All subordinated notes are unsecured and are subordinate to other present and future senior indebtedness. These notes qualify as Tier 2 risk-based capital under the Federal Reserve Board and Office of the Comptroller of the Currency guidelines for assessing capital adequacy. Certain of the subordinated bank notes may require prior regulatory approval to be prepaid prior to maturity.
ITEM 2. FIRST TENNESSEE NATIONAL CORPORATION - MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
GENERAL INFORMATION
First Tennessee National Corporation (FTNC) is headquartered in Memphis, Tennessee, and is a nationwide, diversified financial services institution which provides banking and other financial services to its customers through various regional and national business lines. FTNC’s segments are First Tennessee Banking Group (previously referred to as FTN Banking Group), First Horizon, FTN Financial, Transaction Processing, and Corporate. First Tennessee Banking Group includes the Retail/Commercial Bank, Investments, Insurance, Financial Planning, Trust Services and Asset Management, Credit Card and Cash Management. This segment offers traditional banking financial services and products, commercial insurance and also promotes comprehensive financial planning to address customer needs and desires for investments, insurance, estate planning, education funding, cash reserves and retirement goals. First Horizon includes First Horizon Home Loans, First Horizon Equity Lending and First Horizon Money Centers. During third quarter 2002, FTNC sold the loan portfolio and closed the offices of First Horizon Money Centers as part of an ongoing plan to improve long-term growth by enhancing overall business mix. FTN Financial includes Capital Markets, Equity Research, Investment Banking, Strategic Alliances and Correspondent Services. Transaction Processing includes credit card merchant processing, nationwide bill payment processing, check clearing operations and other products and services. The Corporate segment includes unallocated corporate expenses, interest expense on trust preferred and REIT preferred stock, and select components of SFAS 133 hedge ineffectiveness (see Note 1 – Financial Information).
Based on management’s best estimates, certain revenue and expenses are allocated and equity is assigned to the various segments to reflect the inherent risk in each business line. These allocations are periodically reviewed and may be revised from time to time to more accurately reflect current business conditions and risks; the previous history is restated to ensure comparability.
For the purpose of this management discussion and analysis (MD&A), earning assets, including loans, have been expressed as averages, net of unearned income. First Tennessee Bank National Association, the primary bank subsidiary, is also referred to as FTBNA in this discussion.
The following is a discussion and analysis of the financial condition and results of operations of FTNC for the three-month and six-month periods ended June 30, 2003, compared to the three-month and six-month periods ended June 30, 2002. To assist the reader in obtaining a better understanding of FTNC and its performance, this discussion should be read in conjunction with FTNC’s unaudited consolidated financial statements and accompanying notes appearing in this report. Additional information including the 2002 financial statements, notes, and management’s discussion and analysis is provided in the 2002 Annual Financial Disclosures included as an appendix to the 2003 Proxy Statement.
FORWARD-LOOKING STATEMENTS
Management’s discussion and analysis contains forward-looking statements with respect to FTNC’s beliefs, plans, goals, expectations, and estimates. Forward-looking statements are statements that are not a representation of historical information but rather are related to future operations, strategies, financial results or other developments. The words “believe”, “expect”, “anticipate”, “intend”, “estimate”, “should”, “is likely”, “will”, “going forward”, and other expressions that indicate future events and trends identify forward-looking statements. Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, operational, economic and competitive uncertainties and contingencies, many of which are beyond a company’s control, and many of which, with respect to future business decisions and actions (including acquisitions and divestitures), are subject to change. Examples of uncertainties and contingencies include, among other important factors, general and local economic and business conditions; expectations of and actual timing and amount of interest rate movements (which can have a significant impact on a financial services institution); market and monetary fluctuations; inflation; the financial condition of borrowers and other counterparties; competition within and outside the financial services industry; geo-political developments including possible terrorist activity; technology; and new products and services in the industries in which FTNC operates. Other factors are those inherent in originating and servicing loans, including prepayment risks and fluctuation of collateral values and changes in customer profiles. Additionally, the actions of the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, and other regulators; regulatory and judicial proceedings and changes in laws and regulations applicable to FTNC; and FTNC’s success in executing its business plans and strategies and managing the risks involved in the foregoing, could cause actual results to differ. FTNC assumes no obligation to update any forward-looking statements that are made from time to time.
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FINANCIAL SUMMARY (Comparison of second quarter 2003 to second quarter 2002)
Earnings for second quarter 2003 were $118.4 million, an increase of 31 percent from last year’s second quarter earnings of $90.4 million. Diluted earnings per common share were $.90 in 2003 compared to $.69 in 2002. Return on average shareholders’ equity was 26.5 percent and return on average assets was 1.89 percent for second quarter 2003. Return on average shareholders’ equity was 23.7 percent and return on average assets was 1.87 percent for second quarter 2002.
On June 30, 2003, FTNC was ranked as one of the top 50 bank holding companies nationally in market capitalization ($5.6 billion) and total assets ($27.9 billion). On June 30, 2002, market capitalization was $4.8 billion and total assets were $19.8 billion.
Total revenue grew 46 percent from second quarter 2002, with a 63 percent increase in noninterest income and a 13 percent increase in net interest income.
BUSINESS LINE REVIEW
First Horizon
Pre-tax income for First Horizon increased 149 percent to $110.4 million for second quarter 2003, compared to $44.3 million for second quarter 2002. Total revenues were $365.4 million, an increase of 96 percent from $186.0 million in 2002 reflecting a 177 percent increase in originations. Also contributing to the growth in pre-tax income were improvements in operating efficiencies and a decline in provision for loan losses.
Net interest income increased 78 percent to $86.0 million in 2003 from $48.1 million. Net interest income in First Horizon Equity Lending increased $7.2 million primarily due to an increase of 132 percent in home equity lines of credit which averaged $1.9 billion in second quarter 2003 compared to $.8 billion in 2002. Also impacting the growth in net interest income was an increase of $2.5 million related to growth in residential construction lending. The remaining increase of $28.2 million in net interest income reflects the impact of a larger portfolio of warehouse loans (mortgage loans that are awaiting sale and delivery into the secondary market) which grew 156 percent to $5.2 billion from $2.0 billion in second quarter 2002. Net interest spread on the warehouse, however, was negatively impacted by lower mortgage rates.
Total noninterest income increased 103 percent to $279.4 million in 2003 compared to $137.9 million in 2002. Noninterest income consists primarily of mortgage banking-related fees from the origination process, fees from mortgage servicing and MSR’s net hedge gains or losses. Total noninterest income is net of amortization, impairment and other expenses related to MSR’s and related hedges.
Origination activity increased to $15.3 billion compared to $5.5 billion in 2002. Driven by low mortgage interest rates, refinance activity increased 348 percent to $11.6 billion and represented 76 percent of total originations during 2003 compared to 47 percent in 2002. Contributing to the growth in originations was a 48 percent increase in the size of the sales force. Home purchase related originations grew 26 percent in 2003, demonstrating First Horizon Home Loans’ success in penetrating the purchase market. First Horizon Home Loans’ access to the less volatile purchase market should help support production levels when mortgage rates rise. Due to the high origination volumes, loan sales into the secondary market increased 171 percent to $14.1 billion in 2003 compared to last year. Fees derived from the mortgage origination process increased 149 percent in 2003, to $293.0 million from $117.5 million in 2002. This increase reflects growth in origination fees, in revenue recognized on loans sold, in the value recognized on loans in process, and higher net secondary marketing trading gains, which were influenced by the favorable interest rate environment experienced during the year. Secondary marketing activities increased $105.7 million as revenues from mortgage servicing rights created grew $53.2 million (to $112.6 million) primarily due to the increased production and net secondary marketing trading gains increased $52.5 million (to $67.7 million) primarily from increased production and the favorable interest rate environment experienced during 2003.
While the growth in refinance activity produced increased origination fee income, it also increased actual and projected MSR’s prepayment speeds, resulting in a 9 percent increase, to $32.6 million in MSR’s amortization expense. In addition, MSR’s impairment loss increased 191 percent to $72.3 million due primarily to lower interest rates and changes in short term prepayment expectations. MSR’s amortization was $29.9 million in 2002 and there was a MSR’s impairment loss of $24.9 million. The decrease in fair value of MSR’s attributed to declining interest rates was partially offset by an increase in the value of the derivative financial instruments used to hedge the change in fair value of the hedged MSR’s. MSR’s net hedge gains, excluding select components of SFAS 133 hedge ineffectiveness that are included in the Corporate segment, were $38.3 million in 2003 compared to $23.7 million in 2002 (both years represent a net increase in the value of hedges over the decrease in the value of hedged MSR’s).
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The mortgage-servicing portfolio (which includes servicing for ourselves and others) totaled $64.0 billion on June 30, 2003, compared to $48.7 billion on June 30, 2002. The sustained growth of this asset in a period of historically high prepayment levels was made possible, in part, by the recapture of refinances from the existing servicing portfolio. Servicing fees increased 17 percent as a result of this increase in the servicing portfolio. However, total fees associated with mortgage servicing decreased 1 percent to $43.0 million in second quarter 2003 due to the unfavorable impact of early payoff interest expense. As a result of the strong originations, there was an increase in capitalized MSR’s during second quarter 2003 of $127.4 million, net of sales (see Note 7 – Mortgage Servicing Rights for information summarizing changes in MSR’s).
The provision for loan losses was $7.8 million in 2003 compared to $9.3 million in 2002. The decreased provision reflects the impact of improvements in the risk profile of the retail loan portfolio due to the sale of Money Center loans in 2002, certain classified and nonperforming loans being transferred to available for sale and whole-loan insurance being provided for a segment of the retail loan portfolio.
Total noninterest expense increased 87 percent to $247.2 million in 2003 compared to $132.4 million in 2002. The growth was primarily the result of a 109 percent increase in employee compensation, incentives and benefits (personnel expense), the largest component of noninterest expense, that includes the impact of increased salary and commission expense related to the increased mortgage origination volume produced during 2003. The impact of First Horizon’s initiative to grow the retail sales force is also reflected in this expense growth. In addition to the increased personnel expense, the higher activity levels also impacted various other categories of noninterest expense.
Going forward, the existing level of loans in process (pipeline) due to an as yet unabated surge in applications currently indicates a continuation of strong origination levels. Excluding the impact of the pipeline, fee income from refinance loan originations will generally depend on mortgage interest rates. An increase in rates should reduce origination fees and profit from the sale of loans, but should also reduce MSR’s amortization expense and impairment losses, while a decrease in rates should increase this net revenue. Flat to rising interest rates should reduce net secondary marketing trading gains, while falling rates should increase this net revenue. If total origination volume increases and/or the yield curve steepens, net interest income from the warehouse should increase, while if volume decreases and/or the yield curve flattens, this revenue should decrease. Home purchase-related originations should reflect the relative strength or weakness of the economy and will also be influenced by the size of the sales force. Continued success of national cross-sell strategies should increase revenues from products other than traditional mortgage origination and servicing. Actual results could differ because of various factors, including those presented in the Forward-Looking Statements section of the MD&A discussion.
First Tennessee Banking Group
Pre-tax income for First Tennessee Banking Group decreased 59 percent to $26.1 million for second quarter 2003, compared to $63.4 million for second quarter 2002. Total revenues for the segment were $177.3 million, a decrease of 7 percent from $191.5 million in 2002 due to compression in the net interest margin (NIM). Also impacting the decline in pre-tax income were increased provision for loan losses and growth in noninterest expense that includes investments in initiatives designed to enhance future earnings.
Net interest income decreased to $96.9 million in 2003 or 16 percent, compared to $116.0 million in 2002. The decline in net interest income was related to compression in the NIM, primarily due to the repricing of term assets in this low interest rate environment and due to a change in the mix of the loan portfolio to floating rate products. NIM (based on net interest income of $96.9 million and earning assets of $10.1 billion for second quarter 2003 compared to $116.0 million and $9.7 billion, respectively, for second quarter 2002) fell to 3.82 percent in 2003 from 4.78 percent in 2002.
Noninterest income increased 7 percent to $80.4 million compared to $75.5 million in 2002. This increase was due to growth in insurance revenue, deposit account service charges, and cash management fees. The positive impact of these items was partially offset by a decrease in trust and investment management fees as difficult equity market conditions continued to impact results.
The provision for loan losses was $19.2 million in second quarter 2003 compared to $13.9 million in second quarter of last year primarily due to an increase in historical loss factors on commercial loans used in the allowance model and due to loan growth. The loss factors on commercial loans were influenced by the inclusion of 2002 charge-offs in the historical loss calculation and reflect the impact of an extended period of slow economic growth on our customer base. Going forward the level of provision for loan losses should fluctuate primarily with the strength or weakness of the Tennessee economy.
Total noninterest expense increased 16 percent in 2003 to $132.0 million from $114.2 million last year. Expenses associated with initiatives focused on benefiting future earnings, including marketing programs, severance and professional fees, represent the largest component of this increase.
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FTN Financial
Pre-tax income for FTN Financial increased 52 percent to $52.5 million for second quarter 2003, compared to $34.5 million for second quarter 2002.
Total revenues were $171.7 million, an increase of 59 percent from $108.1 million in 2002. Noninterest income increased 61 percent to $161.1 million in 2003. This increased revenue reflects continued growth and penetration into FTN Financial’s targeted customer base through strengthened product and service lines. Revenue growth has also been influenced by the increased liquidity that capital markets’ depository customers have experienced, as well as continued growth in capital markets’ non-depository account base. FTN Financial’s enhanced institutional product and service lines, which include investment banking, equity research and sales, correspondent services and portfolio advisory services, increased 36 percent compared to 2002. Total securities bought and sold increased 49 percent to $596.5 billion from $400.2 billion in 2002.
Total noninterest expense increased 61 percent to $118.6 million compared to $73.5 million in 2002. This growth was primarily due to an increase of 64 percent in personnel expense resulting from commissions and incentives associated with the higher fee income this year.
Going forward, revenues will fluctuate based on factors which include the expansion or contraction of the customer base, the volume of investment banking transactions and the introduction of new products, as well as the strength of loan growth in the U.S. economy and volatility in the interest rate environment and the equity markets. Actual results could differ because of various factors, including those presented in the Forward-Looking Statements section of the MD&A discussion.
Transaction Processing
Pre-tax income for Transaction Processing decreased 11 percent to $5.0 million for second quarter 2003, compared to $5.7 million for second quarter 2002. Total revenues were $31.3 million, an increase of 2 percent from $30.8 million in 2002. The volume of merchant bank card transactions processed grew 20 percent over second quarter 2002. Total noninterest expense increased 5 percent to $26.3 million from $25.1 million, which includes investments in initiatives designed to enhance future earnings. Both revenue and expense levels were influenced by recent acquisitions.
Corporate
The Corporate segment’s results showed a pre-tax loss of $22.2 million in 2003, compared to a pre-tax loss of $11.7 million in 2002. Included in the pre-tax loss for 2003 is the $9.8 million contribution made to the First Tennessee Foundation, a non-profit entity dedicated to supporting on an annual basis charitable causes in the communities where FTNC does business. FTNC has made contributions to the Foundation in three of the last four quarters. These contributions, which are discretionary, have been made and may continue to be made when a favorable economic environment or other favorable factor (such as the second quarter tax settlement discussed below – see Income Taxes) enables FTNC to produce strong earnings. Also included in the Corporate segment’s results for this quarter were an increase in consulting fees and issuance costs related to the issuance of subordinated notes (see Balance Sheet Review below).
INCOME STATEMENT REVIEW
NONINTEREST INCOME
Noninterest income provides the majority of FTNC’s revenue and contributed 73 percent to total revenue in second quarter 2003 compared to 66 percent in second quarter 2002. Second quarter 2003 noninterest income increased 63 percent to $548.7 million from $336.6 million in 2002. A more detailed discussion of the major line items follows.
Mortgage Banking
First Horizon Home Loans, an indirect subsidiary of FTNC and the major component of the First Horizon business segment, offers residential mortgage banking products and services to customers, which consist primarily of the origination or purchase of single-family residential mortgage loans for sale to secondary market investors and the subsequent servicing of those loans.
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First Horizon Home Loans originates mortgage loans through its retail and wholesale operations and also purchases mortgage loans from third-party mortgage bankers (known as “correspondent brokers”).
The secondary market for mortgages allows First Horizon Home Loans to sell mortgage loans to investors, including government-sponsored enterprises (GSE’s), such as Fannie Mae (FNMA), Ginnie Mae (GNMA), and Freddie Mac (FHLMC). Many private investors are also active in the secondary market as issuers and investors. The majority of First Horizon Home Loans’ mortgage loans are sold through transactions with GSE’s. The risk of credit loss with regard to the principal amount of the loans sold is generally transferred to investors upon sale to the secondary market. To the extent that transferred mortgage loans are subsequently determined not to meet the agreed-upon qualifications or criteria, the purchaser has the right to return those loans to First Horizon Home Loans. In addition, certain mortgage loans are sold to investors with limited or full recourse in the event of mortgage foreclosure (refer to discussion of foreclosure reserves under Critical Accounting Policies).
When First Horizon Home Loans sells mortgage loans in the secondary market to investors, it generally retains the right to service the loans sold in exchange for a servicing fee that is collected over the life of the loan as the payments are received from the borrower. The expected present value of the anticipated cash flows received for servicing the loan, net of the estimated costs of servicing the loan, is capitalized as an asset known as Mortgage Servicing Rights (MSR’s) on the Consolidated Statements of Condition (refer to discussion of MSR’s under Critical Accounting Policies).
Origination fees and gains or losses from the sale of loans are recognized at the time a mortgage loan is sold into the secondary market. A portion of the gain or loss is recognized at the time an interest rate lock commitment (IRLC) is made to the customer. Secondary marketing activities include gains or losses from secondary marketing trading gains, product pricing decisions, and gains or losses from the sale of loans into the secondary market including the capitalized net present value of the MSR’s. As discussed under Critical Accounting Policies, First Horizon Home Loans employs hedging strategies intended to counter a change in the value of its MSR’s through changing interest rate environments. MSR’s hedge gains/(losses) reflect effects of hedging including servicing rights net value changes (see Other - Accounting for Derivative Instruments and Hedging Activities). Other income includes income from the foreclosure repurchase program, bulk sales of MSR’s, and other miscellaneous items. Mortgage trading securities gains/(losses) relate to market value adjustments primarily on interest-only strips that are classified as trading securities and related hedges. As shown in Table 1, total mortgage banking fee income increased 113 percent in 2003.
Table 1 - Mortgage Banking
| | | Three Months Ended
June 30 | | Percent | | | Six Months Ended
June 30 | | Percent | |
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| | | |
| | |
(Dollars and volumes in millions) | | | 2003 | | | 2002 | | Change (%) | | | 2003 | | | 2002 | | Change (%) | |
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Noninterest income: | | | | | | | | | | | | | | | | | |
Loan origination fees | | $ | 112.7 | | $ | 42.9 | | 162.5 | + | $ | 197.3 | | $ | 91.4 | | 115.8 | + |
Secondary marketing activities | | | 180.3 | | | 74.6 | | 141.6 | + | | 340.7 | | | 151.6 | | 124.8 | + |
Mortgage servicing fees | | | 43.0 | | | 43.4 | | .9 | - | | 88.4 | | | 84.8 | | 4.3 | + |
MSR’s net hedge results* | | | 39.0 | | | 21.0 | | 86.4 | + | | 76.3 | | | 32.9 | | 131.9 | + |
Other income | | | 9.1 | | | 6.9 | | 32.9 | + | | 24.7 | | | 14.0 | | 76.5 | + |
Mortgage trading securities net losses | | | (2.6 | ) | | (4.1 | ) | 35.7 | - | | (.5 | ) | | (7.6 | ) | 93.5 | - |
Amortization of MSR’s | | | (32.6 | ) | | (29.9 | ) | 9.2 | + | | (63.7 | ) | | (59.6 | ) | 6.9 | + |
MSR’s impairment loss | | | (72.3 | ) | | (24.9 | ) | 190.7 | + | | (114.8 | ) | | (56.3 | ) | 103.8 | + |
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Total mortgage noninterest income | | $ | 276.6 | | $ | 129.9 | | 112.9 | + | $ | 548.4 | | $ | 251.2 | | 118.3 | + |
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Refinance originations | | $ | 11,584.9 | | $ | 2,587.0 | | 347.8 | + | $ | 20,662.0 | | $ | 5,863.6 | | 252.4 | + |
New loan originations | | | 3,664.1 | | | 2,915.6 | | 25.7 | + | | 6,095.6 | | | 4,940.9 | | 23.4 | + |
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Mortgage loan originations | | $ | 15,249.0 | | $ | 5,502.6 | | 177.1 | + | $ | 26,757.6 | | $ | 10,804.5 | | 147.7 | + |
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Servicing portfolio | | $ | 63,952.2 | | $ | 48,678.7 | | 31.4 | + | $ | 63,952.2 | | $ | 48,678.7 | | 31.4 | + |
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| * | MSR’s net hedge results represent the net gain or loss resulting from the change in value of the hedged component of MSR’s and the offsetting change in value of servicing hedges. |
Certain previously reported amounts have been reclassified to agree with current presentation.
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Origination activity increased 177 percent to $15.3 billion compared to $5.5 billion in second quarter 2002. Driven by low mortgage interest rates, refinance activity increased 348 percent to $11.6 billion and represented 76 percent of total originations during second quarter 2003 compared to 47 percent in second quarter 2002. Due to the high origination volumes, loan sales into the secondary market increased 171 percent to $14.1 billion in 2003 compared to last year. Home purchase related originations grew 26 percent in 2003, demonstrating First Horizon Home Loans’ success in penetrating the purchase market. Due to the more stable nature of this market, which is not as vulnerable to interest rates, First Horizon Home Loans’ access to the purchase market should help support production levels when mortgage rates rise. Fees derived from the mortgage origination process increased 149 percent in 2003, to $293.0 million from $117.5 million in 2002. This increase reflects growth in origination fees, in revenue recognized on loans sold, in the value recognized on loans in process, and higher net secondary marketing trading gains, which were influenced by the favorable interest rate environment experienced during the year. Secondary marketing activities increased $105.7 million as revenues from mortgage servicing rights created grew $53.2 million (to $112.6 million) primarily due to the increased production and net secondary marketing trading gains increased $52.5 million (to $67.7 million) primarily from increased production and the favorable interest rate environment experienced during 2003.
While the growth in refinance activity produced increased origination fee income, it also increased actual and projected MSR’s prepayment speeds, resulting in a 9 percent increase, to $32.6 million in MSR’s amortization expense. In addition, MSR’s impairment loss increased 191 percent to $72.3 million due primarily to lower interest rates and changes in short term prepayment expectations. MSR’s amortization was $29.9 million in 2002 and there was a MSR’s impairment loss of $24.9 million in 2002. The decrease in fair value of MSR’s attributed to declining interest rates was partially offset by an increase in the value of the derivative financial instruments used to hedge the change in fair value of the hedged MSR’s. MSR’s net hedge gains were $39.0 million in 2003 compared to $21.0 million in 2002 (both quarters represent a net increase in the value of hedges over the decrease in the value of hedged MSR’s).
The mortgage-servicing portfolio (which includes servicing for ourselves and others) totaled $64.0 billion on June 30, 2003, compared to $48.7 billion on June 30, 2002. The sustained growth of this asset in a period of historically high prepayment levels was made possible, in part, by the recapture of refinances from the existing servicing portfolio. Servicing fees increased 17 percent as a result of this increase in the servicing portfolio. However, total fees associated with mortgage servicing decreased 1 percent to $43.0 million in second quarter 2003 due to the unfavorable impact of early payoff interest expense. As a result of the strong originations, there was an increase in capitalized MSR’s during second quarter 2003 of $127.4 million, net of sales (see Note 7 – Mortgage Servicing Rights for information summarizing changes in MSR’s).
Other mortgage income increased 33 percent to $9.1 million for 2003 compared to $6.9 million in 2002 primarily due to increased earnings from investments in joint ventures and other partnerships.
Capital Markets
Capital markets fee income, the major component of revenue in the FTN Financial segment, is primarily generated from the purchase and sale of securities as both principal and agent and from investment banking, portfolio advisory and equity research services. Inventory positions are limited to the procurement of securities solely for distribution to customers by the sales staff. Inventory is hedged to protect against movements in interest rates.
For second quarter 2003, capital markets fee income increased 61 percent to $158.7 million from $98.3 million in 2002. This increase reflects continued growth and penetration into the targeted customer base through strengthened product and service lines. This growth has also been influenced by the increased liquidity that capital markets’ depository institution customers have experienced, as well as continued growth in capital markets’ non-depository account base. As shown in Table 2, revenue from depository and non-depository customers has increased in 2003. The enhanced institutional product and service lines, which include investment banking, equity research and sales, and portfolio advisory services, increased 36 percent compared to 2002. Total securities bought and sold increased 49 percent to $596.5 billion from $400.2 billion in 2002.
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Table 2 - Capital Markets
| | Three Months Ended
June 30 | | Growth
Rate (%) | | Six Months Ended
June 30 | | Growth
Rate (%) | |
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| | |
(Dollars in millions) | | 2003 | | 2002 | | | 2003 | | 2002 | | |
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Noninterest income: | | | | | | | | | | | | | | | | | |
Fixed income - depository | | $ | 65.9 | | $ | 36.1 | | 82.5 | + | $ | 136.6 | | $ | 77.6 | | 76.0 | + |
Fixed income - non-depository | | | 42.2 | | | 25.1 | | 68.1 | + | | 80.2 | | | 51.7 | | 55.1 | + |
Other products | | | 50.6 | | | 37.1 | | 36.4 | + | | 81.5 | | | 68.5 | | 19.0 | + |
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Total capital markets noninterest income | | $ | 158.7 | | $ | 98.3 | | 61.4 | + | $ | 298.3 | | $ | 197.8 | | 50.8 | + |
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Securities bought and sold (billions) | | $ | 596.5 | | $ | 400.2 | | 49.0 | + | $ | 1,151.0 | | $ | 772.9 | | 48.9 | + |
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| Certain previously reported amounts have been reclassified to agree with current presentation. |
Other Noninterest Income
Fee income from deposit transactions and cash management for second quarter 2003 increased 6 percent to $38.6 million compared to $36.4 million in 2002 due to growth in deposit account service charges and cash management fees. Total noninterest income from insurance premiums and commissions increased 23 percent, to $15.2 million from $12.4 million in 2002 due in part to growth in revenues from Synaxis, a commercial insurance broker. Trust services and investment management fees decreased 19 percent to $10.8 million from $13.3 million in 2002 as difficult equity market conditions continued to impact results. Assets under management fell 3 percent to $7.4 billion on June 30, 2003, from $7.7 billion on June 30, 2002. Second quarter 2003 fee income from merchant processing increased 10 percent to $13.8 million from $12.6 million in 2002 primarily due to portfolio acquisitions. Net security losses were $.7 million in 2003 compared to net security losses of $2.3 million in 2002. In 2002, the losses were primarily related to impairment of equity investments held by FTNC’s venture capital subsidiaries. All other income and commissions decreased 1 percent to $35.7 million for second quarter 2003 from $36.0 million in 2002.
Going forward, other noninterest income should fluctuate primarily with the strength or weakness of the economy.
NET INTEREST INCOME
Net interest income increased 13 percent to $199.8 million from $177.1 million in second quarter 2002, reflecting a larger portfolio of mortgage warehouse loans which grew 154 percent to $5.1 billion from $2.0 billion in second quarter 2002. Also impacting the growth in net interest income was an increase of 18 percent in the loan portfolio primarily due to growth in equity lending. These positive impacts on net interest income were largely offset by compression in the net interest margin resulting from the repricing of assets to lower yields while liability rates have become less sensitive to rate movements in this historically low interest rate environment and due to a change in the mix of the loan portfolio to a higher percentage of floating rate products. The consolidated margin decreased to 3.72 percent in second quarter 2003 compared to 4.36 percent for the same period in 2002. The activity levels and related funding for FTNC’s mortgage production and servicing and capital markets activities affect the margin. These activities typically produce different margins than traditional banking activities. Mortgage production and servicing activities can affect the overall margin based on a number of factors, including the size of the mortgage warehouse, the time it takes to deliver loans into the secondary market, the amount of custodial balances, and the level of MSR’s. Capital markets activities tend to compress the margin because of its strategy to reduce market risk by hedging its inventory in the cash markets, which effectively eliminates net interest income on these positions. As a result, FTNC’s consolidated margin cannot be readily compared to that of other bank holding companies.
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Table 3 - Net Interest Margin
| | Second Quarter
June 30 | |
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| | 2003 | | 2002 | |
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Consolidated Yields and Rates: | | | | | |
Investment securities | | 4.26 | % | 6.01 | % |
Loans, net of unearned | | 5.13 | | 6.22 | |
Other earning assets | | 4.70 | | 5.37 | |
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Yields on earning assets | | 4.90 | | 6.01 | |
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Interest bearing core deposits | | 1.46 | | 1.98 | |
CD’s over $100,000 | | 1.41 | | 2.18 | |
Fed funds purchased and repos | | 1.11 | | 1.52 | |
Commercial paper and other short-term borrowings | | 3.78 | | 4.25 | |
Long-term debt | | 3.30 | | 4.37 | |
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Rates paid on interest-bearing liabilities | | 1.59 | | 2.15 | |
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Net interest spread | | 3.31 | | 3.86 | |
Effect of interest-free sources | | .37 | | .39 | |
Loan fees | | .05 | | .11 | |
FRB interest and penalties | | (.01 | ) | — | |
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FTNC - NIM | | 3.72 | % | 4.36 | % |
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Going forward, in the near-term, net interest margin should decline further as term assets continue to reprice to lower rates. The adoption of SFAS No. 150 in third quarter 2003 will also result in further compression of the consolidated net interest margin. Historically, the expenses associated with FTNC’s trust preferred and REIT preferred stock have been classified as noninterest expense, but upon adoption of SFAS No. 150 will be classified as interest expense on a prospective basis. Over the long-term, FTNC’s asset sensitive balance sheet position should allow the net interest margin to improve when interest rates begin to rise.
NONINTEREST EXPENSE
Total noninterest expense for second quarter 2003 increased 55 percent to $549.3 million from $354.6 million in 2002. Expenses in First Horizon and FTN Financial fluctuate based on the type and level of activity. Going forward, FTN Financial and First Horizon will continue to influence the level of noninterest expense (see also Business Line Review for additional information). Based on the strong earnings experienced in recent quarters, noninterest expense also has been impacted by investments made to enhance FTNC’s ability to produce future earnings.
Personnel expense increased 63 percent from second quarter 2002, primarily due to higher activity levels in First Horizon and FTN Financial. Occupancy expense increased 7 percent to $19.8 million compared to $18.4 million in 2002 primarily related to realty taxes. Operations services increased 17 percent to $17.4 million from $14.9 million in 2002 primarily due to business expansion and costs related to transitioning to a new information technology provider. Equipment rentals, depreciation and maintenance expenses remained flat in 2003 at $16.6 million. Communications and courier expense increased 30 percent to $15.9 million in 2003 from $12.2 million in 2002 primarily due to increased expenses related to higher activity levels in First Horizon and Midwest Research. All other expense increased 69 percent to $115.6 million in 2003 from $68.5 million in 2002. Contributing to this increase was a $9.8 million contribution made to the First Tennessee Foundation, a non-profit entity dedicated to supporting charitable causes in the communities where FTNC does business. Also contributing to the increase in all other expense was the growth in expense associated with higher activity levels in First Horizon and increased advertising and professional fee expense.
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PROVISION FOR LOAN LOSSES / ASSET QUALITY
The provision for loan losses is the charge to earnings that management determines to be necessary to maintain the allowance for loan losses at an adequate level reflecting management’s estimate of probable incurred losses in the loan portfolio. An analytical model based on a three-year moving average of historical loss experience adjusted for current events, trends and economic conditions is used by management to determine the amount of provision to be recognized and to assess the adequacy of the loan loss allowance. The provision for loan losses increased 18 percent in 2003 to $27.5 million from $23.3 million in 2002. This increase is primarily due to higher historical loss factors on commercial loans and rapid growth in retail loans. The loss factors on commercial loans were influenced by the inclusion of 2002 charge-offs in the historical loss calculation and reflect the impact of an extended period of slow economic growth on our customer base. These negative impacts were partially offset by improvement in asset quality of retail loans due to a change in risk profile, including the effects of whole-loan insurance being provided for a segment of the loan portfolio and the sale of Money Center loans. Additional asset quality information is provided in Table 4 – Asset Quality Information and Table 5 – Charge-off Ratios.
Net charge-offs decreased to $12.9 million in 2003 compared to $24.5 million last year. Net charge-offs were impacted in second quarter 2003 by improvement in both the consumer and commercial loan portfolios. The ratio of allowance for loan losses to total loans, net of unearned income (coverage ratio), decreased to 1.25 percent on June 30, 2003, compared to 1.40 percent on June 30, 2002, primarily reflecting improvements in the retail loan portfolio’s risk profile, including the effects of the whole loan insurance, the sale of Money Center loans and the transfer of certain loans to held for sale.
Nonperforming loans were $66.6 million on June 30, 2003, compared to $59.5 million on June 30, 2002. The ratio of nonperforming loans in the loan portfolio to total loans was .46 percent on June 30, 2003, compared to .56 percent on June 30, 2002. Nonperforming assets totaled $83.1 million on June 30, 2003, compared to $81.1 million on June 30, 2002. On June 30, 2003, FTNC had no concentrations of 10 percent or more of total loans in any single industry.
Going forward, the level of provision for loan losses should fluctuate primarily with the strength or weakness of the economy. In addition, asset quality indicators could be affected by balance sheet strategies and shifts in loan mix to and from products with different risk/reward profiles. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion.
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Table 4 - Asset Quality Information
| | June 30 | |
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(Dollars in thousands) | | 2003 | | 2002 | |
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Lending Activities*: | | | | | | | |
Nonperforming loans | | $ | 57,324 | | $ | 40,300 | |
Foreclosed real estate | | | 8,000 | | | 7,493 | |
Other assets | | | 52 | | | 99 | |
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Total Lending Activities | | | 65,376 | | | 47,892 | |
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Mortgage Production Activities*: | | | | | | | |
Nonperforming loans - held for sale | | | 7,245 | | | — | |
Nonperforming loans - loan portfolio | | | 2,026 | | | 19,152 | |
Foreclosed real estate | | | 8,414 | | | 14,006 | |
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Total Mortgage Production Activities | | | 17,685 | | | 33,158 | |
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Total nonperforming assets | | $ | 83,061 | | $ | 81,050 | |
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Loans and leases 30 to 89 days past due | | $ | 88,698 | | $ | 114,210 | |
Loans and leases 90 days past due | | | 32,208 | | | 34,710 | |
Potential problem assets** | | | 119,991 | | | 125,606 | |
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| | Second Quarter | |
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| | 2003 | | 2002 | |
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Allowance for loan losses: | | | | | | | |
Beginning balance on March 31 | | $ | 144,484 | | $ | 148,602 | |
Provision for loan losses | | | 27,501 | | | 23,286 | |
Charge-offs | | | (16,383 | ) | | (27,842 | ) |
Loan recoveries | | | 3,478 | | | 3,371 | |
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Ending balance on June 30 | | $ | 159,080 | | $ | 147,417 | |
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| | June 30 | |
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| | 2003 | | 2002 | |
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Allowance to total loans | | | 1.25 | % | | 1.40 | % |
Allowance to nonperforming loans in the loan portfolio | | | 268 | | | 248 | |
Nonperforming assets to total loans, foreclosed real estate and other assets (Lending Activities only) | | | .51 | | | .45 | |
Nonperforming assets to unpaid principal balance of servicing portfolio (Mortgage Production Activities only) | | | .03 | | | .07 | |
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| * | Lending activities include all activities associated with the loan portfolio. Mortgage production includes activities associated with the mortgage warehouse. |
** | Includes loans and leases 90 days past due. |
Certain previously reported amounts have been adjusted to agree with current presentation.
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Table 5 - Charge-off Ratios
| | Three Months Ended
June 30 | |
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| | 2003 | | 2002 | |
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Commercial | | | .18 | % | | .68 | % |
Retail real estate | | | .43 | | | .81 | |
Other retail | | | .83 | | | 2.94 | |
Credit card receivables | | | 5.12 | | | 5.12 | |
Total net charge-offs | | | .42 | | | .94 | |
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INCOME TAXES
The effective tax rate decreased to 31.0 percent for second quarter 2003 compared to 33.4 percent for the same period in 2002. This decline reflects a decrease of $6.2 million, or $9.8 million on a pre-tax equivalent basis, related to the settlement of prior years’ tax returns.
BALANCE SHEET REVIEW
Earning assets
Earning assets primarily consist of loans, loans held for sale and investment securities. For second quarter 2003, earning assets averaged $21.6 billion compared with $16.3 billion for second quarter 2002. The 32 percent increase in earning assets was primarily due to growth in the mortgage warehouse of 154 percent and an 18 percent increase in loans. Average total assets increased 29 percent to $25.1 billion from $19.4 billion in second quarter 2002.
Loans
Average total loans increased 18 percent for second quarter 2003 to $12.3 billion primarily due to an increase of 27 percent in retail loans principally from growth in equity lending. Commercial loans increased 10 percent to $6.0 billion. Additional loan information is provided in Table 6.
Table 6 - Average Loans
| | Three Months Ended
June 30 | |
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(Dollars in millions) | | 2003 | | Percent
of Total | | Growth
Rate | | 2002 | | Percent
of Total | |
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Commercial: | | | | | | | | | | | | | |
Commercial, financial and industrial | | $ | 4,274.6 | | 35 | % | 8.9 | % | $ | 3,926.2 | | 37 | % |
Real estate commercial | | | 1,091.3 | | 9 | | 6.8 | | | 1,021.5 | | 10 | |
Real estate construction | | | 616.4 | | 5 | | 21.1 | | | 508.8 | | 5 | |
Retail: | | | | | | | | | | | | | |
Real estate residential | | | 5,409.7 | | 44 | | 33.3 | | | 4,056.9 | | 39 | |
Real estate construction | | | 396.4 | | 3 | | 69.4 | | | 234.0 | | 2 | |
Other retail | | | 265.3 | | 2 | | (37.6 | ) | | 425.4 | | 4 | |
Credit card receivables | | | 260.6 | | 2 | | (1.6 | ) | | 264.7 | | 3 | |
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Total loans, net of unearned | | $ | 12,314.3 | | 100 | % | 18.0 | % | $ | 10,437.5 | | 100 | % |
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During years prior to 2003 certain retail loans have been securitized. The majority of these securities are owned by subsidiaries of FTNC, including FTBNA, and are classified as investment securities.
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Loans Held for Sale / Investment Securities
Loans held for sale, consisting primarily of mortgage loans, increased 155 percent to $5.2 billion in 2003 from $2.0 billion in 2002 due to the high level of originations in 2003. Average investment securities remained flat at $2.4 billion in 2003.
Deposits / Other Sources of Funds
Since second quarter 2002, average core deposits increased 16 percent to $10.8 billion from $9.3 billion while interest-bearing core deposits remained relatively flat at $5.8 billion compared to $5.9 billion in 2002. Noninterest-bearing deposits increased 44 percent in second quarter 2003 to $5.0 billion from $3.5 billion due to growth in mortgage escrow accounts and a cash management product. Short-term purchased funds increased 40 percent to $9.6 billion from $6.8 billion for the previous year. Short-term purchased funds accounted for 44 percent of FTNC’s funding (core deposits plus purchased funds and term borrowings) for second quarter 2003 compared to 41 percent for second quarter 2002. Term borrowings increased to $1.2 billion for second quarter 2003 compared to $.6 billion for second quarter 2002. This increase reflects the issuance in second quarter 2003 of $250 million of unsecured, subordinated notes by FTBNA and $100 million of unsecured, subordinated notes by FTNC (see Note 8 – Term Borrowings for additional information).
LIQUIDITY MANAGEMENT
The objective of liquidity management is to ensure the continuous availability of funds to meet the demands of depositors, other creditors and borrowers. The Asset/Liability Committee, a committee consisting of senior management that meets regularly, is responsible for managing these needs by taking into account the marketability of assets; the sources, stability and availability of funding; and the level of unfunded commitments. Core deposits are FTNC’s primary source of funding and have been a stable source of liquidity for banks. These deposits are insured by the Federal Deposit Insurance Corporation to the maximum extent authorized by law. For second quarter 2003, the average total loan to core deposit ratio was 114 percent compared with 112 percent in second quarter 2002. FTBNA has a bank note program available for additional liquidity, under which the bank may borrow funds from time to time, at maturities of 30 days to 30 years. On June 30, 2003, approximately $1.2 billion was available under the bank note program as a long-term (greater than one year) funding source. FTNC also evaluates alternative sources of funding, including loan sales, securitizations, syndications, and debt offerings in its management of liquidity.
First Horizon Home Loans originates conventional conforming and federally insured single-family residential mortgage loans. Likewise, First Tennessee Capital Assets Corporation frequently purchases the same types of loans from our customers. Substantially all of these mortgage loans are exchanged for securities, which are issued through GNMA for federally insured loans and FNMA and FHLMC for conventional loans, and then sold in the secondary markets. In many cases First Horizon Home Loans retains the right to service and receive servicing fees on these loans. After sale, these loans are not reflected on the Consolidated Statements of Condition. Each of these GSE’s has specific guidelines and criteria for sellers and servicers of loans backing their respective securities. During second quarter 2003, approximately $11.8 billion of conventional and federally insured mortgage loans were securitized and sold by First Horizon Home Loans through these GSE’s. FTNC’s use of these GSE’s as an efficient outlet for mortgage loan production is an essential source of liquidity for FTNC and other participants in the housing industry.
Certain of First Horizon Home Loans’ originated loans do not conform to the requirements for sale or securitization by FNMA and FHLMC due to exceeding the maximum loan size of approximately $323 thousand (jumbo loans). First Horizon Home Loans pools and securitizes these jumbo loans in proprietary transactions. After securitization and sale, these loans are not reflected on the Consolidated Statements of Condition except as described hereafter. These transactions, which are conducted through single-purpose business trusts, are the most efficient way for First Horizon Home Loans and other participants in the housing industry to monetize these assets. In most cases First Horizon Home Loans retains the right to service and receive servicing fees on these loans and, on occasion, has retained senior principal-only certificates or interest-only strips that are classified on the Consolidated Statement of Condition as trading securities. On June 30, 2003, the outstanding principal amount of loans in these off-balance sheet business trusts was $5.2 billion. Given the significance of First Horizon Home Loans’ origination of non-conforming loans, the use of single-purpose business trusts to securitize these loans is an important source of liquidity to FTNC.
In addition to these transactions, liquidity has been obtained in prior years through issuance of guaranteed preferred beneficial interests in FTNC’s junior subordinated debentures through a Delaware business trust wholly owned by FTNC ($100.0 million on June 30, 2003) and through preferred stock issued by an indirect wholly owned subsidiary of FTNC ($44.4 million on June 30, 2003).
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Parent company liquidity is maintained by cash flows stemming from dividends and interest payments collected from subsidiaries, which represent the primary source of funds to pay dividends to shareholders and interest to debtholders. The parent company also has the ability to enhance its liquidity position by raising equity or incurring debt. Under an effective shelf registration statement on file with the Securities and Exchange Commission (SEC), FTNC, as of June 30, 2003, may offer from time to time at its discretion, debt securities, and common and preferred stock aggregating up to $125 million. In addition, FTNC also has an effective capital securities shelf registration statement on file with the SEC under which up to $200 million of capital securities is available for issuance. See Part II, Item 5 – Other Information (paragraph 1) of this Form 10-Q for discussion of subordinated debt purchased during the tender offer period which ended August 8, 2003, which discussion is incorporated herein by reference.
CAPITAL
Capital adequacy is an important indicator of financial stability and performance. Management’s objectives are to maintain a level of capitalization that is sufficient to sustain asset growth, take advantage of profitable growth opportunities and promote depositor and investor confidence.
Shareholders’ equity was $1.8 billion on June 30, 2003, an increase of 15 percent from $1.6 billion on June 30, 2002. The increase in capital was primarily due to the retention of net income after dividends. The change in capital was reduced by share repurchases, primarily related to stock option exercises, which totaled $150.5 million, or 3.6 million shares since June 30, 2002. Pursuant to board authority, FTNC plans to continue to repurchase shares from time to time for its stock option and other compensation plans and will evaluate the level of capital and take action designed to generate or use capital as appropriate for the interests of the shareholders. On October 16, 2001, the board of directors extended from June 30, 2002, until December 31, 2004, the non-stock option plan-related repurchases of up to 9.5 million shares, previously approved in October 2000. Repurchases will be made in the open market or through privately negotiated transactions and will be subject to market conditions, accumulation of excess equity and prudent capital management. Through June 30, 2003, 2.5 million shares have been repurchased pursuant to this authority.
Average shareholders’ equity increased 17 percent since second quarter 2002 to $1.8 billion from $1.5 billion, reflecting internal capital generation. The average shareholders’ equity to average assets ratio was 7.13 percent for second quarter 2003 compared to 7.87 percent for second quarter 2002. Unrealized market valuations had no material effect on the ratios during second quarter 2003.
On June 30, 2003, the corporation’s Tier 1 capital ratio was 8.68 percent, the total capital ratio was 12.88 percent and the leverage ratio was 6.70 percent. On June 30, 2003, FTNC’s bank affiliates had sufficient capital to qualify as well-capitalized institutions.
FINANCIAL SUMMARY (Comparison of first six months of 2003 to first six months of 2002)
For the first six months of 2003, earnings totaled $237.4 million or $1.81 diluted earnings per share. For the same period in 2002, earnings were $177.5 million or $1.36 diluted earnings per share. Return on average shareholders’ equity was 27.1 percent and return on average assets was 1.98 percent for the first six months of 2003 compared to 23.7 percent and 1.82 percent, respectively, for the first six months of 2002.
For the first six months of 2003, total revenues were $1,460.0 million, an increase of 43 percent from 2002. Noninterest expense increased 49 percent to $1,051.8 million for the six-month period in 2003 compared to $707.3 million in 2002.
BUSINESS LINE REVIEW
First Horizon
For the first six months of 2003, pre-tax income increased 168 percent to $229.6 million from $85.5 million in 2002. Total revenues for the six-month period were $717.3 million, an increase of 95 percent from $368.2 million in 2002. During this period, fees from the mortgage origination process increased $295.0 million and MSR’s net hedge results increased $43.4 million compared to the first six months of 2002. Amortization of capitalized mortgage servicing rights was $63.7 million compared to $59.6 million in 2002 and MSR’s impairment loss in 2003 increased to $114.8 million from $56.3 million in 2002. See Table 1 – Mortgage Banking for a breakout of noninterest income as well as mortgage banking origination volume and servicing portfolio levels. Total noninterest expense for the six-month period increased 79 percent to $468.1 million from $262.1 million in 2002. Total noninterest expense increased primarily due to an 89 percent increase in personnel expense primarily due to increased origination volume. In addition, a $14.0 million loss was incurred related to the termination of a lease arrangement with a single purpose entity for First Horizon’s main office headquarters. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed.
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FTN Banking Groups
For the first six months of 2003, pre-tax income decreased 52 percent to $61.7 million from $128.3 million. Total revenues for the six-month period were $354.9 million, a decrease of 7 percent from $383.2 million in 2002. Total noninterest expense for the six-month period increased 14 percent to $258.1 million from $225.6 million in 2002. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed.
FTN Financial
For the first six months of 2003, pre-tax income increased 35 percent to $98.8 million from $73.4 million in 2002. Total revenues for the six-month period were $322.7 million, an increase of 48 percent from $218.0 million in 2002. Total noninterest expense for the six-month period increased 54 percent to $223.6 million from $145.3 million in 2002 primarily due to an increase of 54 percent in personnel expense resulting from commissions and incentives associated with the higher fee income this year. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed.
Transaction Processing
For the first six months of 2003, pre-tax income decreased 20 percent to $9.3 million from $11.6 million in 2002. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed.
Corporate
For the first six months of 2003, Corporate had a pre-tax loss of $45.6 million compared to a pre-tax loss of $31.5 million in 2002. Included in the pre-tax loss for 2003 is the $9.8 million contribution made to the First Tennessee Foundation and $12.4 million of expense related to modifications in and funding of an old deferred compensation plan, primarily for retirees. In 2002, $6.6 million of expense was related to a specific litigation matter.
INCOME STATEMENT REVIEW
Noninterest income for the first six months of 2003 was $1,066.8 million and contributed 73 percent to total revenue as compared to $661.5 million, or 65 percent of total revenues in 2002. Mortgage banking fee income increased 118 percent to $548.4 million from $251.2 million. During this period, fees from the mortgage origination process increased $295.0 million and MSR’s net hedge results increased $43.4 million compared to the first six months of 2002. Amortization of capitalized mortgage servicing rights increased 7 percent to $63.7 million from $59.6 million in 2002 and MSR’s impairment loss in 2003 was $114.8 million compared to $56.3 million in 2002. See Table 1 – Mortgage Banking for a breakout of noninterest income as well as mortgage banking origination volume and servicing portfolio levels. Fee income from capital markets increased 51 percent to $298.3 million from $197.8 million for 2002. For the first six months of 2003, fee income in deposit transactions and cash management grew 4 percent to $71.4 million from $68.8 million. Insurance premiums and commissions increased 14 percent to $29.7 million from $25.9 million in 2002. Trust services and investment management fees decreased 19 percent to $22.2 million from $27.4 million, and merchant-processing fees increased 16 percent to $26.4 million from $22.8 million. Security losses declined 23 percent to $1.8 million from $2.3 million in 2002. All other income and commissions increased 3 percent to $72.2 million from $69.9 million. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed.
Net interest income increased 9 percent to $393.2 million from $361.5 million for the first six months of 2002 while earning assets increased 26 percent to $20.6 billion from $16.4 billion in 2002. Year-to-date consolidated margin decreased to 3.83 percent in 2003 from 4.43 percent in 2002. The reasons for the year-to-date trends were similar to the quarterly trend information already discussed.
Total noninterest expense for the first six months of 2003 increased 49 percent to $1,051.8 million from $707.3 million in 2002. Personnel expense increased $241.1 million or 55 percent in 2003 primarily due to higher activity levels in First Horizon and FTN Financial. This increase also includes $11.7 million of expense related to modifications in and funding of an old deferred compensation plan, primarily for retirees. Occupancy expense increased 11 percent in 2003 to $39.4 million from $35.6 million in 2002 due to higher costs in First Horizon associated with the opening of new offices related to the increased origination volumes and the higher realty taxes in second quarter 2003. Equipment rentals, depreciation and maintenance expense increased 4 percent in 2003 to $33.8 million from $32.5 million in 2002.
32
Communications and courier expense increased 20 percent to $30.7 million in 2003 from $25.5 million in 2002 primarily due to the increased activity levels of First Horizon and FTN Financial. Operations services increased 19 percent to $35.1 million from $29.4 million in 2002. Amortization of intangible assets increased 19 percent to $3.5 million from $3.0 million in 2002. All other expense increased 62 percent to $228.0 million in 2003 from $141.1 million. Included in this increase was the $9.8 million contribution to the First Tennessee Foundation and a loss of $14.0 million related to the termination of a lease arrangement with a single purpose entity for First Horizon’s main office headquarters. Also contributing to the increase in all other expense was the growth in expense associated with higher activity levels in First Horizon and increased advertising and professional fee expense. The provision for loan losses increased 12 percent to $55.0 million from $49.2 million in the first six months of 2002. The effective tax rate decreased to 32.8 percent compared to 33.4 percent. Unless otherwise noted, the reasons for the year-to-date trends were similar to the quarterly trend information already discussed. See also Business Line Review for additional information.
BALANCE SHEET REVIEW
For the first six months of 2003, total assets averaged $24.2 billion compared with $19.7 billion in 2002. Average loans grew 15 percent to $11.9 billion from $10.4 billion for the first six months of 2002. Average commercial loans increased 6 percent to $5.8 billion compared $5.5 billion in 2002. Retail loans increased 25 percent to $6.1 billion in 2003 compared to $4.9 billion in 2002. Average investment securities increased 1 percent to $2.5 billion from $2.4 billion for 2002. Loans held for sale, consisting primarily of mortgage loans, increased 105 percent for the six-month period to $4.7 billion from $2.3 billion in 2002.
For the first six months of 2003, average core deposits increased 13 percent to $10.6 billion from $9.3 billion. While interest-bearing core deposits decreased 1 percent to $5.8 billion from $5.9 billion, noninterest-bearing deposits increased 36 percent to $4.7 billion from $3.5 billion in 2002. Short-term purchased funds increased 29 percent for the six-month period to $9.1 billion from $7.1 billion.
APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES
FTNC’s accounting policies are fundamental to understanding management’s discussion and analysis of financial condition and results of operations. The consolidated financial statements of FTNC are prepared in conformity with accounting principles generally accepted in the United States and follow general practices within the industries in which it operates. The preparation of the financial statements requires management to make certain judgments and assumptions in determining accounting estimates. Accounting estimates are considered critical if (a) the estimate requires management to make assumptions about matters that were highly uncertain at the time the accounting estimate was made, and (b) different estimates reasonably could have been used in the current period, or changes in the accounting estimate are reasonably likely to occur from period to period, that would have a material impact on the presentation of FTNC’s financial condition, changes in financial condition or results of operations.
It is management’s practice to discuss critical accounting policies with the Board of Directors’ Audit Committee, including the development, selection and disclosure of the critical accounting estimates. Management believes the following critical accounting policies are both important to the portrayal of the company’s financial condition and results of operations and require subjective or complex judgments. These judgments about critical accounting estimates are based on information available as of the date of the financial statements.
Mortgage Servicing Rights and Other Related Retained Interests
When First Horizon Home Loans sells mortgage loans in the secondary market to investors, it generally retains the right to service the loans sold in exchange for a servicing fee that is collected over the life of the loan as the payments are received from the borrower. The expected present value of the anticipated cash flows received for servicing the loan, net of the estimated costs of servicing the loan, is capitalized as MSR’s on the Consolidated Statements of Condition. In certain cases, when First Horizon Home Loans sells mortgage loans in the secondary market, it retains an interest in the mortgage loans sold primarily through interest-only certificates. Interest-only certificates are financial assets, which represent rights to receive earnings from serviced assets that exceed contractually specified servicing fees.
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MSR’s Estimated Fair Value
The fair value of MSR’s typically rises as market interest rates increase and declines as market interest rates decrease; however, the extent to which this occurs depends in-part on (1) the magnitude of changes in market interest rates, and (2) the differential between the then current market interest rates for mortgage loans and the mortgage interest rates included in the mortgage servicing portfolio.
Since sales of MSR’s tend to occur in private transactions and the precise terms and conditions of the sales are typically not readily available, there is a limited market to refer to in determining the fair value of MSR’s. As such, like other participants in the mortgage banking business, First Horizon Home Loans relies primarily on a discounted cash flow model to estimate the fair value of its MSR’s. This model calculates estimated fair value of the MSR’s using numerous tranches of MSR’s, which share similar key characteristics, such as interest rates, type of product (fixed vs. variable), age (new, seasoned, moderate), agency type and other factors. First Horizon Home Loans uses assumptions in the model that it believes are comparable to those used by other participants in the mortgage banking business and reviews estimated fair values and assumptions with third-party brokers and other service providers on a quarterly basis. First Horizon Home Loans also compares its estimates of fair value and assumptions to recent market activity and against its own experience.
Estimating the cash flow components of net servicing income from the loan and the resultant fair value of the MSR’s requires First Horizon Home Loans to make several critical assumptions based upon current market and loan production data.
Prepayment speeds: Generally, when market interest rates decline and other factors favorable to prepayments occur there is a corresponding increase in actual and expected borrower prepayments as customers refinance existing mortgages under more favorable interest rate terms. When a mortgage loan is prepaid, or is expected to prepay faster than originally expected, the anticipated cash flows associated with servicing that loan are terminated or reduced, resulting in a reduction, or impairment, to the fair value of the capitalized MSR’s. To estimate prepayment speeds, First Horizon Home Loans utilizes a third-party prepayment model, which is based upon statistically derived data linked to certain key principal indicators involving historical borrower prepayment activity associated with mortgage loans in the secondary market, current market interest rates and other factors. For purposes of model valuation, estimates are made for each product type within the MSR’s portfolio on a monthly basis.
Discount rate: Represents the rate at which the expected cash flows are discounted to arrive at the net present value of servicing income. Estimated discount rates will change with market conditions (i.e., supply vs. demand) and be reflective of the yields expected to be earned by market participants investing in MSR’s.
Cost to service: Expected costs to service are estimated based upon the costs that a market participant would use in evaluating the potential acquisition of MSR’s.
Float income: Estimated float income is driven by expected float balances (principal and interest payments that are held pending remittance to the investor) and current market interest rates, including the thirty day London Inter-Bank Offered Rate (LIBOR) and five-year swap interest rates, which are updated on a monthly basis for purposes of estimating the fair market value of MSR’s.
First Horizon Home Loans engages in a process referred to as “price discovery” on a monthly basis to assess the reasonableness of the estimated fair value of MSR’s. Price discovery is conducted through a process of obtaining the following information: (a) monthly informal valuation of the servicing portfolio by a prominent mortgage-servicing broker, and (b) a collection of surveys and benchmarking data available through third party participants in the mortgage banking business. Although there is no single source of market information that can be relied upon to assess the fair value of MSR’s, First Horizon Home Loans reviews all information obtained during price discovery to determine whether the estimated fair value of MSR’s is reasonable when compared to market information. On June 30, 2003 and 2002, based upon the information obtained through price discovery, First Horizon Home Loans determined that its MSR valuations and assumptions were reasonable based on the price discovery process.
The overall assessment of the estimated fair value of MSR’s is submitted monthly for review by the First Horizon Risk Management Committee (FHRMC). The FHRMC is responsible for approving the critical assumptions used by management to determine the estimated fair value of First Horizon Home Loans’ MSR’s. Each quarter, First Tennessee’s MSR’s Committee reviews the original valuation, impairment, and the initial capitalization rates for newly originated MSR’s. In addition, the Executive Committee of First Tennessee’s board of directors reviews the initial capitalization rates and approves the calculation of amortization expense.
MSR’s are included on the Consolidated Statements of Condition, net of accumulated amortization. The changes in fair value of MSR’s are included as a component of Mortgage Banking – Noninterest Income on the Consolidated Statements of Income.
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Hedging the Fair Value of MSR’s
In order to provide protection from a decline in the fair value of MSR’s, First Horizon Home Loans employs a hedging strategy. This strategy uses derivative financial instruments expected to change in fair value in response to changes in a certain benchmark interest rate (specifically, the 10-year LIBOR) in amounts which will substantially offset the change in fair value of certain MSR’s. On June 30, 2003 and 2002, hedged MSR’s approximated 92 percent and 95 percent of the total MSR’s portfolio, as measured on a dollar at risk basis. In order to substantially hedge the change in fair value of the hedged MSR’s, First Horizon Home Loans generally maintains a coverage ratio (the ratio of the notional amount of derivatives to the carrying amount of the hedged MSR’s) approximating 100 percent of the hedged MSR’s portfolio. As noted above, to the extent that actual borrower prepayments do not react as anticipated by the prepayment model (i.e., the historical data observed in the model does not correspond to actual market activity), it is possible that the prepayment model could fail to accurately predict mortgage prepayments and could result in significant earnings volatility. Pursuant to SFAS No. 133, in any hedge period the difference between the change in fair value of the hedged MSR’s, attributed to the change in the benchmark interest rate, and the change in fair value of the derivatives used to hedge the change in fair value of the MSR’s is recognized as gains or losses in current earnings. First Horizon Home Loans generally attempts to hedge 100 percent of the exposure to a change in the fair value of the hedged MSR’s attributed to a change in the benchmark interest rate, which requires a regular assessment of the amount of derivative financial instruments required to maintain a 100 percent hedge ratio. On June 30, 2003 and 2002, the hedge coverage ratio was approximately 100 percent of the hedged MSR’s portfolio.
Certain components of the fair value of derivatives used to hedge certain MSR’s are excluded from the assessment of hedge effectiveness. Although those amounts are excluded from the assessment of hedge effectiveness, they are included as a component of current earnings in the Consolidated Statements of Income.
The derivative financial instruments used to hedge the change in fair value of hedged MSR’s primarily include interest rate floors, interest rate swaps, swaptions and forward purchase contracts of mortgage backed securities (known as “to be announced” mortgage backed securities, or TBA’s).
First Horizon Home Loans generally experiences increased loan origination and production in periods of low interest rates, which result in the capitalization of new MSR’s associated with new production – this provides for a “natural hedge” in the mortgage banking business cycle. The “replenishment rate” during 2003 – meaning the ratio of new loans originated for every existing customer mortgage loan that prepays – was almost two to one, which includes the retention of existing First Horizon Home Loans customers who prepay their mortgage loans. First Horizon Home Loans capitalized $127.4 million of MSR’s during second quarter 2003, thereby providing a significant offset to the impairment charges recognized related to MSR’s. This new production volume contributed significantly to the overall positive results experienced during 2003, despite significant prepayments and MSR’s impairment charges. New production and origination does not prevent First Horizon Home Loans from recognizing impairment expense on existing servicing rights as a result of prepayments; rather, the new production volume results in loan origination fees and the capitalization of MSR’s as a component of realized gains related to the sale of such loans in the secondary market, thus the “natural hedge” which tends to offset a portion of the MSR’s impairment charges during a period of low interest rates. In a period of increased borrower prepayments, impairment can be significantly offset by a strong replenishment rate and strong net margins on new loan originations. To the extent that First Horizon Home Loans is unable to maintain a strong replenishment rate, or in the event that the net margin on new loan originations declines from historical experience, the value of the natural hedge may diminish, thereby significantly impacting the results of operations in a period of increased borrower prepayments.
First Horizon Home Loans does not specifically hedge the change in fair value of MSR’s attributed to other risks, including anticipated prepayments (representing the difference between actual prepayment experience and estimated prepayments derived from the model, as described above), basis risk (meaning, the risk that changes in the benchmark interest rate may not correlate to changes in the mortgage market interest rates), discount rates, cost to service and other factors. To the extent that these other factors result in changes to the fair value of MSR’s, First Horizon Home Loans experiences volatility in current earnings due to the fact that these risks are not currently hedged.
Actual vs. Estimated MSR’s Critical Assumptions
As discussed above, the estimate of the cash flow components of net servicing income associated with MSR’s requires management to make several critical assumptions based upon current market and loan production data, including prepayment speeds, discount rate, cost to service and float income. Inherent in estimating such assumptions are uncertainties associated with the mortgage banking business (primarily, the change in market interest rates which vary significantly due to multiple economic and non-economic factors) as well as the composition of the MSR’s portfolio, which is not static and changes significantly based upon the production and sale of new loans, customer prepayment experience and other factors. As a result, the estimated assumptions used to value MSR’s – particularly the estimate of prepayment speeds – can vary significantly from actual experience, resulting in the recognition of additional impairment charges in current earnings. Table 7 provides a summary of actual and estimated weighted average prepayment speeds and float income used in determining the estimated fair value of MSR’s for the quarters ended June 30, 2003 and 2002. Although the estimates of discount rates and cost to service assumptions used in determining the estimated fair value of MSR’s can vary from actual experience, such differences have not been material for the quarters ended June 30, 2003 and 2002.
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Table 7 - MSR’s Critical Assumptions
| | Three Months Ended
June 30 | |
| |
| |
(Dollars in millions) | | 2003 | | 2002 | |
|
|
|
|
| |
Prepayment speeds | | | | | |
Actual | | 59.9 | % | 34.0 | % |
Estimated* | | 69.1 | | 29.0 | |
Float income | | | | | |
Actual | | 11.2 | | 8.9 | |
Estimated | | 8.6 | | 8.8 | |
|
|
|
|
| |
| * | Estimated prepayment speeds represent monthly average prepayment speed estimates for each of the periods presented. |
During the quarter ended June 30, 2003 and 2002, impairment charges associated with MSR’s of $72.3 million and $24.9 million, respectively, were recognized, which were principally associated with differences between actual and estimated prepayment speeds and other factors, including basis risk associated with benchmark interest rates and actual float income earnings. The decrease in value of MSR’s was partially offset by an increase in fair value of the derivative financial instruments used to hedge the change in fair value of the hedged MSR’s (see Table 1 – Mortgage Banking).
Interest-Only Certificates Fair Value
Consistent with MSR’s, the fair value of an interest-only certificate typically rises as market interest rates increase and declines as market interest rates decrease. Additionally, similar to MSR’s, the market for interest-only certificates is limited, and the precise terms of transactions involving interest-only certificates are not typically readily available. Accordingly, First Horizon Home Loans relies primarily on a discounted cash flow model to estimate the fair value of its interest-only certificates.
Estimating the cash flow components and the resultant fair value of the interest-only certificates requires First Horizon Home Loans to make certain critical assumptions based upon current market and loan production data. The primary critical assumptions used by First Horizon Home Loans to estimate the fair value of interest-only securities include prepayment speeds and discount rates, as discussed above. First Horizon Home Loans interest-only certificates are included as a component of trading securities on the Consolidated Statements of Condition, with realized and unrealized gains and losses included in current earnings as a component of mortgage banking income on the Consolidated Statements of Income.
Hedging the Fair Value of Interest-Only Certificates
First Horizon Home Loans employs an economic hedging strategy for interest-only certificates, which uses derivative financial instruments expected to change in fair value in response to changes in a certain benchmark interest rate (specifically, the 10-year LIBOR) in amounts which will substantially offset the change in fair value of certain interest-only certificates. Realized and unrealized gains and losses associated with the change in fair value of derivatives used in the economic hedge of interest-only certificates are included in current earnings on the Consolidated Statements of Income. The extent to which the change in fair value of interest-only securities is offset by the change in fair value of the derivatives used to hedge these instruments depends primarily on the hedge coverage ratio maintained by First Horizon Home Loans. Also, as noted above, to the extent that actual borrower prepayments do not react as anticipated by the prepayment model (i.e., the historical data observed in the model does not correspond to actual market activity), it is possible that the prepayment model could fail to accurately predict mortgage prepayments, which could significantly impact First Horizon Home Loans’ ability to effectively hedge certain components of the change in fair value of interest-only certificates and could result in significant earnings volatility. The derivative financial instruments used to hedge the change in fair value of hedged interest-only certificates primarily include interest rate floors, interest rate swaps, swaptions and TBA’s.
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Pipeline and Warehouse
During the period of loan origination, and prior to the sale of mortgage loans in the secondary market, First Horizon Home Loans has exposure to mortgage loans that are in the “mortgage pipeline” and the “mortgage warehouse”. The mortgage pipeline consists of loan applications that have been received, but have not yet closed as loans. Pipeline loans are either “floating” or “locked”. A floating pipeline loan is one on which an interest rate has not been locked by the borrower. A locked pipeline loan is one on which the potential borrower has set the interest rate for the loan by entering into an IRLC resulting in interest rate risk to First Horizon Home Loans. Once a mortgage loan is closed and funded, it is included within the mortgage warehouse, or the “inventory” of mortgage loans that are awaiting sale and delivery (currently an average of approximately 30 days) into the secondary market. First Horizon Home Loans is exposed to credit risk during the short period a mortgage loan is in the warehouse.
An IRLC binds First Horizon Home Loans to lend funds to the potential borrower at the set interest rate, which expires on a fixed date regardless of whether or not interest rates change in the market. IRLC’s generally have a term of up to 60-days before the closing of the loan. The IRLC, however, does not bind the potential borrower to entering into the loan, nor does it guarantee that First Horizon Home Loans will approve the potential borrower for the loan. Therefore, First Horizon Home Loans makes estimates of expected “fallout” (locked pipeline loans not expected to close) using models, which consider cumulative historical fallout rates and other factors. Fallout can occur for a variety of reasons including falling rate environments when a borrower will abandon an IRLC at one lender and enter into a new lower IRLC at another, when a borrower is not approved as an acceptable credit by the lender, or for a variety of other non-economic reasons. Note that once a loan is closed, the risk of fallout is eliminated and the associated mortgage loan is included in the mortgage loan warehouse. Under SFAS No. 133, IRLC’s qualify as derivative financial instruments and, therefore, the changes in fair value of IRLC’s are included in current earnings in the Consolidated Statements of Income. Third party models are also used to manage interest rate risk related to price movements on loans in the pipeline and the warehouse.
Like other participants in the mortgage banking business, First Horizon Home Loans relies primarily on an internal valuation model and one of several industry valuation techniques to estimate the fair value of IRLC’s and the mortgage warehouse. This model calculates the estimated fair value using tranches of mortgage loans that are determined to share similar key characteristics, including product type and interest rate bands. For purposes of determining the market interest rates for forward commitments to sell mortgage loans in the secondary market, First Horizon Home Loans obtains market interest rates from independent third parties, which represent actual trade activity in the secondary market. For purposes of determining the fair value of IRLC’s, management utilizes the median broker price information obtained in the secondary market, resulting in an asset with an estimated fair value of $27.4 million and an asset of $22.5 million on June 30, 2003 and 2002, respectively.
To hedge against changes in fair value of the mortgage pipeline and warehouse due to changes in interest rates, First Horizon Home Loans utilizes various derivative financial instruments, which management expects will experience changes in fair value opposite to the change in fair value of the loans in the pipeline and warehouse, thus minimizing earnings volatility. The instruments and techniques used to hedge the pipeline and warehouse include forward sales commitments and other interest rate derivatives. The extent to which First Horizon Home Loans is able to economically hedge changes in the mortgage pipeline depends largely on the hedge coverage ratio that is maintained relative to mortgage loans in the pipeline. The hedge ratio can change significantly due to changes in market interest rates and the associated forward commitment prices for sales of mortgage loans in the secondary market. Increases or decreases in the hedge coverage ratio can result in significant earnings volatility to First Horizon Home Loans. First Horizon Home Loans does not specifically hedge the change in fair value of the mortgage pipeline attributed to other risks, including basis risk and other factors.
Foreclosure Reserves
As discussed above, First Horizon Home Loans typically originates mortgage loans with the intent to sell those loans to GSE’s and other private investors in the secondary market. Certain of the mortgage loans are sold with limited or full recourse in the event of foreclosure. On June 30, 2003 and 2002, approximately $4.0 billion and $4.8 billion of mortgage loans were outstanding which were sold under limited recourse arrangements. On June 30, 2003 and 2002, approximately $140.5 million and $210.6 million of mortgage loans were outstanding which were sold under full recourse arrangements.
Loans sold with limited recourse include loans sold under government guaranteed mortgage loan programs including Department of Housing and Urban Development (HUD), Federal Housing Administration (FHA) and Veterans Administration (VA). First Horizon Home Loans continues to absorb limited risk of credit losses in the event of foreclosure of the mortgage loan sold. Generally, the amount of recourse liability in the event of foreclosure is determined based upon the respective government program and/or the sale or disposal of the foreclosed property collateralizing the mortgage loan. Another instance of limited recourse is the VA/No bid. In this case, the VA guarantee is limited and First Horizon Home Loans may be required to fund any deficiency in excess of the VA guarantee if the loan goes to foreclosure.
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Loans sold with full recourse generally include mortgage loans sold to investors in the secondary market which are uninsurable under government guaranteed mortgage loan programs, due to issues associated with underwriting activities, documentation or other concerns.
Management closely monitors historical experience, borrower payment activity, current economic trends and other risk factors, and establishes a reserve for foreclosure losses for loans sold with limited and full recourse which management believes is sufficient to cover incurred foreclosure losses in the portfolio. The reserve for foreclosure losses is based upon a historical progression model using a rolling 12-month average, which predicts the probability of a mortgage loan entering foreclosure. In addition, other factors are considered, including qualitative and quantitative factors (e.g., current economic conditions, past collection experience, risk characteristics of the current portfolio and other factors), which are not defined by historical loss trends. On June 30, 2003 and 2002, the foreclosure reserve was $31.3 million and $30.2 million, respectively.
Allowance for Loan Losses
Management’s policy is to maintain the allowance for loan losses at a level sufficient to absorb estimated probable incurred losses in the loan portfolio. Management performs periodic and systematic detailed reviews of its loan portfolio to identify trends and to assess the overall collectibility of the loan portfolio. Accounting standards require that loan losses be recorded when management determines it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. Management believes the accounting estimate related to the allowance for loan losses is a “critical accounting estimate” because: changes in it can materially affect the provision for loan losses and net income, it requires management to predict borrowers’ likelihood or capacity to repay, and it requires management to distinguish between losses incurred as of a balance sheet date and losses expected to be incurred in the future. Accordingly, this is a highly subjective process and requires significant judgment since it is often difficult to determine when specific loss events may actually occur. This critical accounting estimate applies primarily to the First Tennessee Banking Group, First Horizon and FTN Financial business segments.
FTNC’s methodology for estimating the allowance for loan losses is not only critical to the accounting estimate, but to the credit risk management function as well. Key components of the estimation process are as follows: (1) commercial loans determined by management to be individually impaired loans are evaluated individually and specific reserves are determined based on the difference between the outstanding loan amount and the estimated net realizable value of the collateral (if collateral dependent) or the present value of expected future cash flows; (2) individual commercial loans not considered to be individually impaired are segmented based on similar credit risk characteristics and evaluated on a pool basis; (3) retail loans are segmented based on loan types; (4) reserve rates for each portfolio segment are calculated based on historical charge-offs and are adjusted by management to reflect current events, trends and conditions (including economic factors and trends); and (5) management’s estimate of probable incurred losses reflects the reserve rate applied against the balance of loans in each segment of the loan portfolio.
Principal loan amounts are charged off against the allowance for loan losses in the period in which the loan or any portion of the loan is deemed to be uncollectible.
FTNC believes that the critical assumptions underlying the accounting estimate made by management include: (i) the commercial loan portfolio has been properly risk graded based on information about borrowers in specific industries and specific issues with respect to single borrowers; (ii) borrower specific information made available to FTNC is current and accurate; (iii) the loan portfolio has been segmented properly and individual loans have similar credit risk characteristics and will behave similarly; (iv) all known significant loss events have been considered at the time of assessing the adequacy of the allowance for loan losses; (v) the economic factors utilized in the allowance for loan losses estimate are used as a measure of actual incurred losses; (vi) the period of history used for historical loss factors is indicative of the current environment; and (vii) the reserve rates, as well as other adjustments estimated by management for current events, trends, and conditions, utilized in the process reflect an estimate of losses that have been incurred as of the date of the financial statements.
While management uses the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses and methodology may be necessary if economic or other conditions differ substantially from the assumptions used in making the estimates or, if required by regulators, based upon information at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels vary from previous estimates.
In first quarter 2002, management allocated as a component of its allowance for loan losses a general reserve to reflect management’s estimate of additional probable losses that have been incurred but not specifically identified in the commercial portfolio. This reserve helped to minimize the risks related to the margin of imprecision inherent in the estimation of the allowance for loan losses and provided for other factors not considered in computation of reserve rates applied to loan pools. As of December 31, 2002, management decided to specifically quantify risks previously identified and provided for by the general reserve and adjust reserve rates accordingly to reserve for these items in the appropriate pools, and no longer separately presents a general reserve as a component of the allowance for loan losses. As a result of this decision, management has presented the prior period reserves to reflect this methodology change. Except as noted in this paragraph, there have been no significant changes to the methodology for the quarters ended June 30, 2003 and 2002.
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Goodwill and Assessment of Impairment
FTNC’s policy is to assess goodwill for impairment at the reporting unit level on an annual basis or between annual assessments if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. Accounting standards require management to estimate the fair value of each reporting unit in making the annual assessment of impairment. Upon adoption of the new accounting standards on January 1, 2002, goodwill is no longer amortized with a periodic charge to earnings. FTNC performed the initial impairment test as of January 1, 2002. Subsequent to the initial evaluation, the annual impairment test will be performed each year as of October 1. The valuations as of January 1, 2002, and October 1, 2002, indicated no goodwill impairment for any of the reporting units.
Management believes the accounting estimates associated with determining fair value as part of the goodwill impairment test is a “critical accounting estimate” because estimates and assumptions are made about FTNC’s future performance and cash flows, as well as other prevailing market factors (interest rates, economic trends, etc.). FTNC’s policy allows management to make the determination of fair value using internal cash flow models or by engaging independent third parties. If a charge to operations for impairment results, this amount would be reported separately as a component of noninterest expense. This critical accounting estimate applies to the First Tennessee Banking Group, First Horizon, FTN Financial, and Transaction Processing business segments. Reporting units have been defined as the same level as the operating business segments.
The impairment testing process conducted by FTNC begins by assigning net assets and goodwill to each reporting unit. FTNC then completes “step one” of the impairment test by comparing the fair value of each reporting unit (as determined based on the discussion below) with the recorded book value (or “carrying amount”) of its net assets, with goodwill included in the computation of the carrying amount. If the fair value of a reporting unit exceeds its carrying amount, goodwill of that reporting unit is not considered impaired, and “step two” of the impairment test is not necessary. If the carrying amount of a reporting unit exceeds its fair value, step two of the impairment test is performed to determine the amount of impairment. Step two of the impairment test compares the carrying amount of the reporting unit’s goodwill to the “implied fair value” of that goodwill. The implied fair value of goodwill is computed by assuming all assets and liabilities of the reporting unit would be adjusted to the current fair value, with the offset as an adjustment to goodwill. This adjusted goodwill balance is the implied fair value used in step two. An impairment charge is recognized for the amount by which the carrying amount of goodwill exceeds its implied fair value.
As noted above, a key estimate made by management during the assessment of impairment is the fair value of each reporting unit. During first quarter 2002, FTNC engaged an independent valuation firm to compute the fair value estimates of each reporting unit as part of its initial impairment assessment as of January 1, 2002. The independent valuation utilized three separate valuation methodologies and applied a weighted average to each methodology in order to determine fair value for each reporting unit. As of October 1, 2002, FTNC performed an internal analysis of each reporting unit to determine whether impairment existed at that date.
In connection with obtaining the independent valuation, management provided certain data and information that was utilized by the third party in their determination of fair value. This information included the 2002 budget and forecasted earnings of FTNC. Management believes that this information is a critical assumption underlying the estimate of fair value. The independent third party made other assumptions critical to the process, including discount rates, asset and liability growth rates, and other income and expense estimates, through discussions with management.
While management uses the best information available to estimate future performance for each reporting unit, future adjustments to management’s projections may be necessary if economic conditions differ substantially from the assumptions used in making the estimates.
Contingent Liabilities
A liability is contingent if the amount is not presently known, but may become known in the future as a result of the occurrence of some uncertain future event. FTNC estimates its contingent liabilities based on management’s estimates about the probability of outcomes and their ability to estimate the range of exposure. Accounting standards require that a liability be recorded if management determines that it is probable that a loss has occurred and the loss can be reasonably estimated. In addition, it must be probable that the loss will be confirmed by some future event. As part of the estimation process, management is required to make assumptions about matters that are by their nature highly uncertain.
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The assessment of contingent liabilities, including legal contingencies and income tax liabilities, involves the use of critical estimates, assumptions and judgments. Management’s estimates are based on their belief that future events will validate the current assumptions regarding the ultimate outcome of these exposures. However, there can be no assurance that future events, such as court decisions or I.R.S. positions, will not differ from management’s assessments. Whenever practicable, management consults with third party experts (attorneys, accountants, claims administrators, etc.) to assist with the gathering and evaluation of information related to contingent liabilities. Based on internally and/or externally prepared evaluations, management makes a determination whether the potential exposure requires accrual in the financial statements.
OTHER
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
SFAS No. 133, which was adopted on January 1, 2001, establishes accounting standards requiring that every derivative instrument be recorded on the balance sheet as either an asset or liability measured at its fair value. It requires that changes in the instrument’s fair value be recognized currently in earnings (or other comprehensive income). If certain criteria are met, changes in the fair value of the asset or liability being hedged are also recognized currently in earnings. The initial impact of adopting SFAS No. 133 resulted in a net transition adjustment that was recognized as the cumulative effect of a change in accounting principle.
Fair value is determined on the last business day of a reporting period. This point in time measurement of derivative fair values and the related hedged item fair values may be well suited to the measurement of hedge effectiveness, as well as reported earnings, when hedge time horizons are short. The same measurement however may not consistently reflect the effectiveness of longer-term hedges and, in FTNC’s view, can distort short-term measures of reported earnings. FTNC uses a combination of derivative financial instruments to hedge certain components of the interest rate risk associated with its portfolio of capitalized MSR’s, which currently have an average life of approximately three years. Over this long-term time horizon this combination of derivatives can be effective in significantly mitigating the effects of interest rate changes on the value of the servicing portfolio. However, these derivative financial instruments can and do demonstrate significant price volatility depending upon prevailing conditions in the financial markets. If a reporting period ends during a period of volatile financial market conditions, the effect of such point in time conditions on reported earnings does not reflect the underlying economics of the transactions or the true value of the hedges to FTNC over their estimated lives. The fact that the fair value of a particular derivative is unusually low or high on the last day of the reporting period is meaningful in evaluating performance during the period only if FTNC sells the derivative within the period of time before fair value changes and does not replace the hedge coverage with another derivative. FTNC believes the effect of such volatility on short-term measures of earnings is not indicative of the expected long-term performance of this hedging practice.
FTNC believes a review of the trend, if any, of the servicing rights net value changes under SFAS No. 133 over a long period of time, preferably over an interest rate business cycle, is a more meaningful measure to determine the effectiveness of hedging strategies.
For its internal evaluation of performance, for an applicable period, FTNC reclassifies select components of SFAS 133 hedge ineffectiveness from the reported net income of the First Horizon segment to the Corporate segment. The internal evaluation of long-term performance will include the long-term trend, if any, in these select components of SFAS 133 hedge ineffectiveness.
FURTHER INTERPRETATIONS OF SFAS NO. 133
Certain provisions of SFAS No. 133 continue to undergo significant discussion and debate by the Financial Accounting Standards Board (FASB). One such potential issue involves the assessment of hedge effectiveness (and its impact on qualifying for hedge accounting) when hedging fair value changes of prepayable assets due to changes in the benchmark interest rate. As the FASB continues to deliberate interpretation of the new rules, the potential exists for a difference between FTNC’s interpretation and that of the FASB, the effects of which cannot presently be anticipated but failure to obtain hedge accounting treatment could be significant to results of operations.
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ACCOUNTING CHANGES
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” which requires certain financial instruments with both liability and equity characteristics to be classified as liabilities on the Consolidated Statement of Condition. The statement updates the accounting for certain financial instruments that, under previous guidance, registrants could account for as equity. This statement is effective on July 1, 2003, and restatement of prior periods is not permitted. Upon adoption of this statement, FTNC expects to classify its mandatorily redeemable financial instruments (preferred stock of subsidiary ($44.4 million on June 30, 2003) and guaranteed preferred beneficial interests in First Tennessee’s junior subordinated debentures ($100.0 million on June 30, 2003)) as liabilities on the Consolidated Statement of Condition. Historically, the related distributions on these instruments ($12.6 million anually) have been classified as noninterest expense on the Consolidated Statements of Income and will be classified as interest expense on a prospective basis.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments”, which amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”. The provisions of SFAS No. 149 are effective for quarters beginning after June 15, 2003. The impact of adopting this standard will be immaterial to results of future operations.
In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities”, which requires consolidation by a business enterprise of variable interest entities. This interpretation applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. While certain implementation issues related to this standard continue to undergo interpretation, the impact at implementation of adopting this standard will be immaterial to the results of future operations.
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Item 3. Quantitative and Qualitative Disclosures about Market Risk
The information called for by this Item is contained in (a) Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 2 of this report at pages 18 through 41, (b) the Section entitled “Risk Management-Interest Rate Risk Management” of the Management’s Discussion and Analysis of Results of Operations and Financial Condition section of the Financial Appendix to First Tennessee’s 2003 Proxy Statement at pages F-38 through F-42 and (c) the “Interest Rate Risk Management” subsection of Note 1 to FTNC’s consolidated financial statements at pages F-65 through F-66 of the Financial Appendix to FTNC’s 2003 Proxy Statement, and which information is incorporated herein by reference.
Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures. FTNC’s management, with the participation of FTNC’s chief executive officer and chief financial officer, has evaluated the effectiveness of the design and operation of FTNC’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this quarterly report. Based on that evaluation, the chief executive officer and chief financial officer have concluded that FTNC’s disclosure controls and procedures are effective to ensure that material information relating to FTNC and FTNC’s consolidated subsidiaries is made known to such officers by others within these entities, particularly during the period this quarterly report was prepared, in order to allow timely decisions regarding required disclosure.
(b) Changes in Internal Control over Financial Reporting. There have not been any changes in FTNC’s internal control over financial reporting during FTNC’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, FTNC’s internal control over financial reporting.
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Part II.
OTHER INFORMATION
Items 1, 2 and 3
As of the end of the second quarter 2003, the answers to Items 1, 2 and 3 were either inapplicable or negative, and therefore, these items are omitted.
| Item 4 | Submission of Matters to Vote of Security Holders |
| (a) | The Corporation’s annual Meeting of Shareholders was held April 15, 2003. |
| (b) | Proxies for the Annual Meeting were solicited pursuant to Regulation 14 under the Securities Exchange Act of 1934. There were no solicitations in opposition to management’s nominees for election to Class I (Messrs. Martin, Sansom and Ward and Ms. Palmer). The Class I nominees were elected for a three-year term or until their respective successors are duly elected and qualified. Directors continuing in office are Messrs. Blattberg, Cates, Glass, Haslam, Horn, Rose and Yancy. |
| (c) | At the Annual Meeting, the shareholders also approved the 2003 Equity Compensation Plan and ratified the appointment of KPMG LLP as auditors. The shareholder vote was as follows: |
Class I Nominees | | For | | | | Withheld | |
| |
| | | |
| |
R. Brad Martin | | 104,354,122 | | | | 4,733,650 | |
Vicki R. Palmer | | 104,326,967 | | | | 4,760,805 | |
William B. Sansom | | 107,443,606 | | | | 1,644,166 | |
Jonathan P. Ward | | 107,370,771 | | | | 1,717,001 | |
| | For | | Withheld | | Abstained | |
| |
| |
| |
| |
2003 Equity Compensation Plan | | 92,804,561 | | 14,512,744 | | 1,770,467 | |
Ratification of Appointment of Auditors | | 105,984,079 | | 1,956,442 | | 1,147,251 | |
There were no “broker non-votes” with respect to any of the nominees, the 2003 Equity Compensation Plan, or the ratification of the appointment of the auditors and no abstentions with respect to any of the nominees.
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Item 5 Other Information
1) Debt Repurchase
On August 8, 2003, FTNC completed its tender offer for its 6.75% November 2005 subordinated debt by purchasing $52.1 principal amount (of $75.0 million outstanding on June 30, 2003). Form 8-K filed July 30, 2003, provides further details.
2) Blackout Notice
The following information is provided in lieu of a filing on Form 8-K, Item 11 [Temporary Suspension of Trading under Registrant’s Employee Benefit Plans], and is reported herein under this Item 5 in accordance with the instructions in SEC Release No. 2003-41.
On July 3, 2003, the Corporation provided notice to its directors and executive officers that the Corporation was moving the recordkeeping administration of its Savings Plan and Trust (the “Plan”) to another provider and that, as a result of the transition to the new provider, participants in the Plan would be restricted in their ability to make changes under the Plan for a period of time (the “blackout period”). Section 306 of the Sarbanes-Oxley Act of 2002 restricts certain transactions in the Corporation’s common stock by directors and executive officers when a blackout period occurs with respect to plans such as the Corporation’s Plan.
The following notice was provided to the Corporation’s directors and executive officers:
Notice of Trading Restrictions on First Tennessee National Corporation Common Stock under the Sarbanes-
Oxley Act of 2002 (July 3, 2003)
This Notice is provided to you pursuant to Section 306(a)(6) of the Sarbanes-Oxley Act of 2002. Under the Sarbanes-Oxley Act, it is unlawful for any director or executive officer of First Tennessee National Corporation or their affiliates to buy, sell or otherwise acquire or transfer any First Tennessee Common Stock, whether directly or indirectly, during a “blackout period” which suspends the ability of participants in the First Tennessee National Corporation Savings Plan and Trust (the “Plan”) to make trades in First Tennessee Common Stock. This prohibition applies to any First Tennessee Common Stock that you now have or may receive in connection with your service or employment as a director or executive officer.
Please be on notice that a “blackout period” is going into effect during which you are prohibited by law from making the transactions in First Tennessee Common Stock described above.
The blackout period will begin on the close of business July 31, 2003, and it is expected to end sometime during the week of September 15, 2003. During the week of September 15, 2003, you may obtain, free of charge, information as to whether the blackout period has ended by contacting Bill Schwindt at wjschwindt@firsttennessee.com or (901)523-5317.
This blackout period is imposed in connection with the conversion of the Plan to a new recordkeeper. The class of equity securities subject to the blackout period is First Tennessee Common Stock.
If you have any questions about the blackout period or this Notice, please contact Gardiner Gruenewald at ggruenewald@firsttennessee.com or (901) 523-5909.
During the blackout period and for two years after the end of the blackout period, a security holder or other interested person may obtain, without charge, the actual beginning and ending dates of the blackout period by contacting Bill Schwindt.
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No notification of the blackout period was required to be given to the Corporation under Section 101(i)(2)(E) of ERISA because the Corporation participated in the determination of the blackout period.
| Item 6 | Exhibits and Reports on Form 8-K. |
(a) Exhibits.
Exhibit No. | Description |
| |
4 | Instruments defining the rights of security holders, including indentures* |
| |
**10(h) | Directors and Executives Deferred Compensation Plan, as amended and restated. |
| |
**10(n) | Non-Employee Directors’ Deferred Compensation Stock Option Plan, as amended and restated. |
| |
**10(r) | 2003 Equity Compensation Plan, incorporated herein by reference to Appendix A to the Corporation’s Proxy Statement furnished to shareholders in connection with the annual meeting on April 15, 2003, filed March 18, 2003. |
| |
31(a) | Rule 13a-14(a) Certifications of CEO (pursuant to Section 302 of the Sarbanes-Oxley Act of 2002) |
| |
31(b) | Rule 13a-14(a) Certifications of CFO (pursuant to Section 302 of the Sarbanes-Oxley Act of 2002) |
| |
32(a) | Rule 1350 Certifications of CEO (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) |
| |
32(b) | Rule 1350 Certifications of CFO (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) |
| |
99(a) | The “Risk Management-Interest Rate Risk Management” subsection of the Management’s Discussion and Analysis of Results of Operations and Financial Condition section and the “Interest Rate Risk Management” subsection of Note 1 to FTNC’s consolidated financial statements, contained, respectively, at pages F-38 through F-42 and pages F-65 through F-66, in the Financial Appendix to FTNC’s 2003 Proxy Statement furnished to shareholders in connection with the Annual Meeting of Shareholders on April 15, 2003, filed March 18, 2003, and incorporated herein by reference. |
| |
| * | The Corporation agrees to furnish copies of the instruments, including indentures, defining the rights of the holders of the long-term debt of the Corporation and its consolidated subsidiaries to the Securities and Exchange Commission upon request. |
| ** | This is a management contract or compensatory plan required to be filed as an exhibit. |
(b) Reports on Form 8-K.
The following reports on Form 8-K, with the Date of Report as indicated, were filed during second quarter 2003:
| 1. | 4-14-03 - Item 9: earnings release for first quarter 2003 was furnished. |
| 2. | 5-07-03 - Item 5: computation of ratio of earnings to fixed charges for 5 years ended 12-31-02 was filed. |
| 3. | 5-12-03 - Item 5: underwriting agreement, terms agreement, supplemental indenture, and form of security related to $100 million of 4.50% subordinated notes due 5-15-03 were filed. |
| 4. | 6-09-03 - Item 5: reconciliation of non-GAAP financial measures incorporated into 2002 Form 10-K from financial appendix to 2003 proxy statement was filed. |
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | FIRST TENNESSEE NATIONAL CORPORATION
(Registrant) |
| | By: |
/s/ James F. Keen
|
| | | |
|
| | | James F. Keen |
DATE: 8/11/03 | | Executive Vice President,
Chief Financial Officer and
Corporate Controller
(Duly Authorized Officer and
Principal Financial Officer) |
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EXHIBIT INDEX
Exhibit No. | Description |
| |
4 | Instruments defining the rights of security holders, including indentures* |
| |
**10(h) | Directors and Executives Deferred Compensation Plan, as amended and restated. |
| |
**10(n) | Non-Employee Directors’ Deferred Compensation Stock Option Plan, as amended and restated. |
| |
**10(r) | 2003 Equity Compensation Plan, incorporated herein by reference to Appendix A to the Corporation’s Proxy Statement furnished to shareholders in connection with the annual meeting on April 15, 2003, filed March 18, 2003. |
| |
31(a) | Rule 13a-14(a) Certifications of CEO (pursuant to Section 302 of the Sarbanes-Oxley Act of 2002) |
| |
31(b) | Rule 13a-14(a) Certifications of CFO (pursuant to Section 302 of the Sarbanes-Oxley Act of 2002) |
| |
32(a) | Rule 1350 Certifications of CEO (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) |
| |
32(b) | Rule 1350 Certifications of CFO (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002) |
| |
99(a) | The “Risk Management-Interest Rate Risk Management” subsection of the Management’s Discussion and Analysis of Results of Operations and Financial Condition section and the “Interest Rate Risk Management” subsection of Note 1 to FTNC’s consolidated financial statements, contained, respectively, at pages F-38 through F-42 and pages F-65 through F-66, in the Financial Appendix to FTNC’s 2003 Proxy Statement furnished to shareholders in connection with the Annual Meeting of Shareholders on April 15, 2003, filed March 18, 2003, and incorporated herein by reference. |
| |
| * | The Corporation agrees to furnish copies of the instruments, including indentures, defining the rights of the holders of the long-term debt of the Corporation and its consolidated subsidiaries to the Securities and Exchange Commission upon request. |
| ** | This is a management contract or compensatory plan required to be filed as an exhibit. |
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