced total mortgage banking income by $4.6 million and $4.5 million for the first half of 2007 and 2006, respectively.
Securities gains totaled $87 thousand during the first six months of 2007 compared with securities gains of $1.3 million during the same time period in 2006. The securities gains for 2006 came primarily from a voluntary redemption of an investment in one of the family of Performance mutual funds that was originally funded by Trustmark.
Management considers expense management a key area of focus in the support of improving shareholder value. As such, Management has continued to proactively manage expenses as illustrated by the creation of a process designed to identify reengineering and efficiency opportunities, which would reinforce Trustmark’s culture of efficiency and productivity without interrupting customer service. This process will involve the evaluation of technology initiatives, analysis of vendors and review of staffing levels.
Noninterest Expense | | | | | | | | | | | | | | | | | | |
($ in thousands) | | | | | | | | | | | | | | | | | | |
| | | Three Months Ended June 30, | | Six Months Ended June 30, | | |
| | | 2007 | | 2006 | | $ Change | | % Change | | | 2007 | | 2006 | | $ Change | | % Change | |
| Salaries and employee benefits | | $ | 42,853 | | $ | 39,567 | | $ | 3,286 | | | 8.3 | % | | $ | 86,019 | | $ | 78,944 | | $ | 7,075 | | | 9.0 | % |
| Services and fees | | | 9,041 | | | 8,979 | | | 62 | | | 0.7 | % | | | 18,599 | | | 17,743 | | | 856 | | | 4.8 | % |
| Net occupancy - premises | | | 4,634 | | | 4,070 | | | 564 | | | 13.9 | % | | | 9,048 | | | 7,954 | | | 1,094 | | | 13.8 | % |
| Equipment expense | | | 4,048 | | | 3,589 | | | 459 | | | 12.8 | % | | | 7,952 | | | 7,232 | | | 720 | | | 10.0 | % |
| Other expense | | | 8,257 | | | 7,547 | | | 710 | | | 9.4 | % | | | 16,621 | | | 15,391 | | | 1,230 | | | 8.0 | % |
| Total Noninterest Expense | | $ | 68,833 | | $ | 63,752 | | $ | 5,081 | | | 8.0 | % | | $ | 138,239 | | $ | 127,264 | | $ | 10,975 | | | 8.6 | % |
Trustmark’s noninterest expense for the first six months of 2007 increased $11.0 million, or 8.6%, compared to the same time period in 2006. Excluding the impact of the business combination with Republic, the adjusted 2007 increase in noninterest expense was $2.9 million, or 2.3%. The comparative components of noninterest expense for the first six months of 2007 and 2006 are shown in the accompanying table.
Salaries and employee benefits, the largest category of noninterest expense, were $86.0 million in the first six months of 2007 and $78.9 million in the same time period in 2006. Included in the 2007 totals are approximately $6.0 million of salaries and benefits related to the Republic business combination. Adjusting for Republic, the increase was 1.4%, which reflects general merit increases as well as additional benefits resulting from first quarter incentive payments.
The growth in net occupancy-premises expense for the first six months of 2007 was $1.1 million, or 13.8%, when compared with the same time period in 2006. The Republic business combination and the impact of the banking center expansion program resulted in a net increase of seven Trustmark locations when June 30, 2007 is compared with June 30, 2006 which has contributed to additional occupancy expense during that time period.
As part of the reengineering process mentioned above, Trustmark completed the implementation of remote branch capture during the second quarter of 2007 for its Florida, Texas and Memphis locations. As a result, transportation costs have been significantly reduced as air transportation has been eliminated from the check clearing process. Additional technology upgrades are expected to take place throughout the remainder of 2007 that will further reduce courier expenses related to ground transportation routes within the state of Mississippi. Also during the second quarter of 2007, Trustmark completed technology upgrades which have allowed for the exchange of fully imaged cash letters with the Federal Reserve and other upstream correspondent banks thus reducing overall check clearing costs while improving funds availability. During the first quarter of 2007, Trustmark completed the installation of middleware which will be utilized in Trustmark’s legacy systems to allow software adjustments to be made more quickly thus improving efficiency. As a result of these implementations, additional costs related to these processes have accounted for a portion of the increases in services and fees, equipment expenses and other expenses seen above.
Income Taxes
For the six months ended June 30, 2007, Trustmark’s combined effective tax rate was 34.0% compared to 34.4% for the same time period in 2006. The slight decrease in Trustmark’s effective tax rate is due to immaterial changes in permanent items as a percentage of pretax income.
LIQUIDITY
Liquidity is the ability to meet asset funding requirements and operational cash outflows in a timely manner, in sufficient amount and without excess cost. Consistent cash flows from operations and adequate capital provide internally generated liquidity. Furthermore, Management maintains funding capacity from a variety of external sources to meet daily funding needs, such as those required to meet deposit withdrawals, loan disbursements and security settlements. Liquidity strategy also includes the use of wholesale funding sources to provide for the seasonal fluctuations of deposit and loan demand and the cyclical fluctuations of the economy that impact the availability of funds. Management keeps excess funding capacity available to meet potential demands associated with adverse circumstances.
The primary sources of liquidity on the asset side of the balance sheet are maturities and cash flows from loans and securities, as well as the ability to sell certain loans and securities. Liquidity on the liability side of the balance sheet is generated primarily through growth in core deposits. To provide additional liquidity, Trustmark utilizes economical short-term wholesale funding arrangements for federal funds purchased and securities sold under repurchase agreements in both regional and national markets. At June 30, 2007, Trustmark estimated gross fed funds borrowing capacity at $1.599 billion, compared to $1.505 billion at December 31, 2006. In addition, Trustmark maintains a borrowing relationship with the FHLB, which provided $50.0 million in short-term advances at June 30, 2007, compared with $202.5 million in short-term advances at December 31, 2006. These advances are collateralized by a blanket lien on Trustmark’s single-family, multi-family, home equity and commercial mortgage loans. Under the existing borrowing agreement, Trustmark has $1.442 billion available in unused FHLB advances. Another borrowing source is the Federal Reserve Discount Window (Discount Window). At June 30, 2007, Trustmark had approximately $641.9 million available in collateral capacity at the Discount Window from pledges of auto loans and securities, compared with $586.4 million available at December 31, 2006. In September 2006, Trustmark renewed a two-year revolving line of credit facility in the amount of $50.0 million and subject to certain financial covenants. At June 30, 2007, Trustmark was in compliance with all financial covenants and had $17.0 million in draws on this line of credit.
During the fourth quarter of 2006, TNB issued $50.0 million aggregate principal amount of Subordinated Notes (the Notes) due December 15, 2016. At June 30, 2007, the carrying amount of the Notes was $49.7 million. The Notes were sold pursuant to the terms of regulations issued by the Office of the Comptroller of the Currency (OCC) and in reliance upon an exemption provided by the Securities Act of 1933, as amended. The Notes are unsecured and subordinate and junior in right of payment to TNB’s obligations to its depositors, its obligations under bankers’ acceptances and letters of credit, its obligations to any Federal Reserve Bank or the FDIC and its obligations to its other creditors, and to any rights acquired by the FDIC as a result of loans made by the FDIC to TNB. The Notes, which are not redeemable prior to maturity, qualify as Tier 2 capital for both TNB and Trustmark. Proceeds from the sale of the Notes were used for general corporate purposes.
During the third quarter of 2006, Trustmark completed a private placement of $60.0 million of trust preferred securities through a newly formed Delaware trust affiliate, Trustmark Preferred Capital Trust I, (the Trust). The trust preferred securities mature September 30, 2036 and are redeemable at Trustmark’s option beginning after five years. Under applicable regulatory guidelines, these trust preferred securities qualify as Tier 1 capital. The proceeds from the sale of the trust preferred securities were used by the Trust to purchase $61.856 million in aggregate principal amount of Trustmark’s junior subordinated debentures. The net proceeds to Trustmark from the sale of the junior subordinated debentures to the Trust were used to assist in financing Trustmark’s merger with Republic.
Also during the third quarter of 2006, Trustmark National Bank was granted a Class B banking license from the Cayman Islands Monetary Authority. Subsequently, Trustmark established a branch in the Cayman Islands through an agent bank. The branch was established as a mechanism to attract dollar denominated foreign deposits (i.e. Eurodollars) as an additional source of funding. At June 30, 2007, Trustmark had no Eurodollar deposits outstanding.
Trustmark continues to use its “shelf” registration statement filed on Form S-3 with the Securities and Exchange Commission (SEC) as another possible source of liquidity. Under this shelf process, Trustmark may offer from time to time any combination of securities described in the prospectus in one or more offerings up to a total amount of $200.0 million. The securities described in the prospectus include common and preferred stock, depositary shares, debt securities, junior subordinated debt securities and trust preferred securities. Net proceeds from the sales of the offered securities may be used to redeem or repurchase outstanding securities, repay outstanding debt, finance acquisitions of companies and other assets and provide working capital.
The Board of Directors currently has the authority to issue up to 20 million preferred shares with no par value. The ability to issue preferred shares in the future will provide Trustmark with additional financial and management flexibility for general corporate and acquisition purposes. At June 30, 2007, no such shares have been issued.
Liquidity position and strategy are reviewed regularly by the Asset/Liability Committee and continuously adjusted in relationship to Trustmark’s overall strategy. Management believes that Trustmark has sufficient liquidity and capital resources to meet presently known cash flow requirements arising from ongoing business transactions.
CAPITAL RESOURCES
At June 30, 2007, Trustmark’s shareholders’ equity was $886.2 million, a decrease of $5.2 million, or 0.6%, from its level at December 31, 2006. During the first six months of 2007, shareholders’ equity was reduced by shares repurchased at a cost of $38.9 million and dividends paid of $25.6 million which more than offset the increase to shareholders’ equity provided by net income of $55.7 million. Trustmark utilizes a sophisticated capital model in order to provide Management with a monthly tool for analyzing changes in its strategic capital ratios. This allows Management to hold sufficient capital to provide for growth opportunities, protect the balance sheet against sudden adverse market conditions while maintaining an attractive return on equity to shareholders.
Common Stock Repurchase Program
At June 30, 2007, Trustmark had remaining authorization for the repurchase of up to 1.4 million shares of its common stock. Collectively, the capital management plans adopted by Trustmark since 1998 have authorized the repurchase of 24.3 million shares of common stock. Pursuant to these plans, Trustmark has repurchased approximately 22.7 million shares for $518.1 million, including 1.4 million shares during the first six months of 2007.
Dividends
Dividends for the six months ended June 30, 2007 were $0.44 per share, increasing 4.8% when compared with dividends of $0.42 per share for the same time period in 2006. Trustmark’s indicated dividend for 2007 is currently $0.88 per share, up from $0.84 per share for 2006.
Regulatory Capital
Trustmark and TNB are subject to minimum capital requirements, which are administered by various federal regulatory agencies. These capital requirements, as defined by federal guidelines, involve quantitative and qualitative measures of assets, liabilities and certain off-balance sheet instruments. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the financial statements of both Trustmark and TNB. Trustmark aims not only to exceed the minimum capital standards but also the well-capitalized guidelines for regulatory capital. Management believes, as of June 30, 2007, that Trustmark and TNB have met or exceeded all of the minimum capital standards for the parent company and its primary banking subsidiary as established by regulatory requirements. At June 30, 2007, the most recent notification from the OCC, TNB’s primary federal banking regulator, categorized TNB as well-capitalized. To be categorized in this manner, TNB must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios (defined in applicable regulations) as set forth in the accompanying table. There are no significant conditions or events that have occurred since the OCC’s notification that Management believes have affected TNB’s present classification.
In addition, during 2006, Trustmark enhanced its capital structure with the issuance of trust preferred securities and Subordinated Notes. For regulatory capital purposes, the trust preferred securities qualify as Tier 1 capital while the Subordinated Notes qualify as Tier 2 capital. The addition of these capital instruments provided Trustmark a cost effective manner in which to manage shareholders’ equity and enhance financial flexibility.
Regulatory Capital Table | | | |
($ in thousands) | | | |
| | | June 30, 2007 | |
| | | Actual Regulatory Capital | | | Minimum Regulatory Capital Required | | | Minimum Regulatory Provision to be Well-Capitalized | |
| | | Amount | | | Ratio | | | Amount | | | Ratio | | | Amount | | | Ratio | |
| Total Capital (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | |
| Trustmark Corporation | | $ | 764,606 | | | | 10.91 | % | | $ | 560,435 | | | | 8.00 | % | | | n/a | | | | n/a | |
| Trustmark National Bank | | | 749,028 | | | | 10.86 | % | | | 553,395 | | | | 8.00 | % | | $ | 691,744 | | | | 10.00 | % |
| Tier 1 Capital (to Risk Weighted Assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Trustmark Corporation | | $ | 643,965 | | | | 9.19 | % | | $ | 280,218 | | | | 4.00 | % | | | n/a | | | | n/a | |
| Trustmark National Bank | | | 634,392 | | | | 9.19 | % | | | 276,698 | | | | 4.00 | % | | $ | 415,046 | | | | 6.00 | % |
| Tier 1 Capital (to Average Assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| Trustmark Corporation | | $ | 643,965 | | | | 7.60 | % | | $ | 254,297 | | | | 3.00 | % | | | n/a | | | | n/a | |
| Trustmark National Bank | | | 634,392 | | | | 7.62 | % | | | 250,207 | | | | 3.00 | % | | $ | 417,011 | | | | 5.00 | % |
EARNING ASSETS
Earning assets serve as the primary revenue streams for Trustmark and are comprised of securities, loans, federal funds sold and securities purchased under resale agreements. At June 30, 2007, earning assets were $7.813 billion, or 88.5% of total assets, compared with $7.736 billion, or 87.5% of total assets at December 31, 2006, an increase of $76.3 million, or 1.0%.
Securities
Over the past few years, Management has continually deemphasized the use of investment securities as a major contributor to net interest income. Instead, Trustmark has maintained investment balances for the use of collateral for public deposit relationships and as a tool to manage the effect of interest rate changes on the net interest margin. As Management continues its strategy of exiting certain assets and reducing balances of funding sources, it will also constantly reevaluate its collateral needs and interest rate risk profile before reinvestment of securities occur. Net proceeds from sales and maturities of securities have been used to reduce balances of higher-cost funding sources and as a funding source for loan growth. During the first six months of 2007, Trustmark continued to deemphasize the holding of investment securities as seen by the decrease in overall balance of $160.2 million, or 15.3%, when compared to December 31, 2006. Trustmark intends to maintain historically lower balances in investment securities and reduce dependency on wholesale funding until market conditions provide more attractive opportunities.
Management uses the securities portfolio as a tool to control exposure to interest rate risk. Interest rate risk can be adjusted by altering both the duration of the portfolio and the balance of the portfolio. Trustmark has maintained a strategy of offsetting potential exposure to higher interest rates by keeping both the duration and the balances of investment securities at relatively low levels. The estimated duration of the portfolio was 2.09 years at June 30, 2007, as compared to 1.97 years at December 31, 2006.
AFS securities are carried at their estimated fair value with unrealized gains or losses recognized, net of taxes, in accumulated other comprehensive loss, a separate component of shareholders’ equity. At June 30, 2007, AFS securities totaled $608.9 million, which represented 68.4% of the securities portfolio, compared to $758.3 million, or 72.2%, at December 31, 2006. At June 30, 2007, net unrealized losses on AFS securities of $9.5 million, net of $3.6 million of deferred income taxes, were included in accumulated other comprehensive loss, compared with net unrealized losses of $11.4 million, net of $4.4 million in deferred income taxes, at December 31, 2006. At June 30, 2007, AFS securities consisted of U.S. Treasury securities, obligations of states and political subdivisions, mortgage related securities, corporate securities and other securities.
Held to maturity (HTM) securities are carried at amortized cost and represent those securities that Trustmark both intends and has the ability to hold to maturity. At June 30, 2007, HTM securities totaled $281.4 million and represented 31.6% of the total portfolio, compared with $292.2 million, or 27.8%, at the end of 2006.
Management continues to focus on asset quality as one of the strategic goals of the securities portfolio, which is evidenced by the investment of approximately 82% of the portfolio in U.S. Treasury, U.S. Government agencies obligations and other AAA rated securities.
Loans and Allowance for Loan Losses
Loans and loans held for sale represented 88.3% of earning assets at June 30, 2007, as compared to 86.1% at December 31, 2006. Average loans (including loans held for sale) were $6.724 billion for the first six months of 2007, an increase of $641.2 million, or 10.5%, when compared with the same time period in 2006. Growth in the loan portfolio resulted from increases in loans from Trustmark’s Florida panhandle, Houston, Texas and South Mississippi markets, as well as, by growth from the Corporate and Dealer Services (indirect automobile financing) groups.
Trustmark makes loans in the normal course of business to certain directors, their immediate families and companies in which they are principal owners. Such loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than the normal risk of collectibility at the time of the transaction.
The allowance for loan losses is established through provisions for estimated loan losses charged against earnings. The allowance reflects Management’s best estimate of the probable loan losses related to specifically identified loans, as well as, probable incurred loan losses in the remaining loan portfolio and requires considerable judgement. The allowance is based upon Management’s current judgments and the credit quality of the loan portfolio, including all internal and external factors that impact loan collectibility. SFAS No. 5, “Accounting for Contingencies,” and SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” limit the amount of the loss allowance to the estimate of losses that have been incurred at the balance sheet reporting date. Accordingly, the allowance is based upon past events and current economic conditions.
Trustmark’s allowance has been developed using different factors to estimate losses based upon specific evaluation of identified individual loans considered impaired, estimated identified losses on various pools of loans and/or groups of risk rated loans with common risk characteristics and other external and internal factors of estimated probable losses based on other facts and circumstances.
The level of Trustmark’s allowance reflects Management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. This evaluation takes into account other qualitative factors including recent acquisitions, national, regional and local economic trends and conditions, changes in credit concentration, changes in levels and trends of delinquencies and nonperforming loans, changes in levels and trends of net charge-offs, changes in interest rates and collateral, financial and underwriting exceptions.
The allowance for loan losses consists of three elements: (i) specific valuation allowances determined in accordance with SFAS No. 114 based on probable losses on specific loans; (ii) historical valuation allowances determined in accordance with SFAS No. 5 based on historical loan loss experience for similar loans with similar characteristics and trends; and (iii) qualitative risk valuation allowances determined in accordance with SFAS No. 5 based on general economic conditions and other qualitative risk factors, both internal and external, to Trustmark.
Following Katrina, Trustmark identified customers specifically impacted by the storm in an effort to estimate the loss of collateral value and customer payment abilities. In accordance with SFAS No. 5, Trustmark determined, through reasonable estimates, that specific losses were probable and initially increased its allowance for loan losses by $9.8 million, on a pretax basis, during the third quarter of 2005. Trustmark continually reevaluates its estimates for probable losses resulting from Katrina. As a result, during the six months of 2007, Trustmark has reduced its allowance for loan losses by $0.8 million on a pretax basis. At June 30, 2007, the allowance for loan losses included specific Katrina accruals totaling $1.3 million, comprised of $0.9 million for mortgage loans and $0.4 million for consumer loans. Management’s estimates, assumptions and judgments are based on information available as of the date of the consolidated financial statements; accordingly, as the information changes, actual results could differ from those estimates.
At June 30, 2007, the allowance for loan losses was $70.9 million compared with $72.1 million at December 31, 2006, a decrease of $1.2 million. This reduction in Trustmark’s allowance for loan losses is directly attributable to the decrease in nonperforming assets achieved during the first half of 2007 as seen in the accompanying table. The allowance represented 1.05% of total loans outstanding at June 30, 2007, compared to 1.10% at December 31, 2006. As of June 30, 2007, Management believes that the allowance for loan losses adequately provides for probable losses in the loan portfolio.
Net charge-offs for the first six months of 2007 totaled $2.9 million, or 0.09% of average loans, compared to net recoveries of $103 thousand, or 0.00%, in the same time period in 2006. Trustmark’s loan policy dictates the guidelines to be followed in determining when a loan is charged-off. Commercial purpose loans are charged-off when a determination is made that the loan is uncollectible and continuance as a bankable asset is not warranted. Consumer loans secured by residential real estate are generally charged-off when the credit becomes severely delinquent, and the balance exceeds the fair value of the property less costs to sell. Other consumer purpose loans, including both secured and unsecured, are generally charged-off in full no later than when the loan becomes 120 days past due. Credit card loans are generally charged-off in full when the loan becomes 180 days past due.
Trustmark's lending policies have resulted in consistently sound asset quality. One measure of asset quality in the financial services industry is the level of nonperforming assets. The details of Trustmark’s nonperforming assets at June 30, 2007 and December 31, 2006 are shown in the accompanying table.
Nonperforming Assets | | | | | | |
($ in thousands) | | | | | | |
| | | June 30, | | | December 31, | |
| | | 2007 | | | 2006 | |
| Nonaccrual and restructured loans | | $ | 27,770 | | | $ | 36,399 | |
| Other real estate (ORE) | | | 3,408 | | | | 2,509 | |
| Total nonperforming assets | | $ | 31,178 | | | $ | 38,908 | |
| | | | | | | | | |
| Nonperforming assets/total loans and ORE | | | 0.46 | % | | | 0.59 | % |
| | | | | | | | | |
| Accruing loans past due 90 days or more | | $ | 6,433 | | | $ | 2,957 | |
| Serviced GNMA loans eligible for repurchase | | | 11,273 | | | | 8,510 | |
| Total loans past due 90 days or more | | $ | 17,706 | | | $ | 11,467 | |
In recent months, there has been heightened focus on sub-prime lending in the financial services industry. While many within the industry have been severely impacted by deteriorating credit quality associated with sub-prime lending, Trustmark has virtually no sub-prime credit exposure. Trustmark’s credit quality indicators remained strong during the first six months of 2007. Total nonperforming assets at June 30, 2007 were significantly lower when compared with December 31, 2006. The allowance coverage of nonperforming loans was 255.5% at June 30, 2007. Loans held for sale past due 90 days or more include $11.3 million in loans serviced by Trustmark and fully guaranteed by the Government National Mortgage Association that are eligible for repurchase.
Other Earning Assets
Federal funds sold and securities purchased under reverse repurchase agreements were $20.1 million at June 30, 2007, a decrease of $7.2 million when compared with December 31, 2006. Trustmark utilizes these products as a short-term investment alternative whenever it has excess liquidity.
DEPOSITS AND OTHER INTEREST-BEARING LIABILITIES
Trustmark’s deposit base is its primary source of funding and consists of core deposits from the communities served by Trustmark. Total deposits were $7.069 billion at June 30, 2007, compared with $6.976 billion at December 31, 2006, an increase of $93.0 million, or 1.3%. This growth was broad-based with increases noted across Trustmark’s franchise. Management has continued to focus on increasing core deposit relationships under attractive terms as a tool to fuel growth throughout Trustmark’s four-state banking franchise. At June 30, 2007, brokered CDs totaled $49.8 million, a decrease of $84.4 million when compared to December 31, 2006. Due to the growth of core deposits, Trustmark has reduced its dependence on brokered CDs as a funding source.
Trustmark’s commitment to increasing its presence in higher-growth markets is illustrated by its strategic initiative to build additional banking centers within its four-state banking franchise. This commitment will also benefit Trustmark’s continued focus on increasing core deposit relationships. During the first six months of 2007, Trustmark opened three new banking centers in Houston and Memphis, and anticipates opening four additional offices serving the Jackson, Hattiesburg, Houston and Florida panhandle markets during the remainder of 2007. Trustmark also closed three offices during the second quarter of 2007 that had limited growth opportunities.
Trustmark uses short-term borrowings to fund growth of earning assets in excess of deposit growth. Short-term borrowings consist of federal funds purchased, securities sold under repurchase agreements, short-term FHLB advances and the treasury tax and loan note option account. Short-term borrowings totaled $642.0 million at June 30, 2007, a decrease of $99.5 million, compared with $741.5 million at December 31, 2006. Trustmark had $70.1 million in junior subordinated debentures and $49.7 million in subordinated notes outstanding at June 30, 2007. For further information on the issuance of the debentures and notes, see Note 9 in the Notes to Consolidated Financial Statements. On a consolidated basis, total borrowings have decreased $99.5 million when compared to December 31, 2006, as Trustmark utilized liquidity from the sale and maturity of securities and growth in core deposits to reduce Trustmark’s dependency on wholesale funding products.
LEGAL ENVIRONMENT
Trustmark and its subsidiaries are parties to lawsuits and other claims that arise in the ordinary course of business. Some of the lawsuits assert claims related to lending, collection, servicing, investment, trust and other business activities, and some of the lawsuits allege substantial claims for damages. The cases are being vigorously contested. In the regular course of business, Management evaluates estimated losses or costs related to litigation, and provision is made for anticipated losses whenever Management believes that such losses are probable and can be reasonably estimated. In recent years, the legal environment in Mississippi has been considered by many to be adverse to business interests, with regards to the overall treatment of tort and contract litigation as well as the award of punitive damages. However, tort reform legislation that became effective during recent years may reduce the likelihood of unexpected, sizable awards. At the present time, Management believes, based on the advice of legal counsel and Management’s evaluation, that the final resolution of pending legal proceedings will not have a material impact on Trustmark’s consolidated financial position or results of operations; however, Management is unable to estimate a range of potential loss on these matters because of the nature of the legal environment in states where Trustmark conducts business.
OFF-BALANCE SHEET ARRANGEMENTS
Trustmark makes commitments to extend credit and issues standby and commercial letters of credit in the normal course of business in order to fulfill the financing needs of its customers. These loan commitments and letters of credit are off-balance sheet arrangements.
Commitments to extend credit are agreements to lend money to customers pursuant to certain specified conditions. Commitments generally have fixed expiration dates or other termination clauses. Since many of these commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Trustmark applies the same credit policies and standards as it does in the lending process when making these commitments. The collateral obtained is based upon the assessed creditworthiness of the borrower. At June 30, 2007 and 2006, Trustmark had commitments to extend credit of $2.0 billion and $1.7 billion, respectively.
Standby and commercial letters of credit are conditional commitments issued by Trustmark to ensure the performance of a customer to a first party. When issuing letters of credit, Trustmark uses essentially the same policies regarding credit risk and collateral which are followed in the lending process. At June 30, 2007 and 2006, Trustmark’s maximum exposure to credit loss in the event of nonperformance by the other party for letters of credit was $168.3 million and $114.1 million, respectively. These amounts consist primarily of commitments with maturities of less than three years. Trustmark holds collateral to support certain letters of credit when deemed necessary.
ASSET/LIABILITY MANAGEMENT
Overview
Market risk is the risk of loss arising from adverse changes in market prices and rates. Trustmark has risk management policies to monitor and limit exposure to market risk. Trustmark’s market risk is comprised primarily of interest rate risk created by core banking activities. Interest rate risk is the risk to net interest income represented by the impact of higher or lower interest rates. Management continually develops and applies cost-effective strategies to manage these risks. The Asset/Liability Committee sets the day-to-day operating guidelines, approves strategies affecting net interest income and coordinates activities within policy limits established by the Board of Directors. A key objective of the asset/liability management program is to quantify, monitor and manage interest rate risk and to assist Management in maintaining stability in the net interest margin under varying interest rate environments.
Market/Interest Rate Risk Management
The primary purpose in managing interest rate risk is to invest capital effectively and preserve the value created by the core banking business. This is accomplished through the development and implementation of lending, funding, pricing and hedging strategies designed to maximize net interest income performance under varying interest rate environments subject to specific liquidity and interest rate risk guidelines.
The primary tool utilized by the Asset/Liability Committee is a third-party modeling system, which is widely accepted in the financial institutions industry. This system provides information used to evaluate exposure to interest rate risk, project earnings and manage balance sheet growth. This modeling system utilizes the following scenarios in order to give Management a method of evaluating Trustmark’s interest rate, basis and prepayment risk under different conditions:
| v | Rate shocked scenarios of up-and-down 100, 200 and 300 basis points. |
| v | Yield curve twist of +/- two standard deviations of the change in spread of the three-month Treasury bill and the ten-year Treasury note yields. |
| v | Basis risk scenarios where federal funds/LIBOR spread widens and tightens to the high and low spread determined by using two standard deviations. |
| v | Prepayment risk scenarios where projected prepayment speeds in up-and-down 200 basis point rate scenarios are compared to current projected prepayment speeds. |
Based on the results of the simulation models using static balances at June 30, 2007, it is estimated that net interest income may increase 2.2% in a one-year, shocked, up 200 basis point rate shift scenario, compared to a base case, flat rate scenario for the same time period. This minor change in forecasted net interest income illustrates Management’s strategy to mitigate Trustmark’s exposure to cyclical increases in rates by maintaining a neutral position in its interest rate risk position. This projection does not contemplate any additional actions Trustmark could undertake in response to changes in interest rates. In the event of a 100 basis point decrease in interest rates, it is estimated net interest income may decrease by 1.5%, while a 200 basis point decline in interest rates would yield an estimated decrease in net interest income of 4.3%. Management cannot provide any assurance about the actual effect of changes in interest rates on net interest income. The estimates provided do not include the effects of possible strategic changes in the balances of various assets and liabilities throughout 2007. Management will continue to prudently manage the balance sheet in an effort to control interest rate risk and maintain profitability over the long term.
Another component of interest rate risk management is measuring the economic value-at-risk for a given change in market interest rates. The economic value-at-risk may indicate risks associated with longer term balance sheet items that may not affect net interest income at risk over shorter time periods. Trustmark also uses computer-modeling techniques to determine the present value of all asset and liability cash flows (both on- and off-balance sheet), adjusted for prepayment expectations, using a market discount rate. The net change in the present value of the asset and liability cash flows in the different market rate environments is the amount of economic value at risk from those rate movements. As of June 30, 2007, the economic value of equity at risk for an instantaneous 100 basis point shift in rates was no more than 1.6% of the market value of Trustmark’s equity.
As part of Trustmark’s risk management strategy in the mortgage banking area, various derivative instruments such as interest rate lock commitments and forward sales contracts are utilized. Rate lock commitments are residential mortgage loan commitments with customers, which guarantee a specified interest rate for a specified period of time. Forward contracts are agreements to purchase or sell securities or other money market instruments at a future specified date at a specified price or yield. Trustmark’s obligations under forward contracts consist of commitments to deliver mortgage loans, originated and/or purchased, in the secondary market at a future date. These derivative instruments are designated as fair value hedges. Trustmark’s off balance sheet obligations under these derivative instruments totaled $226.3 million at June 30, 2007 and have a negative valuation adjustment of $1.1 million.
During the first quarter of 2006, a strategy was implemented that utilizes a portfolio of derivative instruments, such as Treasury note futures contracts and exchange-traded option contracts, to achieve a fair value return that would substantially offset the changes in fair value of MSR attributable to interest rates. These transactions are considered freestanding derivatives that do not otherwise qualify for hedge accounting. Changes in the fair value of these derivative instruments are recorded in noninterest income in mortgage banking, net and are offset by the changes in the fair value of MSR. During the first six months of 2007, the impact of implementing this strategy resulted in a net negative ineffectiveness of $0.8 million.
RECENT PRONOUNCEMENTS
Accounting Standards Adopted in 2007
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting and disclosure for uncertainty in tax positions, as defined. FIN 48 seeks to reduce the diversity in practice associated with certain aspects of the recognition and measurement related to accounting for income taxes. Trustmark adopted FIN 48 on January 1, 2007 and, at the date of adoption, had unrecognized tax benefits of $1.0 million. Trustmark did not record any cumulative effect adjustment to retained earnings as a result of the adoption of FIN 48. The entire $1.0 million of unrecognized tax benefits would impact the effective income tax rate if recognized. Interest and penalties, if any, related to unrecognized tax benefits are recorded in income tax expense. As of January 1, 2007, Trustmark had $78 thousand of accrued interest expense included in the $1.0 million of unrecognized tax benefits. With limited exception, Trustmark is no longer subject to U. S. federal, state and local audits by tax authorities for 2002 and earlier tax years. As of June 30, 2007, there have been no material changes to the amount of unrecognized tax benefits. Trustmark does not anticipate a significant change to the total amount of unrecognized tax benefits within the next twelve months.
New Accounting Standards
Other new pronouncements issued but not effective until after June 30, 2007 are not expected to have a significant effect on Trustmark’s balance sheets or results of operations, with the possible exception of the following, which are currently being evaluated by Management:
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS No. 159 allows entities the option to measure eligible financial instruments at fair value as of specified dates. Such election, which may be applied on an instrument-by-instrument basis, is typically irrevocable once elected. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007, and early application is allowed under certain circumstances. Management is currently evaluating the impact that SFAS No. 159 will have on Trustmark’s balance sheets and results of operations.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. Provisions of SFAS No. 157 must be applied prospectively as of the beginning of the first fiscal year in which the accounting standard is applied. Management is currently evaluating the impact that SFAS No. 157 will have on Trustmark’s balance sheets and results of operations.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
