Exhibit 13
(Form 10-K)
CITIZENS BANKING CORPORATION
2003 ANNUAL REPORT INFORMATION
CITIZENS BANKING CORPORATION
2003 ANNUAL REPORT INFORMATION
This report contains information required to be included in an annual report
pursuant to the rules of the Securities and Exchange Commission, including
audited financial statements, management's discussion and analysis of financial
condition and results of operations and five year selected financial data. Upon
request, Citizens Banking Corporation will provide without charge a copy of its
annual report on Form 10-K.
TABLE OF CONTENTS
I. Financial Review including Management's Discussion and Analysis
Management's Discussion and Analysis ................................... 34
Five Year Summary of Selected Financial Data ....................... 34
Forward-Looking Statements ......................................... 35
Overview ........................................................... 36
Summary of Financial Results ....................................... 37
Critical Accounting Policies ....................................... 38
Recent Accounting Pronouncements and Recent Developments ........... 39
Results of Operations .............................................. 41
Net Interest Income ............................................ 41
Noninterest Income ............................................. 44
Noninterest Expense ............................................ 45
Federal Income Taxes ........................................... 47
Line of Business Results ....................................... 47
Financial Condition ................................................ 48
Summary ........................................................ 48
Average Total Assets ........................................... 49
Investment Securities and Money Market Investments ............. 49
Loan Portfolio ................................................. 50
Nonperforming Assets ........................................... 56
Deposits ....................................................... 57
Borrowed Funds ................................................. 58
Capital Resources .............................................. 59
Contractural Obligations and Off-Balance Sheet Arrangements .... 59
Liquidity and Debt Capacity ........................................ 62
Interest Rate Risk ................................................. 63
Selected Quarterly Information ..................................... 65
II. Consolidated Financial Statements
Consolidated Balance Sheets ............................................ 66
Consolidated Statements of Income ...................................... 67
Consolidated Statements of Changes in Shareholders' Equity ............. 68
Consolidated Statements of Cash Flows .................................. 69
III. Notes to Consolidated Financial Statements ................................. 70
IV. Report of Independent Auditors ............................................. 102
V. Report of Management ....................................................... 103
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS CITIZENS BANKING CORPORATION AND SUBSIDIARIES
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TABLE 1. FIVE YEAR SUMMARY OF SELECTED FINANCIAL DATA
(in thousands, except per share data) 2003 2002 2001 2000 1999
- ----------------------------------------------------- ----------- ----------- ----------- ----------- -----------
FOR THE YEAR
Net interest income $ 286,258 $ 301,782 $ 307,981 $ 314,874 $ 309,642
Provision for loan losses 62,962 120,200 26,407 20,983 24,675
Noninterest income before securities gains (losses) 94,716 99,340 111,286 90,344 85,044
Investment securities gains (losses) 103 2,436 6,195 -- (3,052)
Noninterest expense(1) 232,988 259,383 251,183 257,762 276,976
Income tax provision (benefit) 19,176 (1,063) 43,215 35,813 27,989
Net income 65,951 25,038 104,657 90,660 61,994
Cash dividends 49,476 50,659 50,158 48,108 30,035
PER COMMON SHARE DATA
Net income:
Basic $ 1.52 $ 0.56 $ 2.27 $ 1.92 $ 1.29
Diluted 1.51 0.56 2.25 1.91 1.28
Cash dividends 1.140 1.130 1.085 1.015 0.915
Book value, end of year 14.69 14.88 15.46 14.62 13.32
Market value, end of year 32.72 24.78 32.88 29.06 22.38
AT YEAR END
Assets $ 7,711,070 $ 7,524,724 $ 7,682,899 $ 8,409,749 $ 7,900,547
Portfolio Loans (2) 5,245,702 5,432,561 5,771,963 6,422,806 5,917,483
Deposits 5,442,267 5,936,913 5,965,126 6,244,141 6,128,998
Long-term debt 936,859 599,313 629,099 471,117 127,104
Shareholders' equity 635,162 650,469 697,464 679,979 633,669
AVERAGE FOR THE YEAR
Assets $ 7,693,931 $ 7,569,341 $ 7,935,843 $ 8,073,021 $ 7,342,167
Earning assets 7,272,887 7,160,596 7,510,332 7,584,932 6,875,643
Portfolio Loans (2) 5,248,922 5,530,790 5,977,744 6,202,157 5,528,963
Deposits 5,665,533 5,924,442 6,008,096 6,121,373 5,906,664
Interest-bearing deposits 4,787,594 5,054,743 5,126,928 5,175,252 5,002,135
Repurchase agreements and
other short-term borrowings 458,673 251,315 538,673 920,323 478,920
Long-term debt 861,704 620,913 596,380 303,597 210,289
Shareholders' equity 632,060 691,834 702,381 650,251 672,227
FINANCIAL RATIOS
Return on average:
Shareholders' equity 10.44% 3.62% 14.90% 13.94% 9.22%
Earning assets 0.91 0.35 1.39 1.20 0.90
Assets 0.86 0.33 1.32 1.12 0.84
Average shareholders' equity/avg. assets 8.21 9.14 8.85 8.05 9.16
Dividend payout ratio 75.02 202.33 47.93 53.06 59.13
Net interest margin (FTE) 4.15 4.45 4.32 4.32 4.68
Tier I leverage ratio 7.45 7.18 7.79 7.11 7.21
Tier I risk-based capital ratio 9.80 9.18 9.87 9.05 9.22
Total risk-based capital ratio 13.23 10.43 11.12 10.30 10.47
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(1) Citizens recorded special charges of $13,402,000 in 2002, $15,541,000 in
2000 and $40,198,000 in 1999 for mergers, restructurings and other
initiatives. Additionally, the year 2003 included a special charge credit
of ($691,000). The special charges and the related credit were included
in noninterest expense.
(2) Excludes mortgage loans held for sale.
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The following commentary presents management's discussion and analysis of
Citizens Banking Corporation's financial condition and results of operations for
each of the past three years and should be read in conjunction with the
accompanying Consolidated Financial Statements and Notes. Unless the context
indicates otherwise, all references in the discussion to "Citizens," the
"Company," "our," "us" and "we" refer to Citizens Banking Corporation and its
subsidiaries.
FORWARD-LOOKING STATEMENTS
Discussions in this report that are not statements of historical fact (including
statements that include terms such as "may," "should," "believe," "expect,"
"anticipate," "estimate," "intend," and "plan") are forward-looking statements
that involve risks and uncertainties, and our actual future results could
materially differ from those discussed. Factors that could cause or contribute
to such differences include, without limitation, risks and uncertainties
detailed from time to time in our filings with the Securities and Exchange
Commission, as well as the following.
- We face the risk that loan losses, including unanticipated loan
losses due to changes in our loan portfolios, fraud and economic
factors, will exceed our allowance for loan losses and that
additional increases in the allowance will be required. Additions to
the allowance would cause net income to decline and could have a
negative impact on our capital.
- While we attempt to manage the risk from changes in market interest
rates, interest rate risk management techniques are not exact. In
addition, we may not be able to economically hedge our interest rate
risk. A rapid or substantial increase or decrease in interest rates
could adversely affect our net interest income and results of
operations.
- An economic downturn, and the negative economic effects caused by
terrorist attacks, potential attacks and other destabilizing events,
would likely contribute to the deterioration of the quality of our
loan portfolio and could reduce our customer base, our level of
deposits, and demand for financial products such as loans.
- If we are unable to continue to attract core deposits, our cost of
funds will increase, adversely affecting our ability to generate the
funds necessary for lending operations, reducing our net interest
margin and negatively affecting our results of operations.
- Increased competition with other financial institutions could reduce
our net income by decreasing the number and size of loans that we
originate, the interest rates we may charge on these loans and the
fees we are able to charge for services to our customers.
- The financial services industry is undergoing rapid technological
changes. If we are unable to adequately invest in and implement new
technology-driven products and services, we may not be able to
compete effectively, or our cost to provide products and services
may increase significantly.
- Our business may be adversely affected by the highly regulated
environment in which we operate. Changes in banking or tax laws,
regulations and regulatory practices at either the federal or state
level may adversely affect us, including our ability to offer new
products and services, obtain financing, dividend funds to our
parent company, attract deposits, make loans and leases and achieve
satisfactory spreads, and may also result in the imposition of
additional costs on us.
- The products and services offered by the banking industry and
customer expectations regarding them are subject to change. We
attempt to respond to perceived customer needs and expectations by
offering new products and services, such as our new wealth
management capabilities, which are often costly to develop and
market initially. A lack of market acceptance of these products and
services would have a negative effect on our results of operations.
- New accounting pronouncements may be issued by the accounting
profession, regulators or other government bodies which could change
our existing accounting methods. Changes in accounting methods could
negatively impact our results of operations and capital.
- We could face unanticipated environmental liabilities or costs
related to both real property that we own or that we acquire through
foreclosure. Compliance with federal, state and local environmental
laws and regulations, including those related to investigation and
clean-up of contaminated sites, may increase our capital costs and
operating expenses.
- As a bank holding company that conducts substantially all of its
operations through its subsidiaries, the ability of the parent
company to pay dividends, repurchase its shares or to repay its
indebtedness depends upon the results of operations of its
subsidiaries and their ability to pay dividends to the parent
company. Dividends paid by these subsidiaries are subject to limits
imposed by federal and state law.
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Other factors not currently anticipated by management may also materially and
adversely affect our results of operations. There can be no assurance that
future results will meet expectations. While we believe that our forward-looking
statements are reasonable, you should not place undue reliance on any
forward-looking statement. In addition, these statements speak only as of the
date made. We do not undertake, and expressly disclaim any obligation, to update
or alter our forward-looking statements whether as a result of new information,
future events or otherwise, except as required by applicable law.
OVERVIEW
OUR BUSINESS
We are a diversified banking and financial services company that provides a full
range of banking and financial services to individuals and businesses through
our Citizens Bank and F&M Bank subsidiaries. We also provide wealth management
services through Citizens Bank Wealth Management, N.A., and through trust
departments of two of our bank affiliates. We conduct our operations through 176
branch, private banking and financial center locations and 194 ATM locations
throughout Michigan, Wisconsin, Iowa and Illinois.
We operate primarily in three business lines: commercial banking, consumer
banking and wealth management. Our performance is monitored by an internal
profitability measurement system that provides line of business results and key
performance measures including return on assets, return on equity, net interest
margin, allowance for loan losses to portfolio loans, net loans charged off
percentage and nonperforming assets as a percent of total assets. These key
performance measures for the last five years are presented in Tables 1, 6 and 8
of Management's Discussion and Analysis of Financial Condition and Results of
Operations.
Our primary source of revenue is net interest income, which is the difference
between interest income on earning assets such as loans and securities and
interest expense on liabilities, including interest-bearing deposits and
borrowings used to fund those assets. Net interest income is affected by
fluctuations in the amount and composition of earning assets and funding sources
and in the yields earned and rates paid, respectively, on these assets and
liabilities. We measure the level of interest income relative to earning assets
and interest bearing liabilities through two statistics - interest spread and
net interest margin. The interest spread represents the difference between
yields on earning assets and the rates paid for interest-bearing liabilities.
The net interest margin is expressed as the percentage of net interest income to
average earning assets. A low interest rate environment, such as experienced in
2003, has the effect of reducing the interest spread and net interest margin.
Our other significant source of revenue is comprised of the fees and charges we
collect in connection with our products and services. These fees and charges,
which are classified as noninterest income, include service charges on deposit
accounts, fees charged for trust services related to personal, institutional and
employee benefit products and services, revenue related to loan products
including commercial loan fees and mortgage banking revenue, and fees for
various other services including brokerage and investment services, ATM network
use, and financial services.
Our net income can also be significantly affected by additions to our allowance
for loan losses. Extending credit to businesses and consumers exposes us to the
risk that the principal balance of a loan and any related interest will not be
collected. We mitigate this credit risk through portfolio diversification that
limits exposure to any single industry or customer and by establishing a
comprehensive system of internal controls. The allowance for credit losses
represents our estimate of probable losses inherent in our loan portfolio. The
allowance is based on ongoing quarterly assessments of historical data and
general economic factors, among other things, and is maintained at a level we
consider adequate to absorb probable loan losses identified with specific
customer relationships and probable losses believed to be inherent in the loan
portfolio which have not been specifically identified. Our evaluation process is
inherently subjective, as it requires estimates that may be susceptible to
significant change and have the potential to materially affect net income. In
the event that we overestimate future cash flows or underestimate losses on loan
pools, we may be required to increase our provision for loan losses, which would
have a negative impact on results of operations in the period in which the
increase occurred.
Business volumes may be influenced by overall economic factors including market
interest rates, business spending, consumer confidence and competitive
conditions. During 2003, record low interest rates resulted in increased
mortgage origination volume and lifted mortgage income to a new high. The high
level of mortgage refinancings had a negative impact on our mortgage-related
securities portfolio, as accelerated prepayments depressed interest yields.
Rising mortgage interest rates during the third quarter slowed mortgage
origination volumes in the fourth quarter and 2004 originations will likely
remain well below 2003 levels. Growth in home equity and indirect lending
experienced during 2003 is anticipated to continue into 2004.
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Commercial loan outstandings declined in 2003 as payoffs exceeded new loan
volume. High payoffs resulted from low levels of corporate investment spending
and our proactive reduction of exposure on credits with the potential to
deteriorate. Commercial credit costs remained high in 2003, but recent trends in
our nonperforming assets and net charge-offs are encouraging. The provision for
loan losses and net charge-offs are expected to decline in 2004.
Proper management of the volume and composition of our earning assets and
funding sources is essential for ensuring strong and consistent earnings
performance, maintaining adequate liquidity and limiting exposure to risks
caused by changing market conditions. Our investment securities portfolio is
structured to provide a source of liquidity principally through the maturity of
the securities held in the portfolio and to generate an income stream with
relatively low levels of principal risk. Loans comprise the largest component of
earning assets and are our highest yielding assets. Client deposits are the
primary source of funding for earning assets while short-term debt and other
managed sources of funds are utilized as market conditions and liquidity needs
change.
We monitor and manage our liquidity position so that funds will be available at
a reasonable cost to meet client cash flow needs, while maintaining funds
available for loan and investment opportunities as well as to pay dividends to
shareholders, service debt, invest in subsidiaries, finance business expansion,
and to satisfy other operating requirements and take advantage of unforeseen
opportunities. We derive liquidity primarily through core deposit growth,
maturity of money market investments, and maturity and sale of investment
securities and loans. We also have access to market borrowing sources for both
short-term and long-term purposes.
SUMMARY OF FINANCIAL RESULTS
An analysis of the major components of net income in 2003, 2002 and 2001 is
presented below.
Year Ended December 31,
---------------------------------
(in thousands) 2003 2002 2001
- --------------------------------------------------------------------------------- --------- --------- ---------
Interest income (1) $ 405,977 $ 463,384 $ 573,559
Interest expense 119,719 161,602 265,578
--------- --------- ---------
Net interest income 286,258 301,782 307,981
Provision for loan losses 62,962 120,200 26,407
Noninterest income (1) 94,819 101,776 117,481
Noninterest expense (1) 232,988 259,383 251,183
Income tax provision (1) 19,176 (1,063) 43,215
--------- --------- ---------
NET INCOME $ 65,951 $ 25,038 $ 104,657
========= ========= =========
(1) INCLUDES SIGNIFICANT CHARGES AND/OR GAINS AS FOLLOWS:
Interest income $ -- $ (701) $ --
--------- --------- ---------
Noninterest income
Gains from sale of securitized portfolio mortgages -- 2,436 5,372
Gains from sale of merchant business, an equity investment and other assets -- 5,400 14,433
Other charges -- (1,587) --
--------- --------- ---------
Total gains and other charges recorded in noninterest income -- 6,249 19,805
--------- --------- ---------
Noninterest expense
Special charge -- (13,402) --
Other charges -- (7,137) --
--------- --------- ---------
Total special and other charges recorded in noninterest expense -- (20,539) --
--------- --------- ---------
Tax benefit (expense) -- 5,247 (6,337)
--------- --------- ---------
NET INCREASE (DECREASE) TO INCOME $ -- $ (9,744) $ 13,468
--------- --------- ---------
- ---------------------------------------------------------------------------------------------------------------------
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For the year ended December 31, 2003, we recorded net income of $66.0 million,
or $1.51 per diluted share, compared with $25.0 million, or $0.56 per diluted
share for 2002 and $104.7 million, or $2.25, per diluted share in 2001. Returns
on average assets and average equity for 2003 were 0.86% and 10.44%,
respectively, compared to returns of 0.33% and 3.62%, respectively, in 2002 and
returns of 1.32% and 14.90%, respectively, in 2001.
Net income increased 163% in 2003 compared to 2002 due largely to actions taken
in the third quarter of 2002 to improve our credit quality risk profile,
restructure the Company along its three major lines of business, improve client
service and reduce future operating costs. The actions taken included a large
loan loss provision ($89.3 million compared to previous quarterly provisions of
$5.0 to $9.0 million) in the third quarter of 2002 and the special charge of
$13.4 million and other charges of $9.4 million, referred to below in "Recent
Developments". As a result of these actions in 2002, loan loss provision and
noninterest expense were substantially lower in 2003 compared to the prior year,
resulting in higher net income in 2003. The increase in net income in 2003 was
offset in part by lower net interest income, as a result of a decline in the net
interest margin, and lower noninterest income due to gains in 2002 from the sale
of securitized portfolio mortgages and the sale of the merchant services
business.
Net income was down 76% in 2002 compared to 2001 due largely to the previously
mentioned higher loan loss provision and special and other charges incurred in
the third quarter of 2002. Full year net income for 2002 was also impacted by
lower gains on the sale of securitized portfolio mortgages and other assets in
2002 than in 2001 and a decline in net interest income due to a lower volume of
earning assets.
CRITICAL ACCOUNTING POLICIES
Citizens' Consolidated Financial Statements are prepared in accordance with
accounting principles generally accepted in the United States and follow general
practices within the industry in which we operate. Application of these
principles requires management to make estimates, assumptions, and judgments
that affect the amounts reported in the financial statements and accompanying
notes. These estimates, assumptions and judgments are based on information
available as of the date of the financial statements; accordingly, as this
information changes, the financial statements could reflect different estimates,
assumptions and judgments. Certain policies inherently have a greater reliance
on the use of estimates, assumptions, and judgments and as such, have a greater
possibility of producing results that could be materially different than
originally reported. Based on the valuation techniques used and the sensitivity
of financial statement amounts to the methods, assumptions and estimates
underlying those amounts, management has identified the determination of the
allowance for loan losses and the benefit obligation and net periodic pension
expense for our employee pension and postretirement benefit plans to be the
accounting areas that require the most subjective or complex judgments, and,
therefore, are the most likely to vary materially as new information becomes
available. Our significant accounting policies are more fully described in Note
1 to the Consolidated Financial Statements.
The allowance for loan losses represents management's estimate of probable
losses inherent in the loan portfolio, the largest asset category on the
consolidated balance sheet. Determining the amount of the allowance for loan
losses is considered a critical accounting policy because it requires
significant judgment and the use of estimates related to the amount and timing
of expected future cash flows on impaired loans, estimated losses on pools of
homogeneous loans based on historical loss experience, and consideration of
current economic trends and conditions, all of which are susceptible to
significant change. Default frequency, internal risk ratings, expected future
cash collections, loss recovery rates, and general economic factors, among other
things, are considered in this evaluation, as are the size and diversity of
individual large credits.
The allowance for loan losses consists of an allocated component and an
unallocated component. The components of the allowance for loan losses represent
an estimation pursuant to either SFAS 5, Accounting for Contingencies, or SFAS
114, Accounting by Creditors for Impairment of a Loan. The allocated component
of the allowance for loan losses reflects expected losses resulting from
analysis developed through specific credit allocations for individual loans (the
specific allocation allowance) and on historical loss experience for each loan
category (the risk allocation allowance). Specific allowances are established in
cases where management has identified significant conditions or circumstances
related to a credit that management believes indicate it is probable that a loss
has been incurred. The specific credit allocations are based on a regular
analysis of all commercial and commercial mortgage loans over a fixed dollar
amount where the internal credit rating is at or below a predetermined
classification.
The unallocated portion of the allowance reflects management's estimate of
inherent but undetected losses within the portfolio due to uncertainties in
economic conditions, delays in obtaining information, including unfavorable
information about a borrower's financial condition, the difficulty in
identifying triggering events that correlate perfectly to subsequent loss rates,
and risk factors that have not yet manifested themselves in loss allocation
factors. In addition, the unallocated allowance includes a component that
explicitly accounts for the inherent imprecision in loan loss projection models.
We
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have grown through acquisition, expanded the geographic footprint in which we
operate, and changed our portfolio mix in recent years. As a result, historical
loss experience data used to establish allocation estimates may not precisely
correspond to the current portfolio. The uncertainty surrounding the strength
and timing of economic cycles, including our concerns over the effects of the
prolonged economic downturn in the current cycle, also affects the allocation
model's estimates of loss. The historical losses used may not be representative
of actual losses inherent in the portfolio that have not yet been realized.
In the event that we overestimate future cash flows or underestimate losses on
loan pools, we may be required to increase our provision for loan losses, which
would have a negative impact on results of operations in the period in which the
increase occurred. In the third quarter of 2002, we experienced a significant
increase in the allowance for loan losses due to elevated past-due and
nonperforming loan levels, a weakened economy and enhancements to the loan loss
allocation model, including the incorporation of more recent historical loss
data in the determination of projected loss rates for pools of loans evaluated
collectively and refinements to our internal risk rating system for commercial
loans, which led to an increase in risk rating downgrades. Note 1 to the
Consolidated Financial Statements describes the methodology used to determine
the allowance for loan losses and a discussion of the factors driving changes in
the amount of the allowance for loan losses is included under "Provision and
Allowance for Loan Losses."
Pension liabilities are established and pension costs are charged to current
operations based on actuarially determined present value calculations. The
valuation of the pension obligation and net periodic pension expense is
considered critical as it requires management to make estimates regarding the
amount and timing of expected future cash outflows including assumptions about
employee mortality, expected employee service periods, rate of employee
compensation increases, and the long-term return on plan assets. If we were to
determine that more conservative assumptions were necessary, our costs would
likely increase and have a negative impact on results of operations in the
period in which the increase occurred. Note 13 to the Consolidated Financial
Statements provides further discussion on the accounting for Citizens' employee
benefit plans and the estimates used in determining the actuarial present value
of the benefit obligations and the net periodic pension expense. In 2003, we
modified assumptions regarding the expected long-term rate of return and the
assumed discount rate under our defined benefit pension plan, which will have a
negative impact on future results. For a discussion of these changes and their
expected impact on 2004 results, refer to "Noninterest Expense." The expected
rate of return was determined using long-term historical returns of the various
investment categories weighted by target asset allocations. See Note 13 of the
Consolidated Financial Statements. The discount rate was derived from current
market yields on long-term corporate bonds. The assumed discount rate is likely
to change each year with fluctuations in market yields for long-term corporate
bonds, while the expected long-term rate of return will likely exhibit less
volatility.
RECENT ACCOUNTING PRONOUNCEMENTS
Note 2 to the Consolidated Financial Statements discusses new accounting
policies adopted by Citizens during 2003 and 2002 and the expected impact of
accounting policies recently issued or proposed but not yet required to be
adopted. To the extent the adoption of new accounting standards materially
affects Citizens' financial condition, results of operations or liquidity, the
impact is discussed elsewhere in "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and in Notes 1, 2 and 7 to the
Consolidated Financial Statements.
RECENT DEVELOPMENTS
In the fourth quarter of 2003, we announced a major expansion in Oakland County,
located in Southeast Michigan, one of the wealthiest counties in the nation. We
intend to invest up to $35 to $40 million and to open as many as 10 to 14 new
branches, including two hub offices over the next 24 months. This initiative
will significantly add to the Bank's current Oakland County presence of six
branches and four financial centers and increase staff by up to 180 employees.
The first hub office, located in Troy, opened in January 2004.
In the second quarter of 2003, Wealth Management formed strategic alliances with
SEI Investments and EnvestnetPMC, Inc. These alliances will enable us to offer
our wealth management clients a broader range of mutual fund family choices,
access to separately managed accounts with specialized portfolio managers, state
of the art research capabilities, and sophisticated client profiling and
portfolio modeling tools. In addition, in the third quarter of 2003, Wealth
Management, through an arrangement with EPIC Advisors, Inc., announced plans to
increase and grow its retirement plan business by offering its clients advanced
state-of-the-art online employee account access, online retirement plan design
and consulting options, and access to industry experts. We successfully
completed the conversion of our trust and investment accounting systems and
operations with SEI Investments and our retirement plan processing systems with
EPIC Advisors, Inc. in the fourth quarter of 2003, see "Noninterest Expense" and
"Line of Business Results".
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During the fourth quarter of 2002 and the first quarter of 2003, we experienced
two unanticipated loan losses of $8.5 million and $11.5 million, respectively,
resulting from collateral value shortfalls due to falsified borrowing base
reports by the borrower. To reduce our risk of further unforeseen losses from
similar collateral issues, we hired outside collateral auditors to conduct field
audits on all loans in excess of specific dollar thresholds. We have also
instituted regular audits of receivable and inventory collateral as a standard
practice going forward. Refer to "Credit Risk Management" for further
discussion.
In 2002, we recorded a special charge of $13.4 million ($8.7 million after-tax)
that included restructuring and impairment costs associated with reorganization
of our consumer, commercial and wealth management lines of business. The
reorganization resulted from a detailed review of our consumer banking,
commercial banking and wealth management areas by key members of management with
assistance from industry consultants. This review revealed opportunities for
process change, staff reassignment, reporting structure changes, branch
closures, expense reduction and business growth. As a result of the
reorganization, we displaced 134 employees (157 employees less employees
subsequently rehired for other available positions). Displaced employees were
offered severance packages and outplacement assistance. As part of our
restructuring initiatives, we recognized a pension curtailment related to the
early termination of certain officers' employment earlier than expected. These
pension benefits were provided under unfunded supplemental benefit plans. The
curtailment resulted in a charge of $891,870 for the accelerated recognition of
their prior service cost bases and was recorded as a component of the $13.4
million special charge. Also, twelve banking offices were closed in the fourth
quarter of 2002 and six additional offices were closed during the second quarter
of 2003.
In the third quarter of 2002, we also charged to earnings $9.4 million ($6.1
million after-tax) of other significant items we considered unusual in nature.
Net interest income was charged $701,000, comprised of an adjustment of $668,000
to premium amortization on mortgage-backed securities and a $33,000 write-off of
accrued interest on a pool of government subsidized loans. Noninterest income
was charged $1.6 million, which included market value adjustments of $662,000 in
an equity investment and $650,000 to life insurance cash surrender values, and
write-offs of $200,000 for obsolete assets and $75,000 for cash management fees
accrued but not collectable. Noninterest expense was charged $7.1 million,
comprised of a $3.3 million prepayment penalty on high cost FHLB debt, a $2.0
million contribution to our charitable trust, a $979,000 market valuation
adjustment in other real estate, $406,000 in additional depreciation on
equipment to be retired early and $452,000 in other items.
The aforementioned $668,000 adjustment of our premium amortization on
mortgage-backed securities in the third quarter of 2002 was the result of our
quarterly review of prepayment assumptions. Low mortgage interest rate levels in
2002 resulted in an increase in prepayments and shortened the expected average
life of these securities. Because the increase in prepayments was inconsistent
with historical norms, the adjustment was determined to be unusual in nature.
The aforementioned equity investment market value writedown in 2002 relates to a
venture capital partnership that specializes in financing technology companies.
In the third quarter of 2002, we received an accounting from the partnership
showing significant writedowns in the carrying value of some of the investments
in technology companies within the partnership due to the poor financial
performance and the poor prospects of recovering some of these investments given
the unfavorable market conditions for technology companies. As a result of these
factors, we reduced the book value of our investment in the partnership by
$662,000 from $1.1 million to $438,000, and, because of the broad scope and
degree of decline in the technology sector, we determined the adjustment to be
unusual in nature.
The cash surrender value of separate-account life insurance policies is
determined based upon the value of the underlying securities held in the
policies. During the third quarter of 2002, the value of the underlying
securities experienced a swift and significant decline due to the decrease in
values in the equity markets. As a result, we reduced the book value on these
policies by $650,000 from $2.2 million to $1.55 million, and considered the
adjustment unusual due to the sharp and significant amount of the decline as a
percent of the total cash surrender value of the policies.
In the second quarter of 2002, we realized gains of $5.4 million on the sale of
the merchant services business and $2.4 million on the sale of securitized
mortgages. Significant gains in 2001 included $5.4 million on the sale of
securitized mortgages, $2.6 million from the sale of credit card assets and
$11.0 million from the sale of NYCE stock. In November 2001, we also sold F&M
Bank-Minnesota with assets of $27.0 million. The bank was our sole location in
Minnesota. This divestiture resulted in a pretax gain of $793,000. See
"Noninterst Income".
40
RESULTS OF OPERATIONS
NET INTEREST INCOME
Table 2 presents net interest income, interest spread and net interest margin
with average balances and related interest rates for the past three years.
TABLE 2. AVERAGE BALANCES/NET INTEREST INCOME/AVERAGE RATES
2003 2002
---------------------------------- ----------------------------------
Year Ended December 31 AVERAGE AVERAGE Average Average
(in millions) BALANCE INTEREST (1) RATE (2) Balance Interest (1) Rate (2)
- ---------------------------------------------------- --------- ------------ -------- --------- ------------ ---------
EARNING ASSETS
Money market investments $ 11.2 $ 0.1 0.94% $ 50.6 $ 0.8 1.61%
Investment securities (3):
Taxable 1,405.6 61.6 4.38 963.6 55.5 5.75
Tax-exempt 405.4 20.5 7.78 416.6 21.3 7.87
Mortgage loans held for sale 155.4 8.6 5.54 146.4 9.2 6.27
Portfolio Loans (4):
Commercial 3,112.3 173.5 5.66 3,343.3 207.8 6.31
Real estate mortgage 527.6 32.3 6.12 686.2 49.8 7.24
Consumer 1,609.0 109.3 6.79 1,501.3 119.0 7.93
--------- ------- --------- -------
Total earning assets (3) 7,226.5 406.0 5.80 7,108.0 463.4 6.72
NONEARNING ASSETS
Allowance for loan losses (120.9) (87.6)
Investment security
fair value adjustment 46.4 52.6
Nonearning assets 541.9 496.3
--------- ---------
Total assets $ 7,693.9 $ 7,569.3
========= =========
INTEREST BEARING LIABILITIES
Deposits:
Interest-bearing demand $ 1,319.9 11.7 0.89 $ 1,148.0 18.0 1.57
Savings 1,329.6 8.9 0.67 1,363.5 15.5 1.14
Time 2,138.1 62.8 2.94 2,543.3 94.4 3.71
Short-term borrowings 458.7 5.0 1.08 251.3 4.0 1.60
Long-term debt 861.7 31.3 3.63 620.9 29.7 4.79
--------- ------- --------- -------
Total interest
bearing liabilities 6,108.0 119.7 1.96 5,927.0 161.6 2.73
NONINTEREST BEARING LIABILITIES
AND SHAREHOLDERS' EQUITY
Noninterest-bearing demand 877.9 869.7
Other liabilities 75.9 80.8
Shareholders' equity 632.1 691.8
--------- ---------
Total liabilities and
shareholders' equity $ 7,693.9 $ 7,569.3
--------- ---------
NET INTEREST INCOME $ 286.3 $ 301.8
======= =======
INTEREST SPREAD (5) 3.84% 3.99%
Contribution of noninterest-bearing sources of funds 0.31 0.46
---- ----
NET INTEREST MARGIN (5)(6) 4.15% 4.45%
==== ====
2001
--------------------------------
Year Ended December 31 Average Average
(in millions) Balance Interest(1) Rate(2)
- ---------------------------------------------------- --------- ----------- --------
EARNING ASSETS
Money market investments $ 46.9 $ 1.8 3.75%
Investment securities (3):
Taxable 896.1 57.6 6.43
Tax-exempt 419.2 21.7 7.97
Mortgage loans held for sale 131.3 9.0 6.85
Portfolio Loans (4):
Commercial 3,440.8 269.7 7.93
Real estate mortgage 1,001.8 76.9 7.67
Consumer 1,535.2 136.9 8.91
--------- -------
Total earning assets (3) 7,471.3 573.6 7.87
NONEARNING ASSETS
Allowance for loan losses (81.2)
Investment security
fair value adjustment 39.0
Nonearning assets 506.7
---------
Total assets $ 7,935.8
=========
INTEREST BEARING LIABILITIES
Deposits:
Interest-bearing demand $ 744.8 14.0 1.88
Savings 1,474.5 34.8 2.36
Time 2,907.6 156.1 5.37
Short-term borrowings 538.7 27.5 5.09
Long-term debt 596.4 33.2 5.57
--------- -------
Total interest
bearing liabilities 6,262.0 265.6 4.24
NONINTEREST BEARING LIABILITIES
AND SHAREHOLDERS' EQUITY
Noninterest-bearing demand 881.2
Other liabilities 90.3
Shareholders' equity 702.4
---------
Total liabilities and
shareholders' equity $ 7,935.8
---------
NET INTEREST INCOME $ 308.0
=======
INTEREST SPREAD (5) 3.63%
Contribution of noninterest-bearing sources of funds 0.69
----
NET INTEREST MARGIN (5)(6) 4.32%
====
(1) Interest income is shown on an unadjusted basis and therefore does not
include taxable equivalent adjustments.
(2) Average rates include taxable equivalent adjustments to interest income of
$13,508,000, $14,470,000, and $14,835,000 for the years ended December 31,
2003, 2002, and 2001, respectively, based on a 35% tax rate.
(3) For presentation in this table, average balances and the corresponding
average rates for investment securities are based upon historical cost,
adjusted for amortization of premiums and accretion of discounts.
(4) Nonaccrual loans are included in average balances.
(5) The interest spread and net interest margin are presented on a
tax-equivalent basis.
(6) Because noninterest-bearing funding sources, demand deposits, other
liabilities and shareholders' equity also support earning assets, the net
interest margin exceeds the interest spread.
41
Net interest income, was $286.3 million in 2003, down from $301.8 million in
2002 and $308.0 million in 2001. The decline in net interest income in 2003 was
attributable to a 30 basis point decline in the net interest margin to 4.15% in
2003 compared with 4.45% in 2002 partially offset by a $112.3 million increase
in average earning assets. The net interest margin declined due to the combined
effects of the continued low interest rate environment and accelerated
prepayments in both the fixed rate commercial loan portfolio and the
mortgage-related securities portfolio. Net premium amortization on investment
securities totaled $10.0 million in 2003 compared with $1.9 million in 2002. The
increase in 2003 is the result of accelerated premium amortization due to
prepayments on the existing mortgage-related securities portfolio and additional
on-going premium amortization on new purchases of mortgage-related securities.
The decline in the net interest margin was also due, in part, to the expansion
of the investment portfolio beginning near the end of the first quarter and
continuing into the second quarter of 2003. Citizens expanded the investment
portfolio by approximately $500 million in the first half of 2003, as we sought
to offset the effects of weak loan demand and the prospect of net interest
margin pressure from continued low interest rates on our net interest income.
Citizens purchased mortgage backed securities and collateralized mortgage
obligations with average lives of three to five years and an average duration of
two to four years, resulting in interest spreads of up to 250 basis points over
funding sources. As this expansion generated a 250 basis point spread to funding
costs, it had a dilutive effect on our net interest margin.
The decline in net interest income in 2002 was attributable to a lower level of
earning assets partially offset by a more favorable asset mix and reduced
reliance on short-term wholesale funding. During 2002 we took several steps to
improve our earning asset mix and increase our net interest margin. In 2002, we
sold 81% of our new mortgage loan production into the secondary market for
$1.024 billion and securitized an additional $28.6 million, or 2%, of new
mortgage loan production which we transferred to our investment portfolio.
Additionally, $114.3 million of fixed and variable rate, seasoned mortgage loans
previously held within our mortgage portfolio were securitized through the
Federal National Mortgage Association ("FNMA") and the Federal Home Loan
Mortgage Corporation ("FHLMC"). During 2002, we also refinanced $75 million of
high cost Federal Home Loan Bank advances, reducing the interest rate on these
funds by 486 basis points.
Table 3 below shows changes in interest income, interest expense and net
interest income due to volume and rate variances for major categories of earning
assets and interest-bearing liabilities.
TABLE 3. ANALYSIS OF CHANGES IN INTEREST INCOME AND INTEREST EXPENSE
2003 COMPARED TO 2002 2002 Compared to 2001
--------------------------------- ---------------------------------
INCREASE (DECREASE) Increase (Decrease)
DUE TO CHANGE IN Due to Change in
Year Ended December 31 NET --------------------- Net --------------------
(in thousands) CHANGE(1) RATE(2) VOLUME(2) Change(1) Rate(2) Volume(2)
- ------------------------------ ---------- --------- ---------- ---------- --------- ---------
INTEREST INCOME:
Money market investments $ (719) $ (248) $ (471) $ (950) $ (1,077) $ 127
Investment securities:
Taxable 6,184 (15,621) 21,805 (2,186) (6,332) 4,146
Tax-exempt (799) (233) (566) (414) (280) (134)
Mortgage loans held for sale (562) (2,435) 1,873 172 (810) 982
Loans:
Commercial (34,297) (22,408) (11,889) (61,821) (54,922) (6,899)
Real estate (17,452) (5,936) (11,516) (27,164) (4,079) (23,085)
Consumer (9,762) (14,637) 4,875 (17,812) (13,436) (4,376)
--------- --------- --------- ---------- --------- ---------
Total (57,407) (61,518) 4,111 (110,175) (80,936) (29,239)
--------- --------- --------- ---------- --------- ---------
INTEREST EXPENSE:
Deposits:
Demand (6,305) (8,703) 2,398 4,042 (2,573) 6,615
Savings (6,590) (6,168) (422) (19,298) (15,985) (3,313)
Time (31,505) (17,969) (13,536) (61,824) (44,609) (17,215)
Short-term borrowings 927 (1,622) 2,549 (23,425) (13,171) (10,254)
Long-term debt 1,590 (8,223) 9,813 (3,471) (4,794) 1,323
--------- --------- --------- ---------- --------- ---------
Total (41,883) (42,685) 802 (103,976) (81,132) (22,844)
--------- --------- --------- ---------- --------- ---------
NET INTEREST INCOME $ (15,524) $ (18,833) $ 3,309 $ (6,199) $ 196 $ (6,395)
========= ========= ========= ========== ========= =========
(1) Changes are based on actual interest income and do not reflect taxable
equivalent adjustments.
(2) The change in interest not solely due to changes in volume or rates has
been allocated in proportion to the absolute dollar amounts of the change
in each.
42
Interest income declined $57.4 million in 2003 compared with 2002 due to lower
yields on all asset categories. Yields declined due to the overall lower
interest rate environment in 2003. Declining interest rates had a particularly
significant impact on the yields on short-term and variable rate assets. In
addition, accelerated prepayments in both the fixed-rate commercial and mortgage
loan portfolios and the mortgage-related securities portfolio, as well as normal
loan repayments and new origination in the lower interest rate environment, also
led to the decline in earning asset yields. The unfavorable rate-related
variances in interest income were partially offset by net favorable
volume-related variances. The expansion of the taxable investment portfolio in
the first half of 2003, growth in the consumer loan portfolio, particularly home
equity loans, and higher average mortgage loans held for sale offset significant
declines in the commercial and real estate loan portfolios and led to the
favorable volume-related variances in 2003.
Interest income declined $110.2 million in 2002 due primarily to unfavorable
rate-related variances in the lower interest rate environment, and to a lesser
extent, unfavorable volume-related variances due to lower average balances in
all loan portfolios. Yields on commercial loans and certain consumer home equity
loans were particularly impacted as many of these loans are tied to the prime
interest rate, which declined 475 basis points during 2001 and another 50 basis
points in November 2002. The largest volume-related decline in interest income
occurred within the real estate loan portfolio due to the restructuring of our
mortgage loan portfolio in 2002 and 2001.
Interest expense decreased $41.9 million in 2003 due to favorable rate-related
variances as the cost of all categories of interest bearing liabilities declined
in 2003 compared with 2002, due to the continued low interest rate environment.
Net unfavorable volume-related variances of $0.8 million partially offset the
favorable rate-related variances. Average time deposits declined $405.2 million
in 2003 from the prior year as a result of less aggressive pricing and
concentrated efforts to grow core demand deposits. Higher average balances for
interest bearing demand deposits, short term borrowings and long term debt
offset the decline in time deposits. The increase in short-term borrowings and
long term debt funded the aforementioned growth in the investment portfolio and
offset the decline in time deposits. The increase in long term debt also
resulted from the issuance of $125 million of subordinated debt in January 2003
and the issuance of approximately $25 million of trust preferred securities in
June 2003 to provide liquidity and increase capital levels at the parent
company.
Interest expense declined $104.0 million in 2002 reflecting a lower cost of
funds on all categories of interest bearing liabilities and less reliance on
wholesale funding due to the balance sheet restructuring in 2002 and 2001.
Average deposits decreased $83.7 million in 2002, as growth in core deposits was
more than offset by declines in higher cost brokered and large denomination time
deposits, which reduced funding costs and minimized our reliance on purchased
deposits.
Net interest margin declined during the first three quarters of 2003 before
stabilizing at 4.07% in the fourth quarter of 2003. We expect net interest
margin in the first quarter of 2004 to be slightly lower than the fourth quarter
2003 level. We also expect the full year 2004 net interest margin to be lower
than the fourth quarter 2003 level. In addition, due to the anticipated lower
net interest margin in 2004 than the full year 2003, net interest income is
expected to be lower in 2004 than in 2003.
43
NONINTEREST INCOME
An analysis of the components of noninterest income is presented in the table
below. To provide more meaningful trend analysis certain significant
transactions not normally incurred are presented separately.
Year Ended December 31, $ Change % Change
------------------------------------ ---------------------- ----------------------
(dollars in thousands) 2003 2002 2001 2003-2002 2002-2001 2003-2002 2002-2001
- ---------------------- --------- --------- --------- --------- --------- --------- ---------
Service charges on deposit accounts $ 29,916 $ 26,456 $ 27,773 $ 3,460 $ (1,317) 13.08% (4.74)%
Trust fees 17,527 18,956 21,028 (1,429) (2,072) (7.5) (9.9)
Mortgage and other loan income 18,046 16,845 13,159 1,201 3,686 7.1 28.0
Bankcard fees 3,042 6,142 11,799 (3,100) (5,657) (50.5) (47.9)
Brokerage and investment fees 7,720 9,502 8,157 (1,782) 1,345 (18.8) 16.5
ATM network user fees 3,533 3,658 3,448 (125) 210 (3.4) 6.1
Financial services 2,479 2,888 3,134 (409) (246) (14.2) (7.8)
Security gains:
Sale of investment securities 103 -- 823 103 (823) 100.0 (100.0)
Sale of securitized mortgages -- 2,436 5,372 (2,436) (2,936) (100.0) (54.7)
Gain on sale of merchant business -- 5,400 -- (5,400) 5,400 (100.0) --
Gain on sale of credit card portfolio -- -- 2,623 -- (2,623) -- (100.0)
Gain on sale of F&M Bank Minnesota -- -- 793 -- (793) -- (100.0)
Gain on sale of equity investment -- -- 11,017 -- (11,017) -- (100.0)
Other charges -- (1,587) -- 1,587 (1,587) -- --
Other 12,453 11,080 8,355 1,373 2,725 12.4 32.6
--------- --------- --------- --------- ---------
TOTAL NONINTEREST INCOME $ 94,819 $ 101,776 $ 117,481 $ (6,957) $ (15,705) (6.8) (13.4)
========= ========= ========= ========= =========
2003 COMPARED TO 2002
As shown in the table, the decline in noninterest income in 2003 was due mostly
to gains of $7.8 million recorded in 2002 from the sale of securitized mortgages
and the sale of our merchant services business, partially offset by $1.6 million
of other charges recorded in 2002 and described above under the caption "Recent
Developments". The securitized mortgage sales were part of our strategy to
restructure the balance sheet to decrease reliance on wholesale funding and
minimize interest rate risk. The remainder of the decline in 2003 was due to
decreases in bankcard fees, trust fees and brokerage and investment fees, which
were nearly offset by increases in deposit service charges, mortgage banking
revenue and other revenue.
Bankcard fees declined in 2003 due to the sale of our merchant services business
in the second quarter of 2002. Brokerage and investment fees declined in 2003
due to slower retail sales of fixed annuity products. Trust fees declined in
2003 due to lower average asset levels resulting from the decline in the
financial markets during the latter half of 2002 and the first quarter of 2003
and from client attrition. Recent operational changes, system and technology
upgrades and new product offerings at our trust bank resulting from strategic
alliances with three third party vendors that began in 2003 are expected to
accelerate new business growth and reduce client attrition. Total assets under
administration were $2.866 billion at December 31, 2003 compared to $2.555
billion at December 31, 2002. The average assets under administration during
2003 were $2.597 billion, down 5.9% or $164 million, from $2.761 billion in
2002.
We made a number of changes in our service charge policies in 2003 that resulted
in additional overdraft fees, a new overdraft monitoring system and fewer waived
fees. The increase in mortgage and other loan income in 2003 reflected higher
mortgage banking revenue from higher gains on sales of mortgages and the related
servicing rights, as well as higher commercial line of credit fees and new home
equity prepayment fee income. Other noninterest income increased in 2003 due to
a $2.2 million increase in life insurance income, partially offset by a decrease
of $0.6 million in gains recorded on the sale of branches and equipment. The
increase in life insurance income resulted from increases in policy cash
surrender values as the equity markets improved in the second half of 2003 and
from the purchase of $78 million of separate account, bank owned life insurance
in the third quarter of 2002. The policies, on which Citizens is the
beneficiary, insure the lives of our officers and are designed as a funding
source for our payment of employee benefits and deferred compensation.
We typically sell our mortgage servicing rights concurrently with the sale of
the underlying mortgage loan. Falling interest rates coupled with appreciating
home values helped create a strong mortgage origination market in both 2003 and
2002. Mortgage originations reached $1.44 billion in 2003, up from $1.27 billion
in 2002 and $1.1 billion in 2001. Over 80% of all new mortgage loan originations
in 2003 and 2002 were sold in the secondary market.
44
2002 COMPARED TO 2001
The decrease in noninterest income in 2002 resulted from fewer gains from sales
of assets and investment securities of $12.8 million, the aforementioned other
charges of $1.6 million and lower bankcard, deposit service charges and trust
fees. These items were offset, in part, by higher mortgage banking revenue and
brokerage and investment fees. In 2001, gains on sales of assets and investment
securities included gains of $5.4 million from sales of securitized mortgages,
$2.6 million from the sale of credit card assets, $793,000 from the sale of F&M
Bank - Minnesota, and $11.0 million from the sale of NYCE stock. NYCE
Corporation is an ATM network provider in which we held an equity position.
Bankcard fees declined significantly in 2002 due to the sale of our $30 million
Michigan-based credit card portfolio in the second quarter of 2001. Service
charges on deposit accounts decreased in 2002 due to a decline in NSF and
overdraft fees partially offset by higher commercial checking account service
charges. Trust fees declined in 2002, principally due to the decline in the
equity markets, which reduced the value of assets under administration. At
December 31, 2002, we had total assets under administration of $2.555 billion at
December 31, 2002 compared to $3.162 billion at December 31, 2001.
The increase in mortgage banking fees in 2002 was due to higher gains on sales
of mortgages and the related servicing rights. In 2002, brokerage and investment
fees benefited from increased fixed annuity product sales driven by clients'
preference for this product over certificates of deposit or equity investments
and more emphasis on selling this product through the retail branch network.
Other noninterest income increased in 2002 due to higher revenue from the sale
of checks, the sale of four branch properties in the fourth quarter of 2002 and
an increase in life insurance income due, in part, to our purchase of bank-owned
life insurance in the third quarter of 2002.
We anticipate noninterest income levels in 2004 to be slightly higher than 2003
levels due in large part, to higher deposit service charges from fee changes
implemented in 2003.
NONINTEREST EXPENSE
An analysis of the components of noninterest expense is presented in the table
below. In order to provide more meaningful trend analysis, special and certain
other significant charges are presented separately.
Year Ended December 31, $ Change % Change
------------------------------------- ------------------------ ---------------------
(dollars in thousands) 2003 2002 2001 2003-2002 2002-2001 2003-2002 2002-2001
- ---------------------- --------- --------- --------- --------- --------- --------- ---------
Salaries and employee benefits $ 122,322 $ 126,847 $ 126,278 $ (4,525) $ 569 (3.6)% 0.5%
Occupancy 18,449 17,855 17,713 594 142 3.3 0.8
Equipment 16,087 19,869 19,317 (3,782) 552 (19.0) 2.9
Professional services 17,815 14,790 12,277 3,025 2,513 20.5 20.5
Data processing services 12,744 12,641 13,101 103 (460) 0.8 (3.5)
Postage and delivery 6,896 7,120 7,746 (224) (626) (3.1) (8.1)
Advertising and public relations 5,786 5,112 5,219 674 (107) 13.2 (2.1)
Telephone 4,793 5,279 5,556 (486) (277) (9.2) (5.0)
Stationery and supplies 3,935 4,032 4,426 (97) (394) (2.4) (8.9)
Intangible asset amortization 2,899 2,899 10,115 -- (7,216) -- (71.3)
Bankcard fees 378 3,879 9,308 (3,501) (5,429) (90.3) (58.3)
Special charge (691) 13,402 -- (14,093) 13,402 -- --
Prepayment penalty on FHLB advances -- 3,300 -- (3,300) 3,300 -- --
Contribution to charitable trust -- 2,000 -- (2,000) 2,000 -- --
Other 21,575 20,358 20,127 1,217 231 6.0 1.1
--------- --------- --------- --------- ---------
TOTAL NONINTEREST EXPENSE $ 232,988 $ 259,383 $ 251,183 $ (26,395) $ 8,200 (10.2) 3.3
========= ========= ========= ========= =========
2003 COMPARED TO 2002
Noninterest expense decreased $26.4 million, or 10.2%, in 2003, primarily as a
result of the special charge of $13.4 million recorded in the second half of
2002 to restructure our three major lines of business and $7.1 million of other
charges recorded in the third quarter of 2002. These charges are described under
"Recent Developments." Also contributing to the decline were reductions in
salaries and employee benefits, equipment expense and bankcard expense. These
reductions were partially offset by increases in professional services,
advertising and public relations costs, occupancy costs and system
implementation and severance costs.
45
Salaries decreased $1.7 million and employee benefits expense decreased $2.8
million in 2003 due to lower staffing levels resulting from the third quarter of
2002 restructuring initiatives, normal attrition and lower pension costs. The
number of full-time equivalent employees declined 7.1% during 2003.
The defined benefit pension plan for our Michigan and Illinois employees was
amended, effective January 1, 2002, to provide a cash balance pension benefit.
The amendment increased the projected benefit obligation of the plan by $1.1
million and increased pension expense by approximately $450,000 annually. Staff
reductions tied to our 2002 restructuring initiatives reduced future pension
expense by approximately $200,000 annually. The higher pension costs in 2002
substantially offset lower salary costs in 2002 due to the restructuring
initiatives. Pension expense for 2004 is expected to increase by approximately
$2.4 million from 2003 levels. The increase reflects changes for 2004 in the
assumptions used to determine our net periodic pension expense, amortization in
2004 of unrecognized losses and a lower market related value of plan assets at
January 1, 2004 than at January 1, 2003. For 2004, we reduced the assumed rate
of return on plan assets to 8.75% from 9.25% and the discount rate to 6.25% from
6.50%. Both changes have the effect of increasing pension expense. The reduction
in the market related value of plan assets reflects the large market asset
losses experienced during 2001 and 2002, which are being phased into the market
related value of plan assets over a three year period. A lower market related
value of plan assets reduces plan earnings and therefore increases pension
expense.
Equipment expenses decreased in 2003 due to lower depreciation and improved
pricing from new or renegotiated maintenance contracts. A $0.4 million charge in
the third quarter of 2002 to record additional depreciation on assets, primarily
personal computer equipment, to be retired early also contributed to the
decrease.
Bankcard fee expense has declined since 2001 due to the sale of our merchant
services business in the second quarter of 2002 and the sale of our Michigan
credit card portfolio in the second quarter of 2001.
Professional services increased in 2003 due to higher legal costs related to
loan collection efforts, increased executive recruiting and relocation costs,
implementation costs for Citizens' new INEA Performance Management software and
costs incurred in 2003 for the collateral field audit initiative which began in
March. In addition, ongoing costs for banking industry consultants assisting us
in completing the reorganization of our major business lines and identifying new
revenue and cost saving opportunities, also contributed to higher professional
services in 2003.
Advertising and public relations expenses increased in 2003 due to our recently
announced expansion into Oakland County, Michigan and several new home equity
and checking account promotions during the year. These additional promotion
costs were offset, in part, by a more focused marketing strategy, seeking higher
promotional exposure at lower costs.
Occupancy expense increased in 2003 reflecting higher maintenance costs and
approximately $0.2 million of additional expense related to a fourth quarter
2003 capital investment of $1.7 million in branch renovations. Additional
expense resulted from a recent change in our capitalization policy to
incorporate higher capitalization thresholds on new expenditures. Partially
offsetting the increased occupancy costs were the favorable effects of fewer
branch locations as a result of the third quarter 2002 restructuring.
Other expenses increased in 2003 due to operational and system implementation
costs associated with Citizens Bank Wealth's strategic alliances with SEI
Investments, EnvestnetPMC, Inc., and EPIC Advisors, Inc., which commenced in
2003. Higher state taxes and other real estate expenses also contributed to the
increase, offset in part, by lower mortgage servicing rights amortization and
other charges of $1.4 million recorded in the third quarter of 2002. Capitalized
mortgage servicing rights associated with our serviced loan portfolio were fully
amortized in June 2003.
2002 COMPARED TO 2001
In 2002, noninterest expense increased $8.2 million, or 3.3%. The increase
reflected the aforementioned special and other charges of $20.5 million and an
increase in professional services. These increases were partially offset by
lower intangible asset amortization and bankcard fees.
Professional services expenses increased in 2002 due to the costs associated
with our engagement of banking industry consultants to assist us in defining our
new business model and reorganizing our consumer, commercial and wealth
management lines of business.
Intangible asset amortization decreased $7.2 million in 2002 due to the adoption
on January 1, 2002 of Statement of Financial Accounting Standards 142 that
eliminated goodwill amortization. Refer to Notes 1, 2 and 7 to the Consolidated
Financial Statements. Bankcard fee expense declined in 2002 because of the sale
of our merchant services business in the second quarter of 2002 and the sale of
our Michigan credit card portfolio in the second quarter of 2001.
46
FEDERAL INCOME TAXES
Citizens recorded an income tax expense of $19.2 million in 2003 as compared to
an income tax benefit of $1.1 million in 2002 and income tax expense of $43.2
million in 2001. The effective tax rate, computed by dividing the provision for
income taxes by income before taxes, was 22.5% in 2003, compared to a negative
4.4% in 2002 and 29.2% in 2001. The effective tax rate is lower than the
statutory tax rate due to tax-exempt interest income (see note (2) to Table 2)
and to a lesser extent other permanent income tax differences. Citizens'
effective tax rate increased in 2003 compared with 2002 due to higher pre-tax
earnings in 2003 resulting from a large loan loss provision and special and
other significant charges recorded in the third quarter of 2002.
LINE OF BUSINESS RESULTS
Net income by line of business is presented in the table below. A description of
each business line, important financial performance data and the methodologies
used to measure financial performance are presented in Note 20 to the
Consolidated Financial Statements.
Net Income
-----------------------------------
(in thousands) 2003 2002 2001
-------- -------- --------
Commercial Banking $ 18,561 $(12,648) $ 46,501
Consumer Banking 38,549 37,200 47,553
Wealth Management 626 4,284 6,148
Other 8,215 (3,798) 4,455
-------- -------- --------
Total $ 65,951 $ 25,038 $104,657
======== ======== ========
2003 COMPARED TO 2002
Commercial Banking net income increased $31.2 million to $18.6 million in 2003
compared to a net loss of $12.6 million in 2002. The increase in net income was
due to a significantly lower loan loss provision and lower noninterest expense,
partially offset by lower net interest income. The loan loss provision decreased
by $60.7 million in 2003 as a result of lower net charge-offs, fewer commercial
loan risk-rating downgrades and improving nonperforming asset levels.
Noninterest expense decreased $6.5 million primarily due to lower staff
compensation costs as a result of the 2002 line of business restructuring and
lower processing costs due to the decline in commercial loan volumes. Higher
legal expenses due to loan collection activity partially offset the decline in
noninterest expense. Taxable equivalent net interest income decreased by $16.6
million as a result of a decline in commercial loan balances and lower yields
due to fixed rate loan refinancing, loan repayments and new origination of
commercial loans in the lower interest rate environment.
Consumer Banking net income increased $1.3 million to $38.5 million in 2003
compared to $37.2 million in the prior year. The increase in Consumer Banking
net income was attributable to a $7.5 million decrease in noninterest expense,
partially offset by lower noninterest income of $5.2 million. Noninterest
expense declined as a result of lower salaries and equipment expenses due to our
restructuring of the branch delivery system and the decline in bankcard expense
due to the June 2002 sale of the merchant services business. Noninterest income
decreased $5.2 million due to the prior year $5.4 million gain on sale of the
merchant services business and the related $3.1 million decline in bankcard
revenue in 2003. These changes were partially offset by $3.4 million improvement
in deposit service charge revenue due to higher overdraft fee income and by
reduced fee waivers. The increase in Consumer Banking net income is also
attributable in part to an increase in net interest income of $1.8 million as a
result of improving spreads on loans and to favorable changes in the deposit mix
from high cost time deposits to lower cost core deposits, offsetting the effect
of lower average mortgage loan balances. Consumer Banking net income in 2003 was
also affected by an increase in the provision for loan losses of $2.0 million to
$15.6 million, as a result of a higher provision for losses on wholesale
mortgage loans.
Wealth Management net income declined $3.7 million to $0.6 million in 2003 from
$4.3 million in the prior year. The decline in net income was due to a decrease
in noninterest income and an increase in noninterest expense. Noninterest income
declined as a result of lower trust and brokerage and investment fees. The
decline in trust fees was primarily due to lower average trust assets resulting
from the decline in the financial markets during the latter half of 2002 and the
first quarter of 2003 and, to a lesser extent, to client attrition. The decline
in brokerage and investment fees reflects slower retail sales of fixed annuity
products. Noninterest expense increased due to severance and implementation
costs associated with our strategic alliances with SEI Investments,
EnvestnetPMC, Inc., and EPIC Advisors, Inc. and $0.3 million of additional trust
litigation and account losses.
47
The Other business line recorded net income of $8.2 million in 2003 compared
with a net loss of $3.8 million in 2002. The improvement in net income was the
result of higher noninterest income and lower noninterest expense, partially
offset by lower net interest income and higher income tax expense. The increase
in noninterest income resulted from higher insurance income due to the full year
effect in 2003 of our purchase of $78 million of bank-owned life insurance in
the third quarter of 2002, and the prior year charges attributable to
noninterest income totaling $1.3 million for valuation adjustments to an equity
investment and life insurance cash surrender values. Noninterest expense
declined due to the prior year special and other charges of $19.1 million
included in noninterest expense, partially offset by higher professional fees in
2003 for industry consultants assisting in the business line restructuring and
for field collateral audits.
2002 COMPARED TO 2001
Commercial Banking recorded a net loss of $12.6 million in 2002 compared with
net income of $46.5 million in 2001, due to a significantly higher loan loss
provision and, to a lesser extent, increased operating expenses. The loan loss
provision increased by $90.6 million in 2002 from the prior year, attributable
to increased charge-offs and nonperforming loans in the commercial loan
portfolio. Taxable equivalent net interest income increased $1.2 million as net
interest spreads on commercial loans improved while average loan balances
declined. Noninterest expense increased $2.3 million due to higher other real
estate and loan collection costs.
Consumer Banking net income declined $10.4 million to $37.2 million in 2002
compared to $47.6 million in the prior year. The decrease in Consumer Banking
net income was attributable to lower net interest income, a higher provision for
loan losses and lower noninterest income, partially offset by lower noninterest
expense. Net interest income declined due to lower average loan balances and
narrower interest spreads on deposits. Loan balances declined due to the sale of
the majority of new mortgage loan production, the current and prior year
securitization of new and portfolio mortgage loans, the June 2001 sale of the
Michigan credit card portfolio and a decline in indirect loans. The higher loan
loss provision was attributable to increased charge-offs in the direct and
indirect loan portfolios. Noninterest expense declined $6.5 million, of which
$5.4 million was attributable to lower bankcard expense due to the sale of the
merchant services business in June 2002.
Wealth Management net income declined $1.8 million to $4.3 million in 2002 from
$6.1 million in the prior year. The decrease in Wealth Management net income is
attributable to a decline in trust fees, lower net interest income and higher
noninterest expenses. Trust fees declined due to a lower level of assets under
administration resulting primarily from weak equity markets and, to a lesser
extent, net account attrition. Noninterest expense increased due to higher
salaries, benefits and other expenses.
The Other business line recorded a net loss of $3.8 million in 2002 compared
with net income of $4.5 million in 2001, due to lower noninterest income and
higher noninterest expenses. Noninterest income decreased $11.5 million due to
lower gains on sales of assets. Noninterest expense increased due to the special
and other charges resulting from the third quarter 2002 restructuring actions.
Combined special and other charges of $21.1 million were attributed to the Other
business line. Noninterest expense was charged $19.1 million, noninterest income
was charged $1.3 million and net interest income was charged $0.7 million.
Partially offsetting the increase in noninterest expense is reduced goodwill
amortization costs of $7.2 million, resulting from the implementation of SFAS
No. 142. See Note 7 to the Consolidated Financial Statements for additional
information.
FINANCIAL CONDITION
SUMMARY
The following table summarizes various indicators of our financial condition for
2003, 2002 and 2001.
2003 2002 2001
-------- -------- --------
Average total assets (in millions) $ 7,694 $ 7,569 $ 7,936
Average short term borrowings (in millions) 458.7 251.3 538.7
Average long term debt (in millions) 861.7 620.9 596.4
Average earning assets as a percent of average assets 94.5% 94.6% 94.6%
Average investment securities and money market investments as a
percent of average earning assets 25.7 20.7 18.7
Average loans (including mortgage loans held for sale) as a percent of
average earning assets 74.3 79.3 81.3
Interest-bearing deposits as a percent of average interest-bearing liabilities 78.4 85.3 81.9
Ratio of average noninterest bearing deposits to average deposits 15.5 14.7 14.7
48
These items are discussed in more detail below.
AVERAGE TOTAL ASSETS
Average total assets increased $125 million, or 1.7%, in 2003 to $7.694 billion
due to the expansion of the investment portfolio beginning near the end of the
first quarter of 2003, offset in part by a decrease in commercial and real
estate mortgage loans.
INVESTMENT SECURITIES AND MONEY MARKET INVESTMENTS
Objectives in managing the securities portfolio are driven by the dynamics of
the balance sheet, including growth, maturity, management of interest-rate risk
and maximizing return. Securities classified as available for sale comprised 99%
of the total portfolio.
A summary of investment securities balances at December 31, 2003, 2002 and 2001
is provided below.
INVESTMENT SECURITIES
December 31 (in thousands) 2003 2002 2001
- -------------------------- ---------- ---------- ----------
AVAILABLE FOR SALE:
U.S. Treasury $ -- $ 6,135 $ 8,163
Federal agencies
Mortgage-backed 1,180,493 787,821 565,393
Other agencies 272,089 148,687 166,236
State and municipal:
Taxable 7,948 9,338 10,776
Tax-exempt 429,055 435,613 433,180
Mortgage and asset-backed 4,135 6,452 10,558
Other securities 71,481 63,235 65,200
---------- ---------- ----------
Total $1,965,201 $1,457,281 $1,259,506
========== ========== ==========
HELD TO MATURITY:
State and municipal - tax exempt $ 19,857 $ -- $ --
========== ========== ==========
Total agency-issued securities increased $516.1 million or 55.1% in 2003 after
increasing $204.9 million or 28.0% in 2002. Agency issued mortgage-backed
securities increased $392.7 million or 49.8% in 2003 compared to an increase of
$222.4 million or 39.3% in 2002. Other agency issued securities increased $123.4
million or 83.0% after decreasing in 2002. The overall increase in 2003 was due
to our strategy of expanding the investment securities portfolio by
approximately $500 million in the first half of 2003 to increase net interest
income. The portfolio expansion was funded with cash-flow from loan pay-offs and
short and medium term funding discussed under "Borrowed Funds." In 2002,
mortgage-backed securities increased as proceeds from Treasury and Other Agency
securities were reinvested in more attractive mortgage-backed securities and due
to the retention of securities created from mortgage loan securitizations.
State and municipal securities were purchased in 2003 and 2002 due to their
higher tax equivalent yields. Purchases of these securities remain dependent on
our capacity to effectively utilize tax-exempt income. Other securities,
consisting of Federal Reserve stock, Federal Home Loan Bank stock and money
market funds, totaled 3.6% of total investment securities at December 31, 2003,
compared with 4.3% at year end 2002.
Money market investments comprised of federal funds sold and government money
market investments averaged $11.2 million for 2003 compared with $50.6 million
in 2002. The amount of funds invested in these assets is adjusted from time to
time based on the present and anticipated interest rate environment, liquidity
needs and other economic factors.
49
Maturities and average yields of investment securities at December 31, 2003 are
presented in Table 4 below.
TABLE 4. MATURITIES AND AVERAGE YIELDS OF SECURITIES AT DECEMBER 31, 2003
U.S. Treasury and
Federal Agency(1) State and Municipal (1),(2)
----------------------------- -----------------------------
Amortized Fair Amortized Fair
(in millions) Cost Value Yield Cost Value Yield
- ----------------------- --------- --------- ----- --------- --------- -----
AVAILABLE FOR SALE:
Due within one year $ 244.8 $ 249.8 5.21% $ 14.2 $ 14.0 8.11%
One to five years 918.1 917.4 3.69 92.4 98.3 7.40
Five to ten years 266.9 267.6 4.13 185.0 200.0 7.36
After ten years 17.8 17.8 4.28 116.0 124.7 7.11
--------- --------- --------- ---------
$ 1,447.6 $ 1,452.6 4.04 $ 407.6 $ 437.0 7.32
========= ========= ========= =========
Average maturity (3) 3.43 yrs. 6.93 yrs.
HELD TO MATURITY:
Due within one year $ -- $ --
One to five years 3.7 3.6 5.73
Five to ten years 12.9 13.0 6.46
After ten years 3.3 3.3 6.59
--------- ---------
$ 19.9 $ 19.9 6.35
========= =========
Average maturity (3) 9.10 yrs.
Other(1) Total
----------------------------- -----------------------------
Amortized Fair Amortized Fair
(in millions) Cost Value Yield Cost Value Yield
- ----------------------- --------- --------- ----- --------- --------- -----
AVAILABLE FOR SALE:
Due within one year $ 3.8 $ 3.9 5.49% $ 262.8 $ 267.7 5.37%
One to five years 5.5 5.6 3.15 1,016.0 1,021.3 4.03
Five to ten years 0.1 0.1 3.30 452.0 467.7 5.45
After ten years 66.0 66.0 5.36 199.8 208.5 6.28
--------- --------- --------- ---------
$ 75.4 $ 75.6 4.95 $ 1,930.6 $ 1,965.2 4.78
========= ========= ========= =========
Average maturity (3) 3.14 yrs. 4.19 yrs.
HELD TO MATURITY:
Due within one year $ -- $ --
One to five years 3.7 3.6 5.73
Five to ten years 12.9 13.0 6.46
After ten years 3.3 3.3 6.59
--------- ---------
$ 19.9 $ 19.9 6.35
========= =========
Average maturity (3) 9.10 yrs.
(1) Maturities for Federal agency, collateralized mortgage obligations and
asset-backed securities are based upon projections of independent cash flow
models. Maturities for state and municipal securities incorporate early call
features, if applicable.
(2) Yields for state and municipal securities are calculated on a tax equivalent
basis using a 35% tax rate.
(3) Average maturity information excludes Federal Reserve and Federal Home Loan
Bank stocks with no stated maturity.
As of December 31, 2003, the estimated aggregate fair value of our investment
securities portfolio was $34.6 million above amortized cost, consisting of gross
unrealized gains of $48.2 million and gross unrealized losses of $13.6 million.
A summary of estimated fair values and unrealized gains and losses for the major
components of the investment securities portfolio is provided in Note 5 to the
Consolidated Financial Statements. Our present policies with respect to the
classification of investments in debt and equity securities are discussed in
Note 1 to the Consolidated Financial Statements.
LOAN PORTFOLIO
We extend credit primarily within the local markets of our banking subsidiaries
located in Michigan, Wisconsin, Iowa and Illinois. We generally lend to
consumers and small to mid-sized businesses and, consistent with our emphasis on
relationship banking, most of these credits represent core, multi-relationship
customers who also maintain deposit relationships and utilize other banking
services such as cash management. Our loan portfolio is diversified by borrower
and industry with no concentration within a single industry that exceeds 10% of
total loans. We do not have any loans to foreign debtors and do not purchase
nationally syndicated loans or participate in highly leveraged transactions. We
seek to limit our credit risk by establishing guidelines to review the aggregate
outstanding commitments and loans to particular borrowers, industries, and
geographic areas. We obtain collateral based on the nature of the credit and our
credit assessment of the customer.
PORTFOLIO LOANS
Loan balances by category at December 31 and an analysis of the maturity and
interest rate sensitivity of commercial and real estate construction loans are
presented below.
50
TABLE 5. PORTFOLIO LOANS (1)
(in millions) 2003 2002 2001 2000 1999
- ------------------------------------------ -------- -------- -------- -------- --------
PORTFOLIO LOANS OUTSTANDING AT DECEMBER 31
Commercial $1,521.9 $1,784.7 $1,923.4 $2,127.2 $1,822.4
Commercial real estate 1,364.0 1,326.5 1,323.0 1,205.0 1,053.0
Real estate construction 192.7 262.4 216.0 235.1 185.4
Real estate mortgage 402.9 545.8 821.1 1,282.8 1,440.1
Consumer 1,764.2 1,513.2 1,488.5 1,572.7 1,416.6
-------- -------- -------- -------- --------
Total $5,245.7 $5,432.6 $5,772.0 $6,422.8 $5,917.5
======== ======== ======== ======== ========
PORTFOLIO LOAN MATURITIES AND INTEREST RATE SENSITIVITY AT DECEMBER 31, 2003
One to After
Within Five Five
One Year Years Years Total
-------- -------- -------- --------
Commercial and commercial real estate $1,212.3 $1,513.7 $ 159.9 $2,885.9
Real estate construction 192.7 -- -- 192.7
-------- -------- -------- --------
Total $1,405.0 $1,513.7 $ 159.9 $3,078.6
======== ======== ======== ========
Loans above:
With floating interest rates $ 976.3 $ 620.0 $ 78.7 $1,675.0
With predetermined interest rates 428.7 893.7 81.2 1,403.6
-------- -------- -------- --------
Total $1,405.0 $1,513.7 $ 159.9 $3,078.6
======== ======== ======== ========
(1) Excludes mortgage loans held for sale
The decreases in total portfolio loans in 2003 and 2002 reflect declining
commercial loan and residential mortgage loan balances, partially offset by
growth in consumer loans. On an average basis, portfolio loans comprised 72.2%
of total average earning assets during 2003, compared to 77.2% in 2002.
COMMERCIAL. The commercial loan category includes mostly in-market small (less
than $500,000) and lower-middle market ($500,000 to $2 million) business loans
to a wide variety of businesses across many industries. Commercial loans are
evaluated for adequacy of repayment sources at the time of approval and are
regularly reviewed for any possible deterioration in the ability of the borrower
to repay the loan. In certain instances, collateral is required to provide us
with an additional source of repayment in the event of default by a commercial
borrower. Credit risk for commercial loans arises when borrowers are unwilling
or unable to repay the loan and, in the case of secured loans, when the
collateral value is less than the outstanding loan balance.
Commercial loans declined $262.8 million, or 14.7% in 2003, to $1.522 billion at
December 31, 2003 after decreasing $138.7 million or 7.2% in 2002. The decrease
in 2003 resulted from increased activity in fixed-rate loan refinancing and
paydowns, lower demand for commercial credit and identification and reduction of
exposure on credits with the potential to deteriorate. The decline occurred in
most of our markets, with the exception of Southeast Michigan, including Oakland
County, which experienced modest growth.
COMMERCIAL REAL ESTATE. The commercial real estate category includes mortgage
loans to developers and owners of commercial real estate and multi-unit
residential properties. Approximately two-thirds of these loans are secured by
mortgages on owner-occupied properties. Commercial real estate loans are
governed by the same lending policies and subject to substantially the same
credit risks as commercial loans. Commercial real-estate balances increased 2.8%
in 2003 to $1.364 billion at December 31, 2003 due to growth in certain Michigan
markets including Southeast Michigan and Oakland County. Commercial real estate
balances were essentially unchanged in 2002 as growth in the Michigan market was
offset by a decrease in the Wisconsin market due to stricter credit standards
and de-emphasis of certain types of commercial real estate lending.
REAL ESTATE CONSTRUCTION. Real estate construction loans consist primarily of
single family and multi-family residential projects made to builders or
developers of real estate properties. These loans are typically refinanced at
completion, becoming either income-producing or owner-occupied properties. Real
estate construction loans are governed by the same lending policies and subject
to substantially the same credit risks as commercial loans. Real estate
construction loans decreased 26.6% to $192.7 million at December 31, 2003,
following an increase of 21.5% in 2002. The decrease in 2003 was a result of
lower origination volume due to higher interest rates and decreased product
emphasis.
51
RESIDENTIAL REAL ESTATE. The residential real estate category is comprised
predominately of owner-occupied residential properties. Residential real estate
loans are evaluated for the adequacy of these repayment sources at the time of
approval, including credit scores, debt-to-income ratios and collateral values.
They are predominately originated in accordance with underwriting standards set
forth by the government-sponsored entities, FNMA, FHLMC and the Government
National Mortgage Association (GNMA), who serve as the primary purchasers of
loans sold in the secondary market by mortgage lenders. These underwriting
standards generally require that the loans be collateralized by one-to-four
family residential real estate, have loan-to-collateral value ratios of 80% or
less and are made to borrowers in good credit standing. Our wholly-owned
subsidiary, Citizens Bank Mortgage Company LLC, originates mortgage loans
through our banking offices and a wholesale network of brokers and mortgage
originators. Substantially all of our residential mortgage loans are sold in the
secondary mortgage market. The right to service the loans and receive servicing
fee income is typically sold along with the underlying mortgages. Credit risks
for residential real estate loans are similar to those arising from commercial
loans.
In 2003, residential mortgage loans declined $142.9 million, or 26.2% to $402.9
million at December 31, 2003 following a decrease of $275.3 million or 33.5% in
2002. The decline in 2003 and 2002 reflects higher payoffs, resulting from
increased refinance activity due to historically low mortgage interest rates,
and the sale of most new mortgage loan originations. In addition, in 2002 we
securitized $28.6 million of new mortgage loan production and $114.3 million of
loans previously held within our mortgage loan portfolio.
CONSUMER. The consumer loan category primarily includes home equity loans, and
direct and indirect installment loans used by customers to purchase boats,
recreational vehicles and autos. Home equity loans consist mainly of revolving
lines of credit to consumers that are secured by residential real estate. These
loans are originated through our banking offices with loan-to-value ratios
generally limited to 90% of collateral value. The same lending policies as
described above for residential real estate loans generally govern consumer
loans. Credit risk in the consumer loan portfolio arises from borrowers lacking
the ability or willingness to repay the loan, and in the case of secured loans,
by a shortfall in the collateral value in relation to the outstanding loan
balance in the event of default and subsequent liquidation of collateral.
In 2003, consumer loans increased $251.0 million, or 16.6%, to $1.764 billion at
December 31, 2003 after increasing $24.7 million, or 1.7%, in 2002. The increase
in consumer loans in 2003 reflects higher home equity loan balances and indirect
loan balances, partially offset by a decline in other direct consumer products.
In 2003, home equity loans increased $196.5 million or 35.6% to $749.2 million
at December 31, 2003, as a result of successful targeted sales and marketing
efforts.
MORTGAGE LOANS HELD FOR SALE
Mortgage loans held for sale were $44.7 million at December 31, 2003, a decrease
of $116.0 million from $160.7 million at December 31, 2002. The decrease was
primarily due to a decrease in residential mortgage loan closings during the
fourth quarter of 2003 of $158.2 million compared to $467.7 million closed
during fourth quarter of 2002, as loans closed generally remain in loans held
for sale for 30 to 60 days after closing. In addition, $16.9 million of mortgage
loan closings during the fourth quarter 2003 were portfolio loan closings
compared to $23.6 million during the fourth quarter of 2002. Mortgage loans held
for sale at December 31, 2002 reflect an increase of $10.3 million, or 6.8%,
from $150.4 million at December 31, 2001. The increase in 2002 reflects a higher
volume of residential mortgage loans originated in the fourth quarter of 2002
compared to the fourth quarter of 2001 due to the low interest rate environment.
CREDIT RISK MANAGEMENT
Extending credit to businesses and consumers exposes us to credit risk -- the
risk that the principal balance of a loan and any related interest will not be
collected due to the inability or unwillingness of the borrower to repay the
loan. Credit risk is mitigated through portfolio diversification that limits
exposure to any single industry or customer. Similarly, credit risk is also
mitigated through the establishment of a comprehensive system of internal
controls, which includes standard lending policies and procedures, underwriting
criteria, collateral safeguards, and surveillance and evaluation by an
independent internal loan review staff of the quality, trends, collectibility
and collateral protection within the loan portfolio. Lending policies and
procedures are reviewed and modified on an ongoing basis as conditions change
and new credit products are offered. Our commercial and commercial real estate
credit administration policies include a loan rating system that is validated by
the internal loan review staff who verify credit ratings by sampling loans based
upon select criteria, including loan size, delinquency status, loan officer
coverage and other factors. Furthermore, account officers are vested with the
responsibility of monitoring their customer relationships and act as the first
line of defense in determining changes in the loan ratings on credits for which
they are responsible. In an ongoing effort to strengthen and monitor loan
structuring and collateral position, collateral field audits are performed on
those credits that have a significant reliance on accounts receivable and
inventory. Loans that have migrated within the loan rating system to a level
that requires remediation are actively reviewed by senior management at
regularly scheduled quarterly meetings with the credit administration staff and
the account officers. At these meetings, action plans are developed to either
remediate any emerging problem loans or develop a specific plan for removing
such loans from the portfolio within a short time frame.
52
During the fourth quarter of 2002 and the first quarter of 2003, we experienced
two unanticipated loan losses resulting from collateral value shortfalls due to
falsified borrowing base reports by the borrower. To reduce our risk of further
unforeseen losses from similar collateral issues and to supplement our normal
credit review procedures, we hired outside collateral auditors in March 2003 to
conduct field audits on all loans in excess of $5 million and risk-selected
loans in excess of $1 million in which the primary collateral consists of
accounts receivable and inventory. A field audit focuses on the value of the
collateral and validates the borrower's reporting processes. Based upon results
of these audits, there have been no additional reserves or charge-offs, although
a small number of commercial customers have been requested to seek alternative
financing because they were unwilling or unable to accommodate our reporting
requests. We have instituted regular audits of receivable and inventory
collateral as standard practice going forward.
PROVISION AND ALLOWANCE FOR LOAN LOSSES
The provision for loan losses represents a charge against income and a
corresponding increase in the allowance for loan losses. Credit losses are
charged and recoveries are credited to the allowance for loan losses. The amount
of the allowance for loan losses is based on our review of the historical credit
loss experience and such factors that, in our judgment, deserve consideration
under existing economic conditions in estimating probable credit losses. While
we consider the allowance for loan losses to be adequate based on information
currently available, future adjustments to the allowance may be necessary due to
changes in economic conditions, delinquencies or loss rates. See "Critical
Accounting Policies."
A summary of our loan loss experience for the past five years appears in Table
6.
TABLE 6. SUMMARY OF LOAN LOSS EXPERIENCE
Year Ended December 31 (dollars in thousands) 2003 2002 2001 2000 1999
- ----------------------------------------------- ----------- ----------- ----------- ----------- -----------
Allowance for loan losses - January 1 $ 106,777 $ 76,275 $ 75,413 $ 75,207 $ 69,740
Allowance of acquired (sold) banks and branches -- -- (240) -- 2,400
Transfer to reserve for commitments -- 1,334 633 (3,467) (1,190)
Provision for loan losses 62,962 120,200 26,407 20,983 24,675
CHARGE-OFFS:
Commercial 49,091 83,503 18,265 10,920 8,675
Real estate 1,234 2,027 189 169 436
Consumer 15,738 16,174 14,278 14,359 17,751
---------- ----------- ----------- ----------- -----------
Total charge-offs 66,063 101,704 32,732 25,448 26,862
---------- ---------- ---------- ---------- ----------
RECOVERIES:
Commercial 14,850 5,860 1,950 3,577 2,483
Real estate 36 11 47 45 149
Consumer 4,983 4,801 4,797 4,516 3,812
---------- ---------- ---------- ---------- ----------
Total recoveries 19,869 10,672 6,794 8,138 6,444
---------- ---------- ---------- ---------- ----------
Net charge-offs 46,194 91,032 25,938 17,310 20,418
----------- ----------- ----------- ----------- -----------
Allowance for loan losses - December 31 $ 123,545 $ 106,777 $ 76,275 $ 75,413 $ 75,207
=========== =========== =========== =========== ===========
Allowance for losses on lending-related
commitments - December 31 $ 2,690 $ 2,690 $ 4,024 $ 4,657 $ 1,190
=========== =========== =========== =========== ===========
Portfolio loans outstanding at year-end (1) $ 5,245,702 $ 5,432,561 $ 5,771,963 $ 6,422,806 $ 5,917,483
Average portfolio loans outstanding (1) 5,248,922 5,530,790 5,977,744 6,202,157 5,528,963
Ratio of allowance for loan losses to
portfolio loans outstanding at year-end 2.36% 1.97% 1.32% 1.17% 1.27%
Ratio of net loans charged off as a percentage
of average portfolio loans outstanding 0.88 1.65 0.43 0.28 0.37
(1) Balances exclude mortgage loans held for sale.
(2) During the fourth quarter of 2003, Citizens reclassified $2.7 million from
the allowance for loan losses related to unfunded loan commitments to other
liabilities. Prior period amounts were restated to conform to the new
presentation.
53
The lower loan loss provision in 2003 resulted from a decline in nonperforming
assets, lower net charge-offs and fewer risk rating downgrades within the
commercial loan portfolio. Additionally, enhancements to the loan loss
allocation model resulted in relatively higher loan loss allocations in 2002.
These enhancements included the incorporation of more recent historical loss
data in the determination of projected loss rates for pools of loans evaluated
collectively and refinements to our internal risk rating system for our
commercial loans, which initially led to an increase in downgrades.
The decrease in net charge-offs in 2003 occurred primarily in the commercial
loan portfolio. Commercial net charge-offs totaled $34.2 million in 2003,
compared with $77.6 million in 2002. Mortgage and consumer loans net charge-offs
also decreased, but by lesser amounts. Eight customers comprised $24.5 million
or 50% of the gross commercial charge-offs during 2003. On a comparative basis,
$45.5 million or nearly 55% of the loans charged off in 2002 related to eight
customers. The commercial loans charge-offs in 2003 were from a variety of
industries, including steel products manufacturing, heavy construction,
industrial supply, electric power distribution, retail grocery, and agriculture.
Many of our commercial clients have been negatively affected by a weak economy
that has only recently begun to show varying signs of recovery. Net residential
mortgage loan charge-offs aggregated $1.2 million in 2003, driven in part by the
discount of $0.6 million on the March 2003 sale of $2.8 million of
non-performing loans. Based on the current economic climate and the trend that
began in the second half of 2003, we expect net charge-offs and the provision
for loan losses to be lower in 2004 than in 2003.
The allowance for credit losses represents our estimate of probable losses
inherent in the loan portfolio. The allowance is based on ongoing quarterly
assessments and is maintained at a level we consider adequate to absorb probable
loan losses identified with specific customer relationships and probable losses
believed to be inherent in the loan portfolio which have not been specifically
identified. Our evaluation process is inherently subjective, as it requires
estimates that may be susceptible to significant change and have the potential
to materially affect net income. Default frequency, internal risk ratings,
expected future cash collections, loss recovery rates, and general economic
factors, among other things, are considered in this evaluation, as are the size
and diversity of individual large credits. We have not substantively changed our
overall approach in the determination of the allowance for loan losses in 2003
from 2002 and the allocation methods used at December 31, 2003 and December 31,
2002 were consistent. Our methodology for measuring the adequacy of the
allowance relies on several key elements, which include specific allowances for
identified problem loans, a formula-based risk-allocated allowance for the
remainder of the portfolio and an unallocated allowance. Management may also
consider overall portfolio indicators, including trends in historical
charge-offs, a review of industry, geographic and portfolio performance, and
other qualitative factors. This methodology is discussed in Note 1 to the
Consolidated Financial Statements.
Internal risk ratings are assigned to each commercial and commercial mortgage
loan at the time of approval and are subject to subsequent periodic reviews by
senior management. These ratings encompass ten categories that define a
borrower's estimated ability to repay their loan obligations. In the third
quarter of 2002, we added a new 6 minus subcategory to our ten point rating
system and incorporated a new scoring methodology for certain larger balance
watch list commercial credits that lowered the number of factors considered from
eight to five and gave additional weight toward discounted service ability (cash
flow capacity), financial condition and capitalization of the borrower, and less
from collateral coverage and prior relationship history. As a result of these
changes, a number of commercial credits were downgraded to higher risk ratings
resulting in higher loss rates being applied to the same dollar of exposure.
Generally, we had used a historical three-year rolling average of net
charge-offs as the base for developing loss factors for commercial credits.
Beginning in the third quarter of 2002, in order to emphasize more recent loss
trends in our methodology, we utilized an eighteen-month rolling average of net
charge-offs. The loss rates were more heavily weighted toward more current loss
experience as we view the most recent loss history as more representative of the
current economic conditions inherent in our loan portfolio. These changes did
not affect the level of net charge-offs or the calculation of the specific
allowances, but increased the risk allocation allowance by approximately $23
million at December 31, 2002, and to a lesser extent at December 31, 2003.
54
Table 7 below summarizes the allocation of the allowance for loan losses for
risk allocated, specific allocated and unallocated allowances by loan type and
the percentage of each loan type of total portfolio loans.
TABLE 7. ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES(1)
2003 2002 2001 2000 1999
--------------- --------------- --------------- --------------- ---------------
% OF % of % of % of % of
December 31 TOTAL Total Total Total Total
(dollars in millions) AMOUNT LOANS Amount Loans Amount Loans Amount Loans Amount Loans
- ----------------------------- ------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Specific allocated allowance:
Commercial(2) $ 18.3 $ 18.7 $ 9.5 $ 5.5 $ --
Risk allocated allowances:
Commercial(2) 68.6 55.0% 62.2 57.3% 29.3 56.2% 26.4 51.9% 21.2 48.6%
Real estate construction 1.1 3.7 1.0 4.8 0.5 3.7 1.1 3.7 0.8 3.2
Real estate mortgage 4.7 7.7 2.3 10.0 3.3 14.2 5.7 20.0 5.9 24.3
Consumer 15.1 33.6 15.2 27.9 15.6 25.9 15.3 24.4 22.5 23.9
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total risk allocated
allowance 89.5 80.7 48.7 48.5 50.4
------ ------ ------ ------ ------
Total allocated 107.8 100.0% 99.4 100.0% 58.2 100.0% 54.0 100.0% 50.4 100.0%
====== ====== ====== ====== ======
Unallocated 15.7 7.4 18.1 21.4 24.8
------ ------ ------ ------ ------
Total $123.5 $106.8 $ 76.3 $ 75.4 $ 75.2
====== ====== ====== ====== ======
(1) The allocation of the allowance for loan losses in the above table is based
upon ranges of estimates and is not intended to imply either limitations on
the usage of the allowance or precision of the specific amounts. Citizens
and its subsidiaries do not view the allowance for loan losses as being
divisible among the various categories of loans. The entire allowance is
available to absorb any future losses without regard to the category or
categories in which the charged-off loans are classified.
(2) The commercial category includes both commercial and commercial real estate
loans
SPECIFIC ALLOCATED ALLOWANCE. Classified credits, which include "doubtful",
"substandard" and "special mention" and are subject to specific reserves,
decreased to $66.7 million at December 31, 2003 from $90.4 million at December
31, 2002. The amount of the specific allowance however, as a percent of
outstanding loan balances subject to such specific reserves, increased to 27.5%
at December 31, 2003 from 20.7% at December 31, 2002 as more substandard credits
were assigned a specific reserve. Credits classified as "doubtful" have critical
weaknesses that make full collection improbable. "Substandard" credits have
well-defined weaknesses which, if not corrected, could jeopardize the full
satisfaction of the debt. "Special mention" credits are potentially weak, as the
borrower has begun to exhibit deteriorating trends that, if not corrected, could
jeopardize repayment of the loan and result in further downgrade.
RISK ALLOCATED ALLOWANCE. The amount allocated to commercial and commercial real
estate loans increased in 2003, reflecting our review of additional loans in
2003 using the new scoring methodology, a migration of loans to higher risk
ratings and assessment of current economic conditions within our local markets.
The increase in 2003 in the real estate mortgage risk allocated allowance was
attributable to an increased allocation for wholesale-originated mortgage loans,
partially offset by lower balances and a reduction in nonaccrual loans. The
reduction in nonaccrual real estate loans was attributable in part to the March
2003 sale of $2.8 million of nonperforming mortgage loans.
UNALLOCATED ALLOWANCE. The increase in the unallocated allowance reflects
continued uncertainty regarding general economic conditions in the near term,
and the lingering effects of the weak economy over the past several years on our
commercial loan portfolio, especially in the manufacturing and agricultural
sectors. Although most observable credit quality indicators have improved, the
manufacturing sector in our markets remains weak as evidenced by continued high
unemployment. The agricultural sector, although improving, is emerging from a
period of prolonged low producer prices and weakness. Additionally, uncertainty
regarding the economy is evidenced by conflicting reports on economic growth,
job creation, the volatility of long term interest rates, budget shortfalls at
the state, local and federal government levels and slow demand for capital
investments. These factors, coupled with an increase at December 31, 2003 in
other credits that are current in terms of principal and interest payments, but
which may deteriorate in quality if economic conditions change, indicate that
additional undetected losses exist in the loan portfolios. Based on these
factors and the possible imprecision in our loan loss allocation models,
management believes that the unallocated allowance at December 31, 2003
appropriately reflects probable inherent but undetected losses in the portfolio.
55
NONPERFORMING ASSETS
Nonperforming assets are comprised of nonaccrual loans, restructured loans and
repossessed assets. Although these assets have more than a normal risk of loss,
they will not necessarily result in a higher level of losses in the future. A
five-year history of nonperforming assets is presented in Table 8.
TABLE 8. NONPERFORMING ASSETS AND PAST DUE LOANS
December 31 (in thousands) 2003 2002 2001 2000 1999
- ---------------------------------------------------- ------- ------- ------- ------- -------
NONPERFORMING LOANS(1),(2)
Nonaccrual
Less than 30 days past due $ 7,721 $15,869 $ 6,528 $ 7,237 $ 1,661
From 30 to 89 days past due 4,474 23,210 5,218 7,297 772
90 or more days past due 56,549 47,638 57,047 44,881 26,498
------- ------- ------- ------- -------
Total 68,744 86,717 68,793 59,415 28,931
90 days past due and still accruing 345 860 4,168 889 2,139
Restuctured (1) -- -- 337 1,068 9
------- ------- ------- ------- -------
Total nonperforming loans 69,089 87,577 73,298 61,372 31,079
OTHER REPOSSESSED ASSETS ACQUIRED 7,943 8,094 5,947 4,917 4,039
------- ------- ------- ------- -------
Total nonperforming assets $77,032 $95,671 $79,245 $66,289 $35,118
======= ======= ======= ======= =======
Nonperforming assets as a percent of portfolio loans
plus other repossessed assets acquired 1.47% 1.76% 1.37% 1.03% 0.59%
Nonperforming assets as a percent of total assets 1.00 1.27 1.03 0.79 0.45
NONPERFORMING LOANS BY TYPE
Commercial $38,774 $51,745 $36,926 $24,758 $11,920
Commercial real estate 16,385 19,301 11,052 12,471 6,085
Real estate mortgage 9,161 10,865 17,304 17,057 7,366
Consumer 4,424 5,666 8,016 7,086 5,708
------- ------- ------- ------- -------
Total $68,744 $87,577 $73,298 $61,372 $31,079
======= ======= ======= ======= =======
(1) Nonperforming loans include loans on which interest is being recognized only
upon receipt (nonaccrual), those on which interest has been renegotiated to
lower than market rates because of the financial condition of the borrowers
(restructured), and loans 90 days past due and still accruing.
(2) Gross interest income that would have been recorded in 2003 for nonaccrual
and restructured loans, as of December 31, 2003, assuming interest had been
accrued throughout the year in accordance with original terms was $6.261
million. The comparable 2002 and 2001 totals were $7.721 million, and $6.392
million, respectively. Interest collected on these loans and included in
income was $4.011 million in 2003, $4.685 million in 2002 and $3.344 million
in 2001. Therefore, on a net basis, total income foregone due to these loans
was $2.250 million in 2003, $3.036 million in 2002 and $3.048 million in
2001.
The decrease in nonperforming commercial and commercial real estate loans was
the result of aggressive collection efforts and, to a lesser extent, continued
charge-off of nonperforming loans. In addition, the decrease was attributable to
a reduction of the inflow of new nonperforming loans, particularly in the second
half of 2003, due to proactive management and reduction of exposure on credits
with the potential to deteriorate. We believe the risk of loss for commercial
real estate nonperforming loans is significantly less than the total principal
balance, due to the nature of the underlying collateral and the value of such
collateral in relation to the total credit exposure. These loans are generally
for owner-occupied properties and the sources of repayment are not dependent on
the performance of the real estate market.
Nonperforming loans in both the residential mortgage and consumer loan
portfolios decreased at December 31, 2003 compared with December 31, 2002. In
the consumer portfolio, a change in asset mix, which included strong growth in
home equity loans, has helped reduce nonperforming levels. Residential mortgage
nonperforming loans declined due to the March 2003 sale of $2.8 million of
nonperforming mortgage loans.
Nonperforming assets, charge-offs and provisions for loan losses tend to decline
in a strong economy and increase in a weak economy, potentially impacting our
results. In addition to loans classified as nonperforming, we carefully monitor
other credits that are current in terms of principal and interest payments but
which we believe may deteriorate in quality if economic conditions change. As of
December 31, 2003, such loans amounted to $189.8 million or 3.6% of total
portfolio
56
loans compared with $134.6 million or 2.5% of total portfolio loans as of
December 31, 2002. These loans are commercial and commercial real estate loans
made in the normal course of business and do not represent a concentration in
any one industry or geographic location.
Under our credit policies and practices, a loan is placed on nonaccrual status
when there is doubt regarding collection of principal or interest, or when
principal or interest is past due 90 days or more and the loan is not well
secured and in the process of collection. Interest accrued but not collected is
reversed and charged against income when the loan is placed on nonaccrual
status. A loan is considered impaired when we determine that it is probable that
all the principal and interest due under the loan may not be collected. In most
instances, impairment is measured based on the fair value of the underlying
collateral. Impairment may also be measured based on the present value of
expected future cash flows discounted at the loan's effective interest rate. We
maintain a valuation allowance for impaired loans. Cash collected on impaired
nonaccrual loans is applied to outstanding principal. Interest income on all
other impaired loans is recorded on an accrual basis.
Certain of our nonperforming loans included in Table 8 are considered to be
impaired. We measure impairment on all large balance nonaccrual commercial and
commercial real estate loans. Certain large balance accruing loans rated
substandard or lower are also measured for impairment. Impairment losses are
included in the provision for loan losses. The policy does not apply to large
groups of smaller balance homogeneous loans that are collectively evaluated for
impairment, except for those loans restructured under a troubled debt
restructuring. Loans collectively evaluated for impairment include certain
smaller balance commercial loans, consumer loans, and residential real estate
loans, and are not included in the impaired loan data. Total loans considered
impaired and their related reserve balances at December 31, 2003 and 2002, as
well as their effect on net income in 2003 and 2002, are set forth in the
following table.
IMPAIRED LOAN INFORMATION Valuation Reserve
-----------------
(in thousands) 2003 2002 2003 2002
- ----------------------------------------------- ------- ------- ------- -------
Balances - December 31
Impaired loans with valuation reserve $36,603 $41,240 $12,449 $13,338
Impaired loans with no valuation reserve 35,155 35,272 -- --
------- ------- ------- -------
Total impaired loans $71,758 $76,512 $12,449 $13,338
======= ======= ======= =======
Impaired loans on nonaccrual basis $55,159 $70,345 $ 3,913 $ 8,690
Impaired loans on accrual basis 16,599 6,167 8,536 4,648
------- ------- ------- -------
Total impaired loans $71,758 $76,512 $12,449 $13,338
======= ======= ======= =======
Average balance for the year $84,077 $80,487
Interest income recognized for the year 854 1,376
Cash collected applied to outstanding principal 3,758 4,415
DEPOSITS
Table 9 below provides a year-to-year comparison of our average deposit balances
over the last three years. Average, rather than period-end, balances are more
meaningful in analyzing our deposit funding sources because of inherent
fluctuations that occur on a monthly basis with most deposit categories.
TABLE 9. AVERAGE DEPOSITS
2003 2002 2001
------------------ ------------------ ------------------
Year Ended December 31 AVERAGE AVERAGE Average Average Average Average
(dollars in millions) BALANCE RATE Balance Rate Balance Rate
- -------------------------- -------- ------- -------- ------- -------- -------
Noninterest-bearing demand $ 877.9 --% $ 869.7 --% $ 881.2 --%
Interest-bearing demand 1,319.9 0.89 1,148.0 1.57 744.8 1.88
Savings 1,329.6 0.67 1,363.5 1.14 1,474.5 2.36
Time 2,138.1 2.94 2,543.3 3.71 2,907.6 5.37
-------- -------- --------
Total $5,665.5 1.47 $5,924.5 2.16 $6,008.1 3.41
======== ======== ========
57
Total average deposits declined 4.4% in 2003. Average noninterest bearing and
interest bearing demand balances increased 0.9% and 15.0%, respectively, in 2003
as a result of deposit campaigns focused on growing core checking deposits.
These increases were more than offset by a 16% decrease in average time deposits
in 2003 a result of less aggressive pricing and efforts to migrate deposits
towards core deposit products. The decline in the average cost for the deposit
portfolio was a result of the lower rate environment and a shift in the deposit
mix from higher cost time deposits to lower cost interest-bearing or
noninterest-bearing demand accounts.
As of December 31, 2003, certificates of deposit of $100,000 or more accounted
for approximately 11.4% of total deposits. The maturities of these deposits are
summarized below in Table 10.
TABLE 10. MATURITY OF TIME CERTIFICATES OF DEPOSIT OF $100,000 OR MORE
December 31,
(in thousands) 2003
- ---------------------------------- ------------
Three months or less $ 154,914
After three but within six months 103,652
After six but within twelve months 143,272
After twelve months 217,119
------------
Total $ 618,957
============
We gather deposits primarily from the local markets of our banking subsidiaries
and have used purchased deposits from time to time when cost effective. Brokered
deposits and time deposits greater than $100,000 declined by $58.7 million at
December 31, 2003 from the prior year-end due to less aggressive pricing of such
deposits and the reduced need for such funding. We will continue to evaluate the
use of alternative funding sources such as brokered deposits as funding needs
change. We continue to promote relationship driven core deposit growth and
stability through focused marketing efforts and competitive pricing strategies.
BORROWED FUNDS
Short-term borrowings are comprised of Federal funds purchased, securities sold
under agreements to repurchase, other bank borrowings, and Treasury Tax and Loan
notes. Total short-term borrowings averaged $458.7 million in 2003, or 7.5%, of
total average interest-bearing liabilities, compared with $251.3 million, or
4.2%, during 2002. The increase in short-term borrowings was due to the
expansion of the investment portfolio and increased need for wholesale funding.
See Note 11 to the Consolidated Financial Statements for additional information
on short-term borrowings.
Long-term debt, comprised of FHLB notes, subordinated notes and other long-term
debt, accounted for $861.7 million, or 14.1%, of average interest-bearing funds
during 2003, increasing from $620.9 million or 10.5% during 2002. On January 27,
2003, we issued $125 million of 5.75% subordinated notes due in 2013. The notes
qualify as Tier 2 capital for regulatory risk-based capital purposes and were
issued to provide funding to support cash flow requirements at our parent
company and to improve our risk-based capital ratios. In June 2003, we issued
approximately $25 million of floating rate 30 year trust preferred securities
through a special purpose trust with an initial interest rate of 4.16%. Interest
only payments are due quarterly and full payment of the principal is due in June
2033. These securities qualify as Tier 1 capital for regulatory risk-based
capital purposes and were issued to improve liquidity and risk-based capital
ratios. FHLB advances increased $188.8 million to $787.9 million at December 31,
2003. The increase reflects our need for additional wholesale funding to support
the expansion of the investment portfolio and the decline in time deposits
during 2003. A summary of long-term debt balances as of December 31, 2003 and
2002 appears in Note 12 to the Consolidated Financial Statements. Borrowed funds
are expected to remain an important, reliable and cost-effective funding vehicle
for us.
During 2002, we prepaid $75 million in high cost FHLB debt with a remaining
maturity of approximately one year to improve balance sheet flexibility, further
reduce our funding costs and adjust our interest rate sensitivity. New FHLB
borrowings with contractual maturity of greater than one year replaced a major
portion of the prepaid debt.
58
CAPITAL RESOURCES
We continue to maintain a strong capital position which supports our current
needs and provides a sound foundation to support further expansion. Our
regulatory capital ratios are consistently at or above the "well-capitalized"
standards and all our bank subsidiaries have sufficient capital to maintain a
well-capitalized designation. Our capital ratios for the past three years are
presented below.
Regulatory Minimum
----------------------- December 31,
"Well- --------------------------
Required Capitalized" 2003 2002 2001
-------- ------------ ------ ------ ------
Risk based:
Tier 1 capital 4.00% 6.00% 9.80% 9.18% 9.87%
Total capital 8.00 10.00 13.23 10.43 11.12
Tier 1 leverage 4.00 5.00 7.45 7.18 7.79
Average shareholders equity was $632.1 million, or 8.22% of average assets for
2003 compared with $691.8 million, or 9.14%, for 2002 and $702.4 million, or
8.85% for 2001. At December 31, 2003, shareholders' equity was $635.2 million,
compared with $650.5 million at December 31, 2002. Book value per common share
at December 31, 2003 and 2002 was $14.69 and $14.88, respectively. We declared
and paid cash dividends of $1.14 per share in 2003, up from $1.13 per share in
2002 and $1.085 per share in 2001. Shareholders' equity declined in 2003 as net
income was more than offset by cash dividends and capital used in our share
repurchase program. Shareholders equity also declined in 2003 due to a decrease
in other comprehensive net income as the net unrealized gain on
available-for-sale securities decreased.
In October 2001, our board of directors approved a plan to repurchase up to
3,000,000 shares of Citizens' common stock for general corporate purposes. At
December 31, 2003, 2,745,400 shares of common stock had been repurchased under
this plan at an average price of $28.28, including 810,800 shares purchased
during 2003 at an average price of $26.30. In October 2003, our board of
directors approved a new plan to repurchase an additional 3,000,000 shares of
common stock. These shares are in addition to the 254,600 shares authorized to
be repurchased under the plan approved in October 2001. The repurchase of our
shares is subject to limitations that may be imposed by applicable securities
laws and regulations and the rules of the Nasdaq Stock Market. The timing of the
repurchases and the number of shares to be bought at any one time depend on
market conditions and our capital requirements. There can be no assurance that
we will repurchase the remaining shares authorized to be repurchased, or that
any additional repurchases will be authorized by our board of directors.
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
CONTRACTUAL OBLIGATIONS
In the ordinary course of its business, we enter into certain contractual
arrangements that require future cash payments and may impact liquidity. These
obligations include issuance of debt to fund operations, purchase obligations to
acquire goods or services, and property leases. The table below summarizes our
non-cancelable contractual obligations and future required minimum payments at
December 31, 2003. Refer to Notes 9 and 12 to the Consolidated Financial
Statements for a further discussion of these contractual obligations.
TABLE 11. CONTRACTUAL OBLIGATIONS
Minimum Payments Due by Period
----------------------------------------------------
Less More
than 1-3 4-5 than
(in thousands) Total 1 year years years 5 years
- --------------------------------------------- -------- -------- -------- -------- --------
Federal Home Loan Bank borrowings $787,930 $ 85,200 $320,200 $ 95,204 $287,326
Subordinated debt 148,835 -- -- -- 148,835
Capital lease/mortgage debt 94 56 38 -- --
Purchase obligations 37,784 11,899 21,874 4,011 --
Operating leases and non-cancelable contracts 14,447 3,126 4,835 2,645 3,841
-------- -------- -------- -------- --------
Total $989,090 $100,281 $346,947 $101,860 $440,002
======== ======== ======== ======== ========
We are also contractually obligated to certain derivative instruments. Refer to
Note 18 to the Consolidated Financial Statements for further discussion of these
contractual obligations.
59
OFF-BALANCE SHEET ARRANGEMENTS
In the normal course of business, in order to meet the financing needs of our
customers and to manage our own exposure to interest rate risk, we become a
party to transactions involving financial instruments with off-balance sheet
risk. These financial instruments which are not reflected in the Consolidated
Financial Statements include commitments to extend credit, standby letters of
credit, forward commitments to sell mortgage loans and interest rate swaps. The
contractual amounts of these instruments express the extent of our involvement
in these transactions as of the balance sheet date. These instruments involve,
to varying degrees, elements of credit risk, market risk and liquidity risk in
excess of the amount recognized in the consolidated balance sheets. However,
they do not represent unusual risks for us and we do not anticipate any
significant losses to arise from these transactions.
Commitments to extend credit are legally binding agreements to lend cash to a
customer as long as there is no breach of any condition established in the
contract. Commitments generally have fixed expiration dates or other termination
clauses and may require the payment of a fee. Commitments to fund loan
applications with agreed-upon rates subject us to market risk due to
fluctuations in interest rates. Standby letters of credit guarantee the
performance of a customer to a third party. We issue these guarantees primarily
to support public and private borrowing arrangements, real estate construction
projects, bond financing and similar transactions.
The credit risk associated with commitments to extend credit and standby letters
of credit is essentially the same as that involved with direct lending.
Therefore, these instruments are subject to our loan review and approval
procedures and credit policies. Based upon management's credit evaluation of the
counter-party, we may require the counter-party to provide collateral as
security for the agreement, including real estate, accounts receivable,
inventories, and investment securities. The maximum credit risk associated with
these instruments equals their contractual amounts and assumes that the
counter-party defaults and the collateral proves to be worthless. The total
contractual amounts of commitments to extend credit and standby letters of
credit do not necessarily represent future cash requirements, since many of
these agreements may expire without being drawn upon. At December 31, 2003 and
2002, we had recorded a liability of $2.7 million for possible losses with
commitments to extend credit and, in accordance with FIN 45, a liability of $0.8
million representing the value of the guarantee obligations associated with
certain standby letters of credit. The guarantee obligation liability will be
amortized into income over the life of the commitments.
At December 31, 2003, we had outstanding $14.7 million of commitments to fund
residential real estate loan applications with agreed-upon rates ("Interest Rate
Lock Commitments"). Interest Rate Lock Commitments and holding residential
mortgage loans for sale to the secondary market exposes us to interest rate risk
during the period from application to when the loan is sold to the investors. To
minimize this exposure to interest rate risk, we enter into firm commitments to
sell such mortgage loans at specified future dates to various third parties.
At December 31, 2003, we had outstanding mandatory forward commitments to sell
$29.0 million of residential mortgage loans. These mandatory forward commitments
covered $23.0 million of mortgage loans held for sale and $6.0 million of
Interest Rate Lock Commitments. These outstanding forward commitments to sell
mortgage loans are expected to settle in the first quarter of 2004 without
producing any material gains or losses. We implemented SFAS 133, as amended
which provides accounting guidance for derivative investments and hedging
activities effective January 1, 2001. See Note 1 to the Consolidated Financial
Statements for further explanation. For the year ended December 31, 2003, the
impact of SFAS 133 on net income was immaterial.
At December 31, 2003, we had interest rate swaps with a notional amount of $190
million with a fixed receive rate of 4.78% and a variable pay rate of 1.62%.
Notional amounts of $165 million and $25 million have variable pay rates based
on LIBOR and prime, respectively.
60
The following table presents the total notional amounts and expected maturity of
our off-balance sheet financial instruments outstanding at December 31, 2003 and
the notional amounts outstanding at December 31, 2002.
TABLE 12. OFF BALANCE SHEET FINANCIAL INSTRUMENTS
Expected Expiration Dates by Period
----------------------------------------------------------
Total Less than More than December 31,
(in thousands) 2003 1 year 1-3 years 4-5 years 5 years 2002
- --------------------------------------------------------- ---------- ---------- ---------- ---------- ---------- ------------
FINANCIAL INSTRUMENTS WHOSE
CONTRACT AMOUNTS REPRESENT CREDIT RISK:
Loan commitments to extend credit $1,593,426 $1,202,613 $ 101,390 $ 15,971 $ 273,452 $ 1,739,091
Standby letters of credit 48,868 39,116 8,115 1,637 -- 36,396
Commercial letters of credit 183,665 40,690 22,151 103,581 17,243 138,679
FINANCIAL INSTRUMENTS SUBJECT TO INTEREST RATE RISK:
Interest rate swaps 190,000 -- 25,000 -- 165,000 --
Residential mortgage loan applications
with agreed-upon rates 14,683 14,683 -- -- -- 66,787
Forward commitments to sell residential mortgage loans 29,000 29,000 -- -- -- 175,537
---------- ---------- ---------- ---------- ---------- ------------
Total $2,059,642 $1,326,102 $ 156,656 $ 121,189 $ 455,695 $ 2,156,490
========== ========== ========== ========== ========== ============
During the ordinary course of business, we also engage in other financial
transactions that are not recorded on our consolidated balance sheets or are
recorded on an equity or cost basis rather than being consolidated. Such
transactions serve a variety of purposes including management of our liquidity,
optimization of capital utilization, meeting the financial needs of our
customers and fulfilling Community Reinvestment Act obligations in the markets
that we serve.
Late in the second quarter of 2003, we issued to institutional investors
approximately $25 million of floating rate trust preferred securities through a
special purpose trust which qualifies as a variable interest entity ("VIE")
under applicable accounting rules. Since we are not the primary beneficiary of
the VIE, consolidation is not required under the terms of Financial Accounting
Standards Board Interpretation 46 "Consolidation of Variable Interest Entities"
("FIN 46"). As a result, the trust preferred securities were not recorded in our
Consolidated Balance Sheets. Instead we recorded a floating rate junior
subordinated deferrable interest debenture (the "Debenture") issued by Citizens
to the VIE for the gross issuance proceeds. The Debenture is the sole asset of
the trust and Citizens has guaranteed that interest payments on the Debenture
made to the trust will be distributed by the trust to the holders of the trust
preferred securities. The Debenture matures in thirty years, is callable at par
after five years and bears interest at an annual rate equal to the three-month
LIBOR plus 3.10%, payable quarterly. The trust preferred securities issued by
the trust have financial terms that are comparable to the Debenture.
We have non-marketable equity investments that have not been consolidated in our
Consolidated Financial Statements. At December 31, 2003, these investments
included $1.0 million in limited partnerships, including a venture capital fund
and an affordable housing tax credit fund that were reported under the equity
method. Not included in the carrying amount were commitments to fund an
additional $2.9 million at some future date. Consolidation of these investments
will not be required pursuant to FIN 46 since we are not the primary beneficiary
in the investments. The maximum exposure to loss for all non-marketable equity
investments is the sum of the carrying amounts plus additional commitments.
We originate residential mortgage loans that we sell to the secondary market.
Typically we sell the right to service the loans that are sold. As of December
31, 2003, the unpaid principal balance of mortgage loans serviced for others was
$58.8 million. These loans are not recorded on our books. Capitalized servicing
rights relating to the serviced loans were fully amortized in June 2003 and were
$0.4 million at December 31, 2002.
We hold assets in a fiduciary or agency capacity that are not included in the
Consolidated Financial Statements because they are not assets of Citizens. The
total assets managed or administered by Citizens at December 31, 2003, in its
fiduciary or agency capacity, were $2.866 billion.
61
LIQUIDITY AND DEBT CAPACITY
We monitor and manage our liquidity position so that funds will be available at
a reasonable cost to meet financial commitments, to finance business expansion
and to take advantage of unforeseen opportunities. We manage the liquidity of
our parent company to pay dividends to shareholders, service debt, invest in
subsidiaries and to satisfy other operating requirements. We manage the
liquidity of our subsidiary banks to meet client cash flow needs while
maintaining funds available for loan and investment opportunities.
Our subsidiary banks derive liquidity primarily through core deposit growth,
maturity of money market investments, and maturity and sale of investment
securities and loans. Additionally, our subsidiary banks have access to market
borrowing sources on an unsecured, as well as a collateralized basis, for both
short-term and long-term purposes including, but not limited to, the Federal
Reserve and Federal Home Loan Banks where the subsidiary banks are members.
The primary sources of liquidity for the parent company are dividends from and
returns on investment in its subsidiaries. Each of our banking subsidiaries is
subject to dividend limits under the laws of the state in which it is chartered
and, as member banks of the Federal Reserve System, is subject to the dividend
limits of the Federal Reserve Board. The Federal Reserve Board allows a member
bank to make dividends or other capital distributions in an amount not exceeding
the current calendar year's net income, plus retained net income of the
preceding two years. Distributions in excess of this limit require prior
approval of the Federal Reserve Board. During 2003, our parent company received
$24.0 million in dividends from subsidiaries and paid $49.5 million in dividends
to its shareholders. As discussed in Note 21 to the Consolidated Financial
Statements, as of January 1, 2004, our banking subsidiaries are able to pay
dividends of $36.2 million to our parent company without further regulatory
approval.
An additional source of liquidity is the ability of our parent company to borrow
funds on both a short-term and long-term basis. Downgrades in the first quarter
of 2003 by FitchRatings and Standard & Poor's Rating Service of our long-term
credit rating to BBB from BBB+ due to asset quality deterioration during 2002
did not materially affect our liquidity position. Our short-term credit ratings
from FitchRatings and Standard & Poor's remained unchanged at F2 and A-2,
respectively. Separately, in the second quarter of 2003, Moody's Investors
Service affirmed our outstanding ratings of Baa-1 (long term) and P-2 (short
term), after their review for a possible downgrade. We believe that our capital
position provides enough financial flexibility to deal with a degree of
additional credit deterioration, if such were to occur.
Our parent company also maintains a $50 million short-term revolving credit
facility with two unaffiliated banks. As of December 31, 2003, we had no
outstanding balance on this credit facility. The current facility will mature in
August 2004 and is expected to be renewed at that time. The credit agreement
requires us to maintain certain financial covenants. We were in full compliance
with all debt covenants as of December 31, 2003.
Our Oakland County branch expansion plan will pose a challenge to liquidity as
both the capital investment and loan growth will require incremental funding. We
are confident that through a combination of wholesale funding and deposit
generation of both the new Oakland County branches and the existing branch
network, we will be able to fund all aspects of the expansion plan.
We also have contingent letter of credit commitments that may impact liquidity.
Since many of these commitments historically have expired without being drawn
upon, the total amount of these commitments does not necessarily represent our
future cash requirements in connection with them. Further information on these
commitments is presented in Note 17 to the Consolidated Financial Statements in
this report.
As discussed in Note 21 to the Consolidated Financial Statements, the Federal
Reserve Bank requires our banking subsidiaries to maintain certain
noninterest-bearing deposits with the Federal Reserve Bank. These balance
requirements averaged $36.4 million and $35.3 million during 2003 and 2002,
respectively, and were satisfied with cash balances maintained by our
subsidiaries.
Our long-term debt to equity ratio was 147.5% as of December 31, 2003 compared
to 92.1% in 2002. The increase in long-term debt reflects our issuance of
additional funding to support the expansion of the investment portfolio and the
decrease in time deposits. The increase also reflects the issuance of $125
million of subordinated debt in January 2003 and approximately $25 million of
trust preferred securities in June 2003 to increase liquidity in our parent
company and improve our capital ratios. Changes in long-term debt during 2003
are further discussed in the section titled "Borrowed Funds". We believe that we
have sufficient liquidity and capital sources to meet presently known short and
long term cash flow requirements arising from ongoing business transactions.
62
INTEREST RATE RISK
Interest rate risk arises when there is a mismatch in the timing of the
repricing of assets and liabilities, typically as a result of option risk, which
can alter the expected timing of repricing of certain assets or liabilities, or
basis risk. Many assets and liabilities contain embedded options which allow
customers, and entities associated with our investments and wholesale funding,
to prepay loans or securities prior to maturity, or to withdraw or reprice
deposits or other funding instruments prior to maturity. Basis risk occurs when
assets and liabilities reprice at the same time but based on different market
rates, or when those market rates change by different amounts. We monitor asset,
liability, and off-balance sheet portfolios to ensure comprehensive management
of interest rate risk. The asset/liability management process includes
monitoring contractual and expected repricing of assets and liabilities as well
as forecasting earnings under different interest rate scenarios and balance
sheet structures with the objective of insulating net interest income from large
swings attributable to changes in market interest rates. Our static interest
rate sensitivity (GAP) as of December 31, 2003 and 2002 is presented in the
following table.
TABLE 13. INTEREST RATE SENSITIVITY TOTAL
0 - 3 4 - 6 7 - 12 WITHIN 1 - 5 Over
(dollars in millions) Months Months Months 1 YEAR Years 5 Years Total
- --------------------- ------ ------ ------ ------ ----- ------- -----
DECEMBER 31, 2003
RATE SENSITIVE ASSETS(1)
Portfolio loans (2) $ 2,482.8 $ 258.2 $ 442.3 $ 3,183.3 $ 1,769.0 $ 293.4 $ 5,245.7
Mortgage loans held for sale 44.7 -- -- 44.7 -- -- 44.7
Investment securities 112.6 63.1 121.4 297.1 1,487.3 200.7 1,985.1
Short-term investments 2.2 -- -- 2.2 -- -- 2.2
--------- --------- --------- --------- --------- --------- ---------
Total $ 2,642.3 $ 321.3 $ 563.7 $ 3,527.3 $ 3,256.3 $ 494.1 $ 7,277.7
========= ========= ========= ========= ========= ========= =========
RATE SENSITIVE LIABILITIES
Deposits (3) $ 1,058.2 $ 521.8 $ 943.8 $ 2,523.8 $ 1,768.8 $ 267.2 $ 4,559.8
Other interest bearing liabilities 678.9 28.0 50.7 757.6 378.8 432.1 1,568.5
--------- --------- --------- --------- --------- --------- ---------
Total $ 1,737.1 $ 549.8 $ 994.5 $ 3,281.4 $ 2,147.6 $ 699.3 $ 6,128.3
========= ========= ========= ========= ========= ========= =========
Period GAP (4) $ 905.2 $ (228.5) $ (430.8) $ 245.9 $ 1,108.7 $ (205.2) $ 1,149.4
Cumulative GAP 905.2 676.7 245.9 1,354.6 1,149.4
Cumulative GAP to total assets 11.74% 8.78% 3.19% 17.57% 14.91% 14.91%
Multiple of rate sensitive assets to
liabilities 1.52 0.58 0.57 1.07 1.52 0.71 1.19
DECEMBER 31, 2002
RATE SENSITIVE ASSETS(1)
Portfolio loans (2) $ 2,670.5 $ 247.3 $ 474.6 $ 3,392.4 $ 1,723.1 $ 317.1 $ 5,432.6
Mortgage loans held for sale 160.7 -- -- 160.7 -- -- 160.7
Investment securities 132.4 53.6 180.7 366.7 645.0 445.6 1,457.3
Short-term investments 71.3 -- -- 71.3 -- -- 71.3
--------- --------- --------- --------- --------- --------- ---------
Total $ 3,034.9 $ 300.9 $ 655.3 $ 3,991.1 $ 2,368.1 $ 762.7 $ 7,121.9
========= ========= ========= ========= ========= ========= =========
RATE SENSITIVE LIABILITIES
Deposits (3) $ 704.9 $ 570.5 $ 1,065.8 $ 2,341.2 $ 2,338.8 $ 356.2 $ 5,036.2
Other interest bearing liabilities 418.0 9.9 -- 427.9 165.6 308.2 901.7
--------- --------- --------- --------- --------- --------- ---------
Total $ 1,122.9 $ 580.4 $ 1,065.8 $ 2,769.1 $ 2,504.4 $ 664.4 $ 5,937.9
========= ========= ========= ========= ========= ========= =========
Period GAP (4) $ 1,912.0 $ (279.5) $ (410.5) $ 1,222.0 $ (136.3) $ 98.3 $ 1,184.0
Cumulative GAP 1,912.0 1,632.5 1,222.0 1,085.7 1,184.0
Cumulative GAP to total assets 25.42% 21.70% 16.25% 16.25% 14.43% 15.74% 15.74%
Multiple of rate sensitive assets to
liabilities 2.70 0.52 0.61 1.44 0.95 1.15 1.20
(1) Incorporates prepayment projections for certain assets which may shorten
the time frame for repricing or maturity compared to contractual runoff.
(2) Balances exclude mortgage loans held for sale.
(3) Includes interest bearing savings and demand deposits without contractual
maturities of $1.143 billion in the less than one year category and $1.436
billion in the over one year category as of December 31, 2003. The same
amounts as of December 31, 2002 were $811 million and $1.855 billion,
respectively. This runoff is based on historical trends, which reflects
industry standards.
(4) GAP is the excess of rate sensitive assets (liabilities).
63
As shown, as of December 31, 2003 rate sensitive assets repricing within one
year exceeded rate sensitive liabilities repricing within one year by $245.9
million or 3.19% of total assets, compared to $1.222 billion or 16.25% of total
assets as of December 31, 2002. These results suggest an interest rate risk
position which is not significantly mismatched. GAP analysis is limited in its
ability to measure interest rate sensitivity, as embedded options can change the
repricing characteristics of assets, liabilities, and off-balance sheet hedges
thereby changing the repricing position from that outlined above. Further, basis
risk is not captured by repricing gap analysis. Because of these limitations, we
utilize net interest income simulation modeling as our primary tool to evaluate
the impact of changes in market interest rates and balance sheet strategies on
net interest income.
We may, from time-to-time, use derivative contracts to help manage or hedge our
exposure to interest rate risk and to market value risk in conjunction with our
mortgage banking operations. We currently use interest rate swaps, mortgage loan
commitments and forward mortgage loan sales. Interest rate swaps are contracts
with a third party (the "counter-party") to exchange interest payment streams
based upon an assumed principal amount (the "notional amount"). The notional
amount is not advanced from the counter-party. Swap contracts are carried at
fair value on the consolidated balance sheet with the fair value representing
the net present value of expected future cash receipts or payments based on
market interest rates as of the balance sheet date. The fair values of the
contracts change daily as market interest rates change. Further discussion of
derivative instruments is included in Notes 1 and 18 to the Consolidated
Financial Statements.
Holding residential mortgage loans for sale and committing to fund residential
mortgage loan applications at specific rates exposes Citizens to market value
risk caused by changes in interest rates during the period from rate commitment
issuance until sale. To minimize this risk, we enter into mandatory forward
commitments to sell residential mortgage loans at the time a rate commitment is
issued. These mandatory forward commitments are considered derivatives under
SFAS 133. These forward commitments qualify and have been designated as fair
value hedges of our portfolio of loans held for sale. Our practice to hedge our
market value risk with mandatory forward commitments has been effective and has
not generated any material gains or losses. As of December 31, 2003, we had
forward commitments to sell mortgage loans of $29 million.
Sensitivity of our net interest income to changes in market interest rates is
quantified using income simulation modeling. Key assumptions in the model
include prepayment speeds on various loan and investment assets; cash flows and
maturities of financial instruments, changes in market conditions, loan and
deposit volumes, pricing, client preferences and our financial capital plans.
These assumptions are inherently uncertain, subject to fluctuation and revision
in a dynamic environment and, as a result, the model cannot precisely estimate
net interest income nor exactly predict the impact of higher or lower interest
rates on net interest income. Actual results will differ from simulated results
due to timing, magnitude, and frequency of balance sheet component and interest
rate changes, differences in client behavior, market conditions and management
strategies, among other factors.
We performed simulations as of December 31, 2003 to evaluate the impact of
market rate changes on net interest income over the following 12 months assuming
expected levels of balance sheet growth over that time period. Net interest
income is expected to decline modestly over the period if rates remain at
December 31, 2003 levels. See "Net Interest Income". If market interest rates
were to increase immediately by 100 or 200 basis points (a parallel and
immediate shift along the yield curve) net interest income would be expected to
decline by 0.5% and 1.5% respectively from what it would be if rates were to
remain at December 31, 2003 levels. An immediate 50 basis point parallel decline
in market rates would be expected to reduce net interest income over the
following 12 months by 0.9% from what it would be if rates remain constant over
the entire time period at December 31, 2003 levels. The expansion of the
investment portfolio in 2003 has modified our interest rate risk profile. At
December 31, 2003, unlike at the prior year end, as the model results indicate,
an increase in interest rates will have a negative impact on net interest
income. Net interest income is not only affected by the level and direction of
interest rates, but also by the shape of the yield curve, pricing spreads in
relation to market rates, balance sheet growth, the mix of different types of
assets or liabilities, and the timing of changes in these variables. A
flattening of the yield curve would exacerbate the negative impact on net
interest income. Scenarios different from those outlined above, whether
different by only timing, level, or a combination of factors, could produce
different results.
64
SELECTED QUARTERLY INFORMATION
Table 14 below sets forth selected quarterly financial information for each
calendar quarter during 2003 and 2002.
TABLE 14. SELECTED QUARTERLY INFORMATION
<Table>
<Caption>
2003 2002
(in thousands except, --------------------------------------------- ----------------------------------------------
per share data) FOURTH THIRD SECOND FIRST Fourth Third Second First
--------- --------- --------- --------- --------- --------- --------- ---------
Interest income $ 97,398 $ 99,687 $ 104,683 $ 104,209 $ 112,558 $ 115,558 $ 116,993 $ 118,275
Interest expense 26,720 28,533 31,763 32,703 36,326 40,376 41,584 43,316
Net interest income 70,678 71,154 72,920 71,506 76,232 75,182 75,409 74,959
Provision for loan losses 8,020 10,300 25,650 18,992 16,300 89,250 9,400 5,250
Noninterest income
before securities gains (1) 21,629 25,012 24,836 23,239 26,689 19,689 28,238 24,724
Investment securities gains (2) 2 42 11 48 12 45 2,377 2
Noninterest expense (3) 60,446 59,600 56,361 56,581 57,126 79,545 61,521 61,191
Net income (loss) 18,074 19,605 13,214 15,058 21,525 (45,929) 25,339 24,103
PER SHARE OF COMMON STOCK
Net income (loss):
Basic 0.42 0.45 0.30 0.35 0.49 (1.03) 0.57 0.53
Diluted 0.41 0.45 0.30 0.34 0.48 (1.03) 0.56 0.53
Cash dividends declared 0.285 0.285 0.285 0.285 0.285 0.285 0.285 0.275
Market value:(4)
High 34.26 28.01 28.17 26.05 26.46 29.43 33.88 33.20
Low 26.41 24.77 21.72 23.58 21.25 23.35 27.82 30.67
Close 32.72 26.41 27.01 23.62 24.78 24.17 28.98 32.47
</Table>
(1) Noninterest income includes, in the third quarter of 2002, charges of $1.6
million, and in the second quarter of 2002, a gain of $5.4 million on the
sale of our merchant services business. The charges in the third quarter of
2002 included market valuation write-downs to an equity investment and life
insurance cash surrender values as well as the write-off of certain obsolete
assets and uncollectible fees.
(2) Investment securities gains include $2.4 million in the second quarter of
2002 from the securitization of mortgages and subsequent sale of the related
mortgage-backed securities.
(3) Noninterest expense includes special and other charges in each period as
follows:
<Table>
<Caption>
2003 2002
-------------------------------------- ----------------------------------
FOURTH THIRD SECOND FIRST Fourth Third Second First
------ ------- ------- ------- ------- ------- ----- -----
Special charge $ -- $ (370) $ (221) $ (100) $ (405) $13,807 $ -- $ --
Other charges -- -- -- -- -- 7,137 -- --
</Table>
The special charge covered the cost of restructuring our consumer,
commercial and wealth management lines of business. The other charges in the
third quarter of 2002 included: a $3.3 million prepayment penalty on FHLB
advances, a $2.0 million contribution to Citizens' charitable trust, $1.0
million valuation allowance on other real estate owned, $406,000 in
additional equipment depreciation and $452,000 in losses and other items.
(4) Citizens Banking Corporation common stock is traded on the National Market
tier of the Nasdaq stock market (trading symbol: CBCF). At December 31,
2003, there were approximately 15,158 shareholders of the Corporation's
common stock.
65
CONSOLIDATED BALANCE SHEETS
CITIZENS BANKING CORPORATION AND SUBSIDIARIES
December 31,
(in thousands, except share amounts) 2003 2002
----------- -----------
ASSETS
Cash and due from banks $ 182,545 $ 171,864
Money market investments:
Federal funds sold -- 69,000
Interest-bearing deposits with banks 2,223 2,332
----------- -----------
Total money market investments 2,223 71,332
Securities available for sale (amortized cost
$1,930,606 in 2003; $1,391,089 in 2002) 1,965,201 1,457,281
Securities held to maturity (fair value of
$19,913 in 2003) 19,857 --
Mortgage loans held for sale 44,677 160,743
Loans:
Commercial 2,885,868 3,111,208
Real estate construction 192,759 262,363
Real estate mortgage 402,910 545,834
Consumer 1,764,165 1,513,156
----------- -----------
Total loans 5,245,702 5,432,561
Less: Allowance for loan losses (123,545) (106,777)
----------- -----------
Net loans 5,122,157 5,325,784
Premises and equipment 112,784 117,704
Goodwill 54,785 54,785
Other intangible assets 16,932 19,862
Bank owned life insurance 80,461 78,434
Other assets 109,448 66,935
----------- -----------
TOTAL ASSETS $ 7,711,070 $ 7,524,724
=========== ===========
LIABILITIES
Noninterest-bearing deposits $ 882,429 $ 900,674
Interest-bearing deposits 4,559,838 5,036,239
----------- -----------
Total deposits 5,442,267 5,936,913
Federal funds purchased and securities sold
under agreements to repurchase 588,593 223,289
Other short-term borrowings 43,077 79,062
Other liabilities 65,112 35,678
Long-term debt 936,859 599,313
----------- -----------
Total liabilities 7,075,908 6,874,255
SHAREHOLDERS' EQUITY
Preferred stock - no par value:
Authorized - 5,000,000 shares; Issued -
none
Common stock - no par value:
Authorized - 100,000,000 shares
Issued and outstanding - 43,241,918 in 2003;
43,702,371 in 2002 100,314 112,253
Retained earnings 512,045 495,570
Accumulated other comprehensive income 22,803 42,646
----------- -----------
Total shareholders' equity 635,162 650,469
----------- -----------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 7,711,070 $ 7,524,724
=========== ===========
See notes to consolidated financial statements.
66
CONSOLIDATED STATEMENTS OF INCOME
CITIZENS BANKING CORPORATION AND SUBSIDIARIES
(in thousands, except share amounts) 2003 2002 2001
------------ ------------ ------------
INTEREST INCOME
Interest and fees on loans $ 323,739 $ 385,812 $ 492,437
Interest and dividends on investment securities:
Taxable 61,631 55,447 57,633
Tax-exempt 20,502 21,301 21,715
Money market investments 105 824 1,774
------------ ------------ ------------
Total interest income 405,977 463,384 573,559
INTEREST EXPENSE
Deposits 83,449 127,849 204,929
Short-term borrowings 4,960 4,033 27,458
Long-term debt 31,310 29,720 33,191
------------ ------------ ------------
Total interest expense 119,719 161,602 265,578
------------ ------------ ------------
NET INTEREST INCOME 286,258 301,782 307,981
Provision for loan losses 62,962 120,200 26,407
------------ ------------ ------------
Net interest income after provision for loan losses 223,296 181,582 281,574
------------ ------------ ------------
NONINTEREST INCOME
Service charges on deposit accounts 29,916 26,456 27,773
Trust fees 17,527 18,956 21,028
Mortgage and other loan income 18,046 16,845 13,159
Bankcard fees 3,042 6,142 11,799
Brokerage and investment fees 7,720 9,502 8,157
Investment securities gains 103 2,436 6,195
Gain on sale of merchant business -- 5,400 --
Gain on sale of equity investment -- -- 11,017
Gain on sale of credit card assets -- -- 2,623
Gain on sale of bank -- -- 793
Other 18,465 16,039 14,937
------------ ------------ ------------
Total noninterest income 94,819 101,776 117,481
------------ ------------ ------------
NONINTEREST EXPENSE
Salaries and employee benefits 122,322 126,847 126,278
Equipment 16,087 19,869 19,317
Occupancy 18,449 17,855 17,713
Data processing fees 12,744 12,641 13,101
Professional services 17,815 14,790 12,277
Postage and delivery 6,896 7,120 7,746
Telephone 4,793 5,279 5,556
Advertising and public relations 5,786 5,112 5,219
Stationery and supplies 3,935 4,032 4,426
Intangible asset amortization 2,899 2,899 10,115
Bankcard fees 378 3,879 9,308
Special charge (691) 13,402 --
Other 21,575 25,658 20,127
------------ ------------ ------------
Total noninterest expense 232,988 259,383 251,183
------------ ------------ ------------
INCOME BEFORE INCOME TAXES 85,127 23,975 147,872
Income tax provision (benefit) 19,176 (1,063) 43,215
------------ ------------ ------------
NET INCOME $ 65,951 $ 25,038 $ 104,657
============ ============ ============
NET INCOME PER SHARE:
Basic $ 1.52 $ 0.56 $ 2.27
Diluted 1.51 0.56 2.25
AVERAGE SHARES OUTSTANDING:
Basic 43,303,573 44,657,153 46,085,405
Diluted 43,609,148 45,076,684 46,589,962
See notes to consolidated financial statements.
67
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
CITIZENS BANKING CORPORATION AND SUBSIDIARIES
Accumulated
Other
Common Retained Comprehensive
(in thousands, except per share amounts) Stock Earnings Income (loss) Total
- ---------------------------------------- ----- -------- ------------- -----
BALANCE - JANUARY 1, 2001 $201,549 $466,692 $11,738 $679,979
Comprehensive income:
Net income 104,657 104,657
Other comprehensive income:
Net unrealized gain on securities available-for-sale,
net of tax effect of $7,858 14,569
Less: Reclassification adjustment for net gains
included in net income, net of tax effect of $2,168 (4,027)
Minimum pension liability, net of tax effect of $929 (1,727)
-------
Other comprehensive income total 8,815
-----
Total comprehensive income 113,472
Tax benefit on non-qualified stock options 2,000 2,000
Exercise of stock options, net of shares purchased 10,662 10,662
Cash dividends - $1.085 per share (50,158) (50,158)
Shares acquired for retirement (58,491) (58,491)
-------- ------- ------- --------
BALANCE - DECEMBER 31, 2001 155,720 521,191 20,553 697,464
Comprehensive income:
Net income 25,038 25,038
Other comprehensive income:
Net unrealized gain on securities available-for-sale,
net of tax effect of $12,023 22,328
Less: Reclassification adjustment for net gains
included in net income, net of tax effect of $853 (1,583)
Minimum pension liability, net of tax effect of $724 1,348
-----
Other comprehensive income total 22,093
------
Total comprehensive income 47,131
Exercise of stock options, net of shares purchased 6,562 6,562
Net change in deferred compensation, net of tax effect 267 267
Cash dividends - $1.13 per share (50,659) (50,659)
Shares acquired for retirement (50,296) (50,296)
-------- ------- ------- --------
BALANCE - DECEMBER 31, 2002 112,253 495,570 42,646 650,469
Comprehensive income:
Net income 65,951 65,951
Other comprehensive income:
Net unrealized loss on securities available-for-sale,
net of tax effect of ($11,023) (20,472)
Less: Reclassification adjustment for net gains
included in net income, net of tax effect of $36 (67)
Net change in unrealized gain on qualifying cash flow
hedges, net of tax effect of $280 520
Minimum pension liability, net of tax effect of $95 176
---
Other comprehensive income total (19,843)
--------
Total comprehensive income 46,108
Tax benefit on non-qualified stock options 2,500 2,500
Exercise of stock options, net of shares purchased 6,334 6,334
Net change in deferred compensation, net of tax effect 350 350
Stock issued for compensation 200 200
Cash dividends - $1.14 per share (49,476) (49,476)
Shares acquired for retirement (21,323) (21,323)
-------- ------- ------- --------
BALANCE - DECEMBER 31, 2003 $100,314 $512,045 $22,803 $ 635,162
======== ======== ======= =========
See notes to consolidated financial statements.
68
CONSOLIDATED STATEMENTS OF CASH FLOWS
CITIZENS BANKING CORPORATION AND SUBSIDIARIES YEAR ENDED DECEMBER 31,
(in thousands) 2003 2002 2001
----------- ----------- -----------
OPERATING ACTIVITIES:
Net income $ 65,951 $ 25,038 $ 104,657
Adjustments to reconcile net income to net cash provided by
operating activities:
Provision for loan losses 62,962 120,200 26,407
Depreciation and amortization 13,864 17,045 16,241
Amortization of goodwill and other intangibles 2,899 2,899 11,063
Deferred income tax (credit) 1,526 (5,110) (279)
Net amortization (accretion) on investment securities 9,969 1,926 (563)
Investment securities gains (103) (2,436) (6,195)
Loans originated for sale (1,207,072) (1,024,257) (782,009)
Proceeds from sales of mortgage loans held for sale 1,334,182 1,023,821 638,407
Gains from loan sales (11,044) (9,864) (6,841)
Gains on sale of equity securities, credit card assets and bank -- -- (14,433)
Accrued merger related and other special charges -- (8,614) (3,337)
Amortization of stock-based compensation expense 350 267 --
Stock-based compensation 200 -- --
Other (3,843) 723 (2,720)
----------- ----------- -----------
Net cash provided by operating activities 269,841 141,638 (19,602)
INVESTING ACTIVITIES:
Net (increase) decrease in money market investments 69,109 (66,986) (15,003)
Securities available-for-sale:
Proceeds from sales 1,440 69,677 297,492
Proceeds from maturities 749,774 307,546 352,369
Purchases (1,300,600) (504,382) (502,261)
Securities held-to-maturity:
Purchases (19,854) -- --
Net decrease in loans and leases 140,665 248,370 595,211
Net increase in properties and equipment (8,944) (5,944) (7,952)
Purchase of bank owned life insurance -- (78,000) --
Sale of credit card assets -- -- 29,454
Net cash provided by acquisitions and sales -- -- 14,433
----------- ----------- -----------
Net cash used by investing activities (368,410) (29,719) 763,743
FINANCING ACTIVITIES:
Net increase (decrease) in demand and savings deposits (83,877) 255,720 143,669
Net decrease in time deposits (410,769) (283,933) (422,684)
Net increase (decrease) in short-term borrowings 329,319 (12,079) (618,820)
Proceeds from issuance of long-term debt 370,332 121,000 183,182
Principal reductions in long-term debt (31,290) (150,786) (25,200)
Cash dividends paid (49,476) (50,659) (50,158)
Proceeds from stock options exercised 6,334 6,562 10,662
Shares acquired for retirement (21,323) (50,296) (58,491)
----------- ----------- -----------
Net cash provided by financing activities 109,250 (164,471) (837,840)
----------- ----------- -----------
Net increase (decrease) in cash and due from banks 10,681 (52,552) (93,699)
Cash and due from banks at beginning of period 171,864 224,416 318,115
----------- ----------- -----------
Cash and due from banks at end of period $ 182,545 $ 171,864 $ 224,416
=========== =========== ===========
Supplemental Cash Flow Information:
Interest paid $ 119,834 $ 168,588 $ 278,979
Income taxes paid 114 22,888 40,481
See notes to consolidated financial statements.
69
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of Citizens Banking Corporation (Citizens)
and its subsidiaries conform to generally accepted accounting principles in the
United States. Management makes estimates and assumptions that affect the
amounts reported in the financial statements and accompanying notes. Actual
results could differ from these estimates. The following describes Citizens'
policies:
CONSOLIDATION: The Consolidated Financial Statements include the accounts of
Citizens and its subsidiaries after elimination of all material intercompany
transactions and accounts.
BUSINESS COMBINATIONS: Since the issuance of SFAS 141, Business Combinations, by
the Financial Accounting Standards Board (FASB), business combinations initiated
after June 30, 2001, are required to be accounted for by the purchase method.
Under the purchase method, net assets of the business acquired are recorded at
their estimated fair values as of the date of acquisition with any excess of the
cost of the acquisition over the fair value of the net tangible and intangible
assets acquired recorded as goodwill. Results of operations of the acquired
business are included in the income statement from the date of acquisition.
Prior to SFAS 141, certain business combinations not accounted for as purchase
acquisitions were accounted for under the pooling-of-interests method, which
required the retroactive combining of the assets, liabilities, stockholders'
equity, and results of operations of the merged entity with Citizens' respective
accounts at historical amounts. Prior period financial statements were then
restated to give effect to business combinations accounted for under this
method.
SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL AND SECURITIES SOLD UNDER
AGREEMENTS TO REPURCHASE: Securities purchased under agreements to resell and
securities sold under agreements to repurchase are generally accounted for as
collateralized financing transactions and are recorded at the amounts at which
the securities were acquired or sold plus accrued interest. Securities,
generally U.S. government and Federal agency securities, pledged as collateral
under these financing arrangements cannot be sold or repledged by the secured
party. The fair value of collateral either received from or provided to a third
party is continually monitored and additional collateral obtained or requested
to be returned to Citizens as deemed appropriate.
INVESTMENT SECURITIES: Citizens classifies substantially all debt and equity
securities as available for sale. Debt and marketable equity securities are
reported at fair value with unrealized gains and losses included in
shareholders' equity. Non-marketable equity securities such as Federal Reserve
Bank and Federal Home Loan Bank stock are reported at cost. In the event that an
investment security is sold, the adjusted cost of the specific security sold is
used to compute the applicable gain or loss. In the third quarter of 2003,
Citizens began classifying purchases of certain municipal securities as held to
maturity. These securities are recorded at amortized cost. When it is determined
that securities or other investments are impaired and the impairment is other
than temporary, an impairment loss is recorded in earnings and a new basis is
established. Citizens intends to hold securities with unrealized losses for a
period of time necessary to recover the amortized cost.
LOANS: Loans are generally reported at the principal amount outstanding, net of
unearned income. Interest income is recognized on an accrual basis. Loan
origination fees, certain direct costs, and unearned discounts are deferred and
amortized into interest income as an adjustment to the yield over the term of
the loan. Loan commitment fees are generally deferred and amortized into fee
income on a straight-line basis over the commitment period. Other credit-related
fees, including letter and line of credit fees, are recognized as fee income
when earned.
Gains and losses on the sales of loans are determined using the
specific-identification method. Mortgage loans held for sale are valued on an
aggregate basis at the lower of carrying amount or fair value. The majority of
mortgage loans held for sale are sold within 60 days after closing. Citizens
uses mandatory forward commitments, generally entered into at time of
application, to protect the value of the mortgage loans from changes in interest
rates during the period held. The cost basis of mortgage loans held for sale is
adjusted, if material, by any gains or losses generated from mandatory forward
commitments to sell the loans to investors in the secondary market. Citizens'
policy to hedge its market rate risk with mandatory forward commitments has been
highly effective and has not generated any material gains or losses.
Loans are placed on nonaccrual status when the collection of principal or
interest is considered doubtful, or payment of principal or interest is past due
90 days or more and the loan is not well secured and in the process of
collection. When these loans (including a loan impaired) are placed on
nonaccrual status, all interest previously accrued but unpaid is reversed
70
against current year interest income. Interest payments received on nonaccrual
loans are credited to income if future collection of principal is probable.
Loans are normally restored to accrual status when interest and principal
payments are current and it is believed that the financial condition of the
borrower has improved to the extent that future principal and interest payments
will be met on a timely basis.
Commercial loans and commercial loans secured by real estate are generally
charged off to the extent principal and interest due exceed the net realizable
value of the collateral, with the charge-off occurring when the loss is
reasonably quantifiable but not later than when the loan becomes 180 days past
due. Loans secured by residential real estate are generally charged off after
foreclosure to the extent principal and interest due exceed 75% of the current
appraised value. Consumer loans (open and closed end) are generally charged off
before the loan becomes 120 days past due.
Based on their internal credit rating, commercial and commercial real estate
loans exceeding certain fixed dollar amounts are evaluated for impairment in
accordance with the provisions of SFAS 114, Accounting by Creditors for
Impairment of a Loan, which requires an allowance to be established as a
component of the allowance for loan losses when it is probable all amounts due
will not be collected pursuant to the contractual terms of the loan and the
recorded investment in the loan exceeds its fair value. In most instances the
fair value is measured based on the fair value of the collateral. Fair value may
also be measured using either the present value of expected future cash flows
discounted at the loan's effective interest rate or the observable market price
of the loan.
ALLOWANCE FOR LOAN LOSSES: The allowance for loan losses is maintained at a
level believed adequate by management to absorb probable losses inherent in the
loan portfolio and is based on the size and current risk characteristics of the
loan portfolio, an assessment of individual problem loans and actual loss
experience, current economic events in specific industries and geographical
areas, including unemployment levels, and other pertinent factors, including
regulatory guidance and general economic conditions. Determination of the
allowance is inherently subjective as it requires significant estimates,
including the amounts and timing of expected future cash flows on impaired
loans, estimated losses on pools of homogeneous loans based on historical loss
experience, and consideration of current economic trends, all of which may be
susceptible to significant change. The allowance is increased by the provision
charged to income and reduced by the amount charged-off, net of recoveries. Loan
losses are charged off against the allowance, while recoveries of amounts
previously charged off are credited to the allowance. A provision for loan
losses is charged to operations based on management's periodic evaluation of the
factors previously mentioned, as well as other pertinent factors. Evaluations
are conducted at least quarterly and more often if deemed necessary.
The allowance for loan losses consists of an allocated component and an
unallocated component. The components of the allowance for loan losses represent
an estimation done pursuant to either SFAS 5, Accounting for Contingencies, or
SFAS 114. The allocated component of the allowance for loan losses reflects
expected losses resulting from analysis developed through specific credit
allocations for individual loans (the specific allocation allowance) and on
historical loss experience for each loan category (the risk allocation
allowance). Specific allowances are established in cases where management has
identified significant conditions or circumstances related to a credit that
management believes indicate it is probable that a loss has been or will be
incurred. The specific credit allocations are based on a regular quarterly
analysis of all commercial and commercial mortgage loans over a fixed dollar
amount where the internal credit rating is at or below a predetermined
classification. The allowance attributed to these credits is determined in
accordance with the methods prescribed by SFAS 114, "Accounting by Creditors for
Impairment of a Loan" by analyzing the borrower's debt service capacity (a
discounted estimate of future cash flows); overall financial condition,
resources and payment record; the prospects for support from any financially
responsible guarantors; and the liquidation value of any collateral. The risk
allocated allowance is calculated by applying projected loss rates to
outstanding loans (excluding specifically identified credits) stratified by risk
rating for commercial credits and by accrual and past due status for homogenous
residential mortgage and consumer pools of loans. The projected loss rates are
based on historical loss experience (generally an eighteen month rolling average
of net charge-offs) adjusted for trends in past due and nonaccrual amounts, the
condition of the economy, and changes in portfolio concentrations, mix and
volume. The allocated component of the allowance for loan losses also includes
consideration of Citizens' current business strategy and credit process,
including credit limit setting and compliance, credit approvals, loan
underwriting, and loan workout procedures.
The unallocated portion of the allowance reflects management's estimate of
probable inherent but undetected losses within the portfolio due to
uncertainties in economic conditions, delays in obtaining information, including
unfavorable information about a borrower's financial condition, the difficulty
in identifying triggering events that correlate perfectly to subsequent loss
rates, and risk factors that have not yet manifested themselves in loss
allocation factors. In addition, the unallocated
71
allowance includes a component that explicitly accounts for the inherent
imprecision in loan loss projection models. Citizens has grown through
acquisition, expanded the geographic footprint in which it operates, and changed
its portfolio mix in recent years. As a result, historical loss experience data
used to establish allocation estimates may not precisely correspond to the
current portfolio. The uncertainty surrounding the strength and timing of
economic cycles, including management's concerns over the effects of the
prolonged economic downturn in the current cycle, also affects the allocation
model's estimates of loss. The historical losses used may not be representative
of actual losses inherent in the portfolio that have not yet been realized.
DEPRECIABLE ASSETS: Premises and equipment, including leasehold improvements,
are carried at cost less accumulated depreciation and amortization. Depreciation
and amortization are computed principally on a straight-line basis and are
charged to expense over the lesser of the estimated useful life of the assets or
lease term. Maintenance and repairs are charged to expense as incurred. Gains
and losses on dispositions are charged to income as incurred.
Long-lived depreciable assets are evaluated periodically for impairment when
events or changes in circumstances indicate the carrying amount may not be
recoverable. Impairment exists when the expected undiscounted future cash flows
of a long-lived asset are less than its carrying value. In that event, Citizens
recognizes a loss for the difference between the carrying amount and the
estimated fair value of the asset based on a quoted market price, if applicable,
or a discounted cash flow analysis.
OTHER REAL ESTATE: Other real estate is comprised of commercial and residential
real estate properties acquired in partial or total satisfaction of a debt.
These properties are carried at the lower of cost or fair value, net of
estimated costs to sell, based upon current appraised value. Losses arising from
the initial acquisition of such properties are charged against the allowance for
loan losses at time of transfer. Subsequent valuation adjustments and gains or
losses on disposal of these properties are charged to other expenses as
incurred.
BANK OWNED LIFE INSURANCE: Bank Owned Life Insurance is recorded as an asset at
the amount that could be realized under the insurance contracts as of the date
of the consolidated balance sheets. The change in cash surrender value during
the period is an adjustment of premiums paid in determining the expense or
income to be recognized under the contracts for the period. This change is
recorded in noninterest income as cash surrender value of life insurance
revenue.
GOODWILL AND OTHER INTANGIBLE ASSETS: Goodwill represents the excess of the cost
of an acquisition over the fair value of net identifiable tangible and
intangible assets acquired. Other intangible assets represent purchased assets
that also lack physical substance but can be distinguished from goodwill because
of contractual or other legal rights or because the asset is capable of being
sold or exchanged either on its own or in combination with a related contract,
asset, or liability. On January 1, 2002, Citizens adopted SFAS 142, Goodwill and
Other Intangible Assets. Under the provisions of SFAS 142, goodwill is no longer
ratably amortized into the income statement over an estimated life, but rather
is tested at least annually for impairment. Impairment of goodwill is evaluated
by line of business and geographic region and is based on a comparison of the
recorded balance of goodwill to the applicable market value or discounted cash
flows. To the extent that impairment may exist, the current carrying amount is
reduced by the estimated shortfall. Intangible assets which have finite lives
continue to be amortized over their estimated useful lives and also continue to
be subject to impairment testing. All of Citizens' other intangible assets have
finite lives and are amortized on a straight-line basis over varying periods not
exceeding 10 years. Prior to the adoption of SFAS 142, Citizens' goodwill was
amortized on a straight-line basis over varying periods not exceeding 20 years.
Note 7 includes a summary of Citizens' goodwill and other intangible assets as
well as further detail about the impact of the adoption of SFAS 142.
MORTGAGE SERVICING RIGHTS: Citizens recognizes as a separate asset rights to
service mortgage loans it does not own but services for others for a fee. This
asset is included in other assets on the balance sheet and is carried at the
lower of the initial carrying value, adjusted for amortization, or estimated
fair value. Amortization is determined in proportion to and over the period of
estimated net servicing income. Impairment of servicing assets is assessed based
on the fair value of those rights. For purposes of measuring impairment, the
rights are stratified by product type and interest rate.
The fair value of mortgage servicing assets is estimated by calculating the
present value of estimated future net servicing cash flows, taking into
consideration actual and expected mortgage loan prepayment rates, discount
rates, servicing costs, and other economic factors. The expected and actual rate
of mortgage loan prepayments are the most significant factors driving the value
of mortgage servicing assets. Increases in mortgage loan prepayments reduce
estimated future net servicing cash flows because the life of the underlying
loan is reduced.
72
SECURITIZATIONS AND SALES OF MORTGAGE LOANS: Citizens sells substantially all of
the fixed-rate single-family mortgage loans it originates, including
adjustable-rate loans that convert to fixed-rate loans. These sales are
accomplished through cash sales to Federal Home Loan Mortgage Corporation
("FHLMC"), Federal National Mortgage Association ("FNMA") and other third-party
investors, as well as through securitizations with FHLMC and FNMA. In general,
mortgage-backed securities ("MBSs") received from FHMLC or FNMA in exchange for
fixed-rate mortgage loans are sold immediately in the securities market. From
time to time, Citizens also exchanges fixed and variable rate mortgage loans
held in portfolio for FHLMC or FNMA MBSs backed by the same loans. The resulting
MBSs are sold to third party investors or classified as held for sale in
Citizens' investment security portfolio.
If MBSs are retained in the investment portfolio, any gain or loss at time of
sale is recorded as a security gain or loss. All other gains or losses
associated with sales of single-family mortgage loans are recorded as a
component of mortgage banking revenue. Typically, Citizens does not service the
loans after they are sold or exchanged, but sells the mortgage servicing rights,
in a separate transaction, before or at the time of the securitization. Sales or
securitizations of mortgage loans through FHLMC and FNMA are done under terms
that do not provide for any material recourse to Citizens by the investor.
Citizens does not retain any interest in these securitized mortgage loans.
DERIVATIVE INSTRUMENTS: Citizens enters into derivative transactions principally
to protect against the risk of adverse price or interest rate movements on the
value of certain assets and liabilities and on future cash flows. Citizens is
also required to recognize certain contracts and commitments as derivatives when
the characteristics of those contracts and commitments meet the definition of a
derivative. Citizens utilizes mandatory forward commitments for the
aforementioned fair value hedge of its mortgage loans held for sale. This
hedging policy has been highly effective and therefore the impact on income has
been immaterial. Citizens has also utilized derivatives to hedge the fair value
of $125 million of subordinated debt issued in January 2003 and certain brokered
time deposits issued in the second half of 2003. In addition, Citizens has
utilized derivatives to hedge the cash flows on a pool of prime-based variable
rate commercial loans.
Under the guidelines of SFAS 133, Accounting for Derivative Instruments and
Hedging Activities, as amended, all derivative instruments are required to be
carried at fair value on the balance sheet. SFAS 133 also provides special hedge
accounting provisions. Derivative instruments designated in a hedge relationship
to mitigate exposure to changes in the fair value of an asset, liability, or
firm commitment attributable to a particular risk, such as interest rate risk,
are considered fair value hedges under SFAS 133. Derivative instruments
designated in a hedge relationship to mitigate exposure to variability in
expected future cash flows, or other types of forecasted transactions, are
considered cash flow hedges.
Fair value hedges are accounted for by recording the fair value of the
derivative instrument and the fair value related to the risk being hedged of the
hedged asset or liability on the balance sheet with corresponding offsets
recorded in the income statement. The adjustment to the hedged asset or
liability is included in the basis of the hedged item, while the fair value of
the derivative is recorded as a freestanding asset or liability. Actual cash
receipts or payments and related amounts accrued during the period on
derivatives included in a fair value hedge relationship are recorded as
adjustments to the interest income or expense recorded on the hedged asset or
liability.
Cash flow hedges are accounted for by recording the fair value of the derivative
instrument on the balance sheet as either a freestanding asset or liability,
with a corresponding offset recorded in other comprehensive income within
shareholders' equity, net of tax. Amounts are reclassified from other
comprehensive income to the income statement in the period or periods the hedged
forecasted transaction affects earnings.
Under both the fair value and cash flow hedge methods, derivative gains and
losses not effective in hedging the change in fair value or expected cash flows
of the hedged item are recognized immediately in the income statement.
STOCK-BASED COMPENSATION: Citizens' stock-based compensation plans are accounted
for based on the intrinsic value method set forth in Accounting Principles Board
(APB) Opinion 25, Accounting for Stock Issued to Employees, and related
interpretations. Compensation expense for employee stock options is generally
not recognized if the exercise price of the option equals or exceeds the fair
value of the stock on the date of grant. Compensation expense for restricted
share awards is ratably recognized over the period of service, usually the
restricted period, based on the fair value of the stock on the date of grant.
73
The following table illustrates the effect on net income and earnings per share
if Citizens had applied the fair value recognition provisions of SFAS 123,
Accounting for Stock-Based Compensation, to its stock option awards.
Year Ended December 31,
(in thousands, except per share amounts) 2003 2002 2001
----------- ----------- -----------
Net income, as reported $ 65,951 $ 25,038 $ 104,657
Less pro forma expense related to options granted 2,261 2,401 1,849
----------- ----------- -----------
Pro forma net income $ 63,690 $ 22,637 $ 102,808
=========== =========== ===========
Pro forma net income per share:
Basic - as reported $ 1.52 $ 0.56 $ 2.27
Basic - pro forma 1.47 0.51 2.23
Diluted - as reported 1.51 0.56 2.25
Diluted - pro forma 1.46 0.50 2.21
The fair values of stock options granted were estimated at the date of grant
using a Black-Scholes option pricing model. The weighted-average assumptions
used to determine the fair value of options granted are provided in Note 16 to
the Consolidated Financial Statements.
INCOME TAXES: Citizens and its subsidiaries file a consolidated federal income
tax return. Income tax expense is based on income as reported in the
Consolidated Statements of Income. When income and expenses are recognized in
different periods for tax purposes, applicable deferred taxes are provided in
the Consolidated Financial Statements.
NET INCOME PER SHARE: Basic net income per share is based on net income divided
by the weighted average number of shares outstanding in each period. Diluted net
income per share shows the dilutive effect of additional common shares issuable
upon the assumed exercise of stock options granted under Citizens' stock option
plans, using the treasury stock method.
CASH FLOWS: For purposes of reporting cash flows, cash and cash equivalents
include cash on hand and amounts due from banks.
RECLASSIFICATIONS: Certain amounts have been reclassified to conform to the
current year presentation.
NOTE 2. RECENT ACCOUNTING PRONOUNCEMENTS
EMPLOYERS' DISCLOSURES ABOUT PENSIONS AND OTHER POSTRETIREMENT BENEFITS: In
December 2003, the FASB issued a revised SFAS 132, Employers' Disclosures about
Pensions and Other Postretirement Benefits - an amendment SFAS 87,88, and 106
which revises employers' disclosures about pension plans and other
postretirement benefit plans. SFAS 132 does not change the measurement or
recognition of those plans required by SFAS 87, Employers' Accounting for
Pensions, SFAS 88, Employers' Accounting for Settlements and Curtailments of
Defined Benefit Pension Plans and for Termination Benefits, and SFAS 106,
Employers' Accounting for Postretirement Benefits Other Than Pensions. SFAS 132,
as revised, retains the disclosure requirements contained in the original SFAS
132, which it replaces. Additional disclosures, however, have been added to
those in the original SFAS 132 about the assets, obligations, cash flows, and
net periodic benefit cost of defined benefit pension plans and other defined
benefit postretirement plans. The required information should be provided
separately for pension plans and for other postretirement benefit plans. In
addition, SFAS 132 requires interim period disclosure of the components of net
period benefit cost and contributions if significantly different from previously
reported amounts. The new disclosures required by SFAS 132 become effective for
Citizens as of year end 2003 (see Note 13) and do not impact our results of
operations, financial position, or liquidity.
ACCOUNTING FOR CERTAIN FINANCIAL INSTRUMENTS WITH CHARACTERISTICS OF BOTH
LIABILITIES AND EQUITY: In May 2003, the FASB issued SFAS 150 Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity which establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of
74
both liabilities and equity. SFAS 150 also addresses questions about the
classification of certain financial instruments that embody obligations to issue
equity shares. SFAS 150 requires that an issuer classify a financial instrument
that is within its scope as a liability (or an asset in some circumstances).
Many of those instruments were previously classified as equity. SFAS 150 was
effective for Citizens as of July 1, 2003. As Citizens has not issued any
instruments within the scope of this Statement, adoption did not have any impact
on our results of operations, financial position, or liquidity.
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES: In April 2003, the FASB issued
SFAS 149 Amendment of Statement 133 on Derivative Instruments and Hedging
Activities which amends and clarifies financial accounting and reporting for
derivative instruments, including certain derivative instruments embedded in
other contracts (collectively referred to as derivatives) and for hedging
activities under SFAS 133, Accounting for Derivative Instruments and Hedging
Activities. In particular, this SFAS 149 (1) clarifies under what circumstances
a contract with an initial net investment meets the characteristic of a
derivative, (2) clarifies when a derivative contains a financing component, (3)
amends the definition of an underlying to conform it to language used in FASB
Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others, and (4)
amends certain other existing pronouncements. Those changes result in more
consistent reporting of contracts as either derivatives or hybrid instruments.
SFAS 149 is generally effective for contracts entered into or modified after
June 30, 2003 and for hedging relationships designated after June 30, 2003.
Citizens does not expect the requirements of SFAS 149 to have a material impact
on results of operations, financial position, or liquidity.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES: In December 2003, the FASB revised
FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest
Entities, first issued in January 2003. The objective of this interpretation is
to provide guidance on how to identify a variable interest entity (VIE) and
determine when the assets, liabilities, noncontrolling interests, and results of
operations of a VIE need to be included in a company's Consolidated Financial
Statements. A company that holds variable interests in an entity will need to
consolidate the entity if the company's interest in the VIE is such that the
company will absorb a majority of the VIE's expected losses and/or receive a
majority of the entity's expected residual returns, if they occur. FIN 46 also
requires additional disclosures by primary beneficiaries and other significant
variable interest holders. The provisions of this interpretation became
effective upon issuance. Citizens does not hold any variable interests that
require consolidation. Therefore, the adoption of this interpretation did not
have any effect on Citizens' financial position, results of operations or cash
flows.
GUARANTEES: In November 2002, the FASB issued FASB Interpretation No. 45 (FIN
45), Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others. This interpretation
expands the disclosures to be made by a guarantor in its financial statements
about its obligations under certain guarantees and requires the guarantor to
recognize a liability for the fair value of an obligation assumed under a
guarantee. FIN 45 clarifies the requirements of SFAS 5, Accounting for
Contingencies, relating to guarantees. In general, FIN 45 applies to contracts
or indemnification agreements that contingently require the guarantor to make
payments to the guaranteed party based on changes in an underlying that is
related to an asset, liability, or equity security of the guaranteed party.
Certain guarantee contracts are excluded from both the disclosure and
recognition requirements of this interpretation, including, among others,
guarantees relating to employee compensation, residual value guarantees under
capital lease arrangements, commercial letters of credit, loan commitments,
subordinated interests in an SPE, and guarantees of a company's own future
performance. Other guarantees are subject to the disclosure requirements of FIN
45 but not to the recognition provisions and include, among others, a guarantee
accounted for as a derivative instrument under SFAS 133, a parent's guarantee of
debt owed to a third party by its subsidiary or vice versa, and a guarantee
which is based on performance not price. The disclosure requirements of FIN 45
were effective for Citizens as of December 31, 2002, and require disclosure of
the nature of the guarantee, the maximum potential amount of future payments
that the guarantor could be required to make under the guarantee, and the
current amount of the liability, if any, for the guarantor's obligations under
the guarantee. The recognition requirements of FIN 45 have been applied
prospectively to guarantees issued or modified after December 31, 2002.
Significant guarantees that have been entered into by Citizens are disclosed in
Note 17. The adoption of FIN 45 did not have a material impact on results of
operations, financial position, or liquidity.
ACCOUNTING FOR STOCK-BASED COMPENSATION: In December 2002, the FASB issued SFAS
148, Accounting for Stock-Based Compensation - Transition and Disclosure, which
provides guidance on how to transition from the intrinsic value method of
accounting for stock-based employee compensation under APB 25 to SFAS 123's fair
value method of accounting, if a company so elects. Citizens has elected to
continue its current practice of accounting for stock based employee
compensation in accordance with APB Opinion 25 and SFAS 123. Therefore, the
adoption of this interpretation did not have an impact on Citizens' financial
position, results of operations or cash flows.
75
ACQUISITIONS OF CERTAIN FINANCIAL INSTITUTIONS: In October 2002, the FASB issued
SFAS 147, Acquisitions of Certain Financial Institutions, which provides
guidance on the accounting for the acquisition of a financial institution and
supersedes the specialized accounting guidance provided in SFAS 72, Accounting
for Certain Acquisitions of Banking or Thrift Institutions. SFAS 147 became
effective upon issuance and requires companies to cease amortization of
unidentified intangible assets associated with certain branch acquisitions and
reclassify these assets to goodwill. SFAS 147 also modifies SFAS 144 to include
in its scope long-term customer-relationship intangible assets and thus subject
those intangible assets to the same undiscounted cash flow recoverability test
and impairment loss recognition and measurement provisions required for other
long-lived assets.
While SFAS 147 may affect how future business combinations, if undertaken, are
accounted for and disclosed in the financial statements, the issuance of the new
guidance had no effect on results of operations, financial position, or
liquidity because Citizens does not have any assets subject to the specialized
accounting guidance provided in SFAS 72 or SFAS 147.
ACCOUNTING FOR COSTS ASSOCIATED WITH EXIT OR DISPOSAL ACTIVITIES: SFAS 146,
Accounting for Costs Associated with Exit or Disposal Activities, was issued in
July 2002 and became effective for Citizens beginning January 1, 2003. This
statement requires a cost associated with an exit or disposal activity, such as
the sale or termination of a line of business, the closure of business
activities in a particular location, or a change in management structure, to be
recorded as a liability at fair value when it becomes probable the cost will be
incurred and no future economic benefit will be gained by the company for such
cost. Applicable costs include employee termination benefits, contract
termination costs, and costs to consolidate facilities or relocate employees.
SFAS 146 supersedes EITF Issue No. 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity, which in some
cases required certain costs to be recognized before a liability was actually
incurred. The adoption of this standard did not have a material impact on
results of operations, financial position, or liquidity.
GOODWILL AND OTHER INTANGIBLE ASSETS: On January 1, 2002, Citizens adopted SFAS
142, Goodwill and Other Intangible Assets, which addresses the accounting and
reporting for acquired goodwill and other intangible assets and supersedes APB
Opinion 17, Intangible Assets. Notes 1 and 7 provide further detail on the
accounting for goodwill and intangible assets under the standard and the impact
of the adoption on the financial statements. The standard's adoption had no
impact on liquidity but reduced goodwill amortization by $7.2 million ($5.5
million after tax) in both 2003 and 2002 from the 2001 amount.
NOTE 3. DIVESTITURE
In November 2001, Citizens sold F&M Bank-Minnesota with assets of $27 million,
resulting in a pretax gain of $793,000. The bank was Citizens' sole location in
Minnesota.
NOTE 4. BUSINESS RESTRUCTURING, MERGER AND OTHER CHARGES
In the third quarter of 2002, Citizens recorded a charge of $13.8 million ($9.0
million after-tax) for restructuring, impairment and other costs associated with
reorganization of Citizens' consumer, commercial and wealth management lines of
business. In December 2002, the charge was reduced to $13.4 million as Citizens
reversed $404,600 of employee benefits and severance, professional fees and
lease termination fees included in the original charge that were no longer
expected to be paid. An additional $690,800 of employee benefits and severance,
professional fees and other fees no longer expected to be paid were reversed in
2003. The charge was recorded as a separate component of noninterest expense and
identified as the "special charge."
The reorganization was the result of a detailed review of Citizens' consumer
banking, commercial banking and wealth management areas by banking industry
consultants and key members of management during the second and third quarters
of 2002. This review revealed opportunities for process change, staff
reassignment, reporting structure changes, branch closures, expense reduction
and business growth. As a result of the reorganization, we displaced 134
employees (157 original employees less employees subsequently rehired for other
available positions). Displaced employees are offered severance packages and
outplacement assistance. Twelve banking offices were closed in the fourth
quarter of 2002 and six additional offices were closed during the second quarter
of 2003. The following table provides details on the special charge recorded and
presents the activity in the related liability during 2003 and 2002.
76
Beginning Reserve Reserve
Reserve/ Balance Balance
Special Changes in 2002 December 31, Changes in 2003 December 31,
(in thousands) Charge Cash Noncash(1) 2002 Cash Noncash(1) 2003
------- ----- --------- ------------ ---- ---------- -----------
Employee benefits and severance $ 8,072 $(3,433) $ (358) $ 4,281 $(3,578) $ (378) $ 325
Professional fees 2,369 (1,899) (62) 408 (83) (316) 9
Facilities and lease impairment 2,358 (77) (1,959) 322 (46) -- 276
Contract termination fees and write-off
of obsolete equipment, software and
supplies 1,008 (725) (101) 182 (51) (131) --
------- ------- ------- ------- ------- ------- -------
Total $13,807 $(6,134) $(2,480) $ 5,193 $(3,758) $ (825) $ 610
======= ======= ======= ======= ======= ======= =======
(1) Includes credits (accrual reversals) of $690,800 in 2003 and $404,600 in
2002 primarily for employee benefits and severance, and professional fees.
NOTE 5. INVESTMENT SECURITIES
The amortized cost, estimated fair value and gross unrealized gains and losses
of investment securities follow:
<Table>
<Caption>
DECEMBER 31, 2003 December 31, 2002
------------------------------------------------- -------------------------------------------------
ESTIMATED GROSS UNREALIZED Estimated Gross Unrealized
AMORTIZED FAIR --------------------- Amortized Fair -----------------------
(in thousands) COST VALUE GAINS LOSSES Cost Value Gains Losses
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
AVAILABLE FOR SALE:
U.S. Treasury $ -- $ -- $ -- $ -- $ 5,978 $ 6,135 $ 157 $ --
Federal agencies:
Mortgage-backed 1,186,539 1,180,493 6,413 12,459 762,733 787,821 25,281 193
Other 261,051 272,089 11,066 28 135,436 148,687 13,251 --
State and municipal 407,625 437,003 30,384 1,006 417,549 444,951 27,670 268
Mortgage and asset-backed 3,994 4,135 141 -- 6,228 6,452 236 12
Other 71,397 71,481 84 -- 63,165 63,235 70 --
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total available for sale $1,930,606 $1,965,201 $ 48,088 $ 13,493 $1,391,089 $1,457,281 $ 66,665 $ 473
========== ========== ========== ========== ========== ========== ========== ==========
HELD TO MATURITY:
State and municipal 19,857 19,913 153 97 -- -- -- --
---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Total held to maturity $ 19,857 $ 19,913 $ 153 $ 97 $ -- $ -- $ -- $ --
========== ========== ========== ========== ========== ========== ========== ==========
</Table>
Management does not believe any individual unrealized loss as of December 31,
2003 represents other-than-temporary impairment. The unrealized losses reported
for mortgage-backed securities primarily relate to securities issued by FNMA,
FHLMC and GNMA. These unrealized losses are attributable to changes in interest
rates and were for periods of less than twelve months. The unrealized losses
reported for state and municipal securities also are attributable to changes in
interest rates and were predominately for periods of less than twelve months.
Citizens has both the intent and ability to hold the securities with unrealized
losses for a period of time necessary to recover the amortized cost.
77
The amortized cost, estimated fair value and weighted average yields of debt
securities by maturity at December 31, 2003 are shown below. Maturities of
mortgage-backed securities are based upon current industry prepayment schedules.
- -------------------------------------------------------------------------------------------------------------------------------
Weighted
Within 1 to 5 5 to 10 After 10 Average
(in thousands) 1 Year Years Years Years Total Yield
- -------------------------------------------------------------------------------------------------------------------------------
AVAILABLE FOR SALE:
U S Treasury and Federal Agency $ 90,599 $ 150,947 $ 19,506 $ -- $ 261,052 5.30%
Mortgage-backed securities 154,137 767,179 247,412 17,810 1,186,538 3.76
Asset-backed and corporate debt 3,214 5,565 61 168 9,008 4.31
State and Municipal 14,276 92,342 184,991 116,016 407,625 7.32
Other 592 -- -- 65,792 66,384 5.32
---------- ---------- ---------- ---------- ----------
Amortized Cost $ 262,818 $1,016,033 $ 451,970 $ 199,786 $1,930,607
---------- ---------- ---------- ---------- ----------
Fair Value $ 267,718 $1,021,279 $ 467,638 $ 208,566 $1,965,201
---------- ---------- ---------- ---------- ----------
Weighted Average Yield 5.37% 4.03% 5.45% 6.28% 4.78%
HELD TO MATURITY:
State and Municipal $ -- $ 3,669 $ 12,879 $ 3,309 $ 19,857 6.35
---------- ---------- ---------- ---------- ----------
Amortized Cost $ -- $ 3,669 $ 12,879 $ 3,309 $ 19,857
---------- ---------- ---------- ---------- ----------
Fair Value $ -- $ 3,635 $ 12,949 $ 3,329 $ 19,913
---------- ---------- ---------- ---------- ----------
Weighted Average Yield -- 5.73% 6.46% 6.59% 6.35%
- -------------------------------------------------------------------------------------------------------------------------------
Sales of investment securities resulted in realized gains and losses as follows:
- ---------------------------------------------------------
Year Ended December 31,
(in thousands) 2003 2002 2001
- ---------------------------------------------------------
Securities gains $ 182 $ 2,527 $ 6,202
Securities losses (79) (91) (7)
------- ------- -------
Net gain $ 103 $ 2,436 $ 6,195
======= ======= =======
- ---------------------------------------------------------
Securities with amortized cost of $1.178 billion at December 31, 2003, and
$775.2 million at December 31, 2002, were pledged to secure public deposits,
repurchase agreements, and other liabilities. Except for obligations of the U.S.
Government and its agencies, no holdings of securities of any single issuer
exceeded 10% of consolidated shareholders' equity at December 31, 2003 or 2002.
NOTE 6. LOANS AND NONPERFORMING ASSETS
Citizens extends credit primarily within the Midwestern states of Michigan,
Wisconsin, Illinois and Iowa. In Michigan the primary market includes most parts
of the Lower Peninsula. In Wisconsin the primary market area is the Fox Valley
region extending from Green Bay to Appleton to Oshkosh as well as northeastern
and southwestern Wisconsin. Other primary market areas are central Iowa and the
western suburban market of Chicago, Illinois. Citizens seeks to limit its credit
risk by establishing guidelines to review its aggregate outstanding commitments
and loans to particular borrowers, industries and geographic areas. Collateral
is secured based on the nature of the credit and management's credit assessment
of the customer.
Citizens' loan portfolio is widely diversified by borrowers with no
concentration within a single industry that exceeds 10% of total loans. Citizens
does not have any loans to foreign debtors and generally does not purchase
nationally syndicated loans or participate in highly leveraged transactions.
Approximately two-thirds of Citizens' commercial real estate loans consist of
mortgages on owner-occupied properties. Those borrowers are involved in business
activities other than real estate, and the sources of repayment are not
dependent on the performance of the real estate market.
78
A summary of nonperforming assets follows:
December 31,
(in thousands) 2003 2002
------- -------
Nonperforming loans:
Nonaccrual $68,744 $86,717
Loans 90 days past due (still accruing) 345 860
Restructured -- --
------- -------
Total nonperforming loans 69,089 87,577
Other real estate 6,634 6,599
Other assets acquired by repossession 1,309 1,495
------- -------
Total nonperforming assets $77,032 $95,671
======= =======
The effect of nonperforming loans on interest income follows:
Year Ended December 31,
(in thousands) 2003 2002 2001
------ ------ ------
Interest income:
At original contract rates $6,261 $7,721 $6,392
As actually recognized 4,011 4,685 3,344
------ ------ ------
Interest foregone $2,250 $3,036 $3,048
====== ====== ======
There are no significant commitments outstanding to lend additional funds to
clients whose loans were classified as nonaccrual or restructured at December
31, 2003.
A summary of impaired loans and their effect on interest income follows:
Valuation Reserve
-----------------
(in thousands) 2003 2002 2003 2002
------- ------- ------- -------
Balances - December 31
Impaired loans with valuation reserve $36,603 $41,240 $12,449 $13,338
Impaired loans with no valuation reserve 35,155 35,272 -- --
------- ------- ------- -------
Total impaired loans $71,758 $76,512 $12,449 $13,338
======= ======= ======= =======
Impaired loans on nonaccrual basis $55,159 $70,345 $ 3,913 $ 8,690
Impaired loans on accrual basis 16,599 6,167 8,536 4,648
------- ------- ------- -------
Total impaired loans $71,758 $76,512 $12,449 $13,338
======= ======= ======= =======
Average balance for the year $84,077 $80,487
Interest income recognized for the year 854 1,376
Cash collected applied to outstanding principal 3,758 4,415
Certain directors and executive officers of Citizens and its significant
subsidiaries, including their families and entities in which they have 10% or
more ownership, were clients of the banking subsidiaries. Total loans to these
clients aggregated $16.3 million and $3.4 million at December 31, 2003 and 2002,
respectively. During 2003, new loans of $13.5 million were made and repayments
totaled $0.6 million. Substantially all such loans were made in the ordinary
course of business on substantially the same terms, including interest rates and
collateral, as those for comparable transactions with unrelated parties and did
not involve more than normal risk of collectibility.
79
The Consolidated Financial Statements do not include loans serviced for others,
which totaled $58.8 million and $159.8 million at December 31, 2003 and 2002,
respectively. The carrying value of mortgage servicing rights approximates fair
value at December 31, 2003 and 2002.
Changes in originated mortgage servicing rights for the years ended December 31
were as follows:
(in thousands) 2003 2002 2001
------- ------- -------
UNAMORTIZED COST OF MORTGAGE SERVICING RIGHTS
Balance - January 1 $ 942 $ 1,993 $ 2,940
Additions of mortgage servicing rights -- -- --
Amortization (432) (1,051) (947)
------- ------- -------
Balance - December 31 $ 510 $ 942 $ 1,993
------- ------- -------
IMPAIRMENT VALUATION ALLOWANCE
Balance - January 1 $ (510) $ (260) $ (260)
Impairment valuation allowance charged to expense -- (250) --
------- ------- -------
Balance - December 31 $ (510) $ (510) $ (260)
------- ------- -------
NET CARRYING VALUE OF MORTGAGE SERVICING RIGHTS $ -- $ 432 $ 1,733
======= ======= =======
The valuation reserve for impairment of mortgage servicing rights was $510,000
at December 31, 2003 and 2002.
NOTE 7. GOODWILL AND OTHER INTANGIBLE ASSETS
On January 1, 2002 Citizens adopted SFAS 142 which changed the accounting for
intangible assets. Upon adoption, Citizens ceased amortizing its goodwill, which
decreased noninterest expense and increased net income in 2003 and 2002 as
compared to 2001. The following table shows the pro forma effects of applying
SFAS 142 to the year 2001 period.
2003 2002 2001
---- ---- ----
(in thousands, except Net Earnings Net Earnings Net Earnings
per share amounts) Income Per Share Income Per Share Income Per Share
-------- -------- -------- -------- -------- --------
Diluted earnings per common share computation:
Net income/diluted EPS as reported $ 65,951 $ 1.51 $ 25,038 $ 0.56 $104,657 $ 2.25
Add back: Goodwill amortization,
net of tax effect -- -- -- -- 5,545 0.12
-------- -------- -------- -------- -------- --------
Adjusted net income/diluted EPS $ 65,951 $ 1.51 $ 25,038 $ 0.56 $110,202 $ 2.37
======== ======== ======== ======== ======== ========
SFAS 142 requires that goodwill be tested for impairment at adoption and at
least annually thereafter. Citizens completed it's transitional impairment
testing in June 2002 and no impairment under SFAS 142 was identified. Citizens
performed its annual impairment testing as of October 1, 2003 and no impairment
was identified. A summary of goodwill allocated to Citizens' lines of business
as of December 31, 2003 follows.
December 31,
(in thousands) 2003 2002
---- ----
Commercial Banking $23,982 $23,982
Consumer Banking 29,002 29,002
Wealth Management 1,801 1,801
Other -- --
------- -------
Total Goodwill $54,785 $54,785
======= =======
80
No changes in the carrying amount of goodwill were recorded during 2003.
Citizens' other intangible assets are shown in the table below.
December 31,
(in thousands) 2003 2002
---- ----
Core deposit intangibles $28,989 $28,989
Accumulated amortization 12,058 9,160
------- -------
Net core deposit intangibles 16,931 19,829
Minimum pension liability 1 33
------- -------
Total other intangibles $16,932 $19,862
======= =======
The estimated annual amortization expense for core deposit intangibles for each
of the next five years is $2.9 million. As part of adopting SFAS 142, Citizens
has had no material reclassifications or adjustments to the useful lives of
finite-lived (core deposit) intangible assets.
NOTE 8. ALLOWANCE FOR LOAN LOSSES
A summary of changes in the allowance for loan losses follows:
(in thousands) 2003 2002 2001
---- ---- ----
Allowance for loan losses - January 1 $ 106,777 $ 76,275 $ 75,413
Allowance of sold banks and branches -- -- (240)
Transfer to reserve for commitments -- 1,334 633
Provision for loan losses 62,962 120,200 26,407
Charge-offs (66,063) (101,704) (32,732)
Recoveries 19,869 10,672 6,794
--------- --------- --------
Net charge-offs (46,194) (91,032) (25,938)
--------- --------- --------
Allowance for loan losses - December 31 $ 123,545 $ 106,777 $ 76,275
========= ========= ========
Allowance for losses on lending-related
commitments - December 31 $ 2,690 $ 2,690 $ 4,024
========= ========= ========
During the fourth quarter of 2003 Citizens reclassified $2.7 million of the
allowance for loan losses related to unfunded loan commitments to other
liabilities. Prior period amounts were restated to conform to the new
presentation.
NOTE 9. PREMISES AND EQUIPMENT
A summary of premises and equipment follows:
December 31,
(in thousands) 2003 2002
---- ----
Land $ 20,722 $ 21,115
Buildings 147,840 145,511
Leasehold improvements 5,509 5,544
Furniture and equipment 117,946 124,450
--------- ---------
292,017 296,620
Accumulated depreciation and amortization (179,233) (178,916)
--------- ---------
Total $ 112,784 $ 117,704
========= =========
81
Certain branch facilities and equipment are leased under various operating
leases. Total rental expense, including expenses related to these operating
leases, was $4.6 million in 2003, $4.5 million in 2002 and $4.8 million in 2001.
Future minimum rental commitments under non-cancelable operating leases are as
follows at December 31, 2003: $3.1 million in 2004, $2.7 million in 2005, $2.1
million in 2006, $1.6 million in 2007, $1.1 million in 2008, and $3.8 million
after 2008.
NOTE 10. DEPOSITS
A summary of deposits follows:
December 31,
(in thousands) 2003 2002
---- ----
Noninterest-bearing demand $ 882,429 $ 900,674
Interest-bearing demand 1,360,756 1,307,524
Savings 1,239,178 1,358,042
Time deposits over $100,000 618,957 677,628
Other time deposits 1,340,947 1,693,045
---------- ----------
Total $5,442,267 $5,936,913
========== ==========
Excluded from total deposits are demand deposit account overdrafts, which have
been reclassified as loans. At December 31, 2003 and 2002, these overdrafts
totaled $5.3 million and $5.4 million, respectively. Time deposits with
remaining maturities of one year or more are $578.7 million at December 31,
2003. The maturities of these time deposits are as follows: $354.5 million in
2005, $120.1 million in 2006, $21.0 million in 2007, $20.2 million in 2008 and
$62.9 million after 2008.
NOTE 11. SHORT-TERM BORROWINGS
Short-term borrowings consist of federal funds purchased and securities sold
under agreements to repurchase, Federal Home Loan Bank (FHLB) borrowings, other
bank borrowings, and demand notes to the U.S. Treasury. Federal funds purchased
are overnight borrowings from other financial institutions. Securities sold
under agreements to repurchase are secured transactions done principally with
investment banks which generally mature within ninety days.
Information relating to federal funds purchased and securities sold under
agreements to repurchase follows:
(in thousands) 2003 2002 2001
---- ---- ----
At December 31:
Balance $588,593 $223,289 $233,077
Weighted average interest rate paid 1.01% 1.29% 1.81%
During the year:
Maximum outstanding at any month-end $664,065 $281,676 $354,612
Daily average 445,383 195,983 242,945
Weighted average interest rate paid 1.08% 1.51% 4.32%
82
Citizens did not have any significant short-term borrowings with the FHLB in
2003 or 2002. In 2001 a significant amount of short-term borrowings consisted of
FHLB advances and lines of credit to Citizens' subsidiary banks. Information
relating to short-term FHLB borrowings in 2001 follows:
(in thousands) 2001
----
At December 31:
Balance $ --
Weighted average interest rate paid --
During the year:
Maximum outstanding at any month-end $ 425,200
Daily average 222,310
Weighted average interest rate paid 6.25%
Citizens' parent company maintains a short-term line of credit with two
unaffiliated banks totaling $50 million. As of December 31, 2003, there was no
outstanding balance. The credit facility will mature in August 2004 and is
expected to renew at that time. The credit agreement requires Citizens to
maintain certain financial covenants. Citizens is in full compliance with all
debt covenants as of December 31, 2003.
NOTE 12. LONG-TERM DEBT
A summary of long-term debt follows:
December 31,
(in thousands) 2003 2002
---- ----
Citizens (Parent only):
Subordinated debt:
Notes maturing February 2013 $123,061 --
Deferrable interest debenture maturing
June 2033 25,774 --
Subsidiaries:
Federal Home Loan Bank advances 787,930 599,139
Other borrowed funds 94 174
-------- --------
Total long-term debt $936,859 $599,313
======== ========
On January 27, 2003, Citizens issued $125 million of 5.75% subordinated notes
maturing February 1, 2013. Citizens also entered into an interest rate swap to
hedge the interest rate risk on the subordinated debt. The carrying value of the
subordinated notes has been adjusted to reflect the gain or loss attributable to
the risk hedged. Issuance costs of $1.3 million were capitalized and are
included in other assets on the balance sheet. The issuance costs are being
amortized over 10 years as a component of interest expense. The subordinated
debt qualifies under the risk-based capital guidelines as Tier 2 supplementary
capital for regulatory purposes.
On June 26, 2003, Citizens issued approximately $25 million of floating rate, 30
year trust preferred securities through an unconsolidated special purpose trust
to unrelated institutional investors. The gross proceeds from issuance were used
to purchase a floating rate junior subordinated deferrable interest debenture
(the "Debenture") issued by Citizens, which is the sole asset of the trust. The
Debenture matures in thirty years and bears interest at an annual rate equal to
the three-month LIBOR plus 3.10%, payable quarterly beginning in September,
2003. Interest is adjusted on a quarterly basis provided that prior to May 2008,
the interest rate shall not exceed 11.75%. The Debenture is an unsecured
obligation of Citizens and is junior in the right of payment to all future
senior indebtedness of Citizens. Citizens has guaranteed that interest payments
on the Debenture made to the trust will be distributed by the trust to the
holders of the trust preferred securities. Issuance costs of $490,000 were
incurred related to the issuance. These costs have been capitalized and are
included in other assets on the balance sheet. The issuance costs are being
amortized over five years as a component of interest expense. The trust
preferred securities of the special purpose trust are callable after five years
at par and must be redeemed in 30 years after issuance. For regulatory purposes,
these trust preferred securities qualify under the risk-based capital guidelines
as Tier 1 capital.
83
Long-term advances from the FHLB are at fixed and variable rates ranging from
1.16% to 7.10% and mature in 2004 through 2021. The majority of the fixed rate
FHLB advances are convertible to a floating rate at the option of the Federal
Home Loan Bank. Interest is paid monthly. At December 31, 2003, qualifying
mortgage loans of $484 million, investment securities of $455 million and FHLB
stock collaterized long-term advances from the FHLB. At December 31, 2002, $699
million of mortgage loans, $286 million of investment securities and FHLB stock
collateralized long-term advances from the FHLB.
Maturities of long-term debt during the next five years follow:
(in thousands) Parent Subsidiaries Consolidated
- -------------- ------ ------------ ------------
2004 $ -- $ 85,256 $ 85,256
2005 -- 225,038 225,038
2006 -- 95,200 95,200
2007 -- 25,000 25,000
2008 -- 70,204 70,204
Over 5 Years 148,835 287,326 436,161
-------- -------- --------
Total $148,835 $788,024 $936,859
======== ======== ========
NOTES 13. EMPLOYEE BENEFIT PLANS
PENSION AND POSTRETIREMENT BENEFITS: Citizens maintains cash balance defined
benefit pension plans covering the majority of its employees, and postretirement
benefit plans for retirees that include health care benefits and life insurance
coverage. Pension retirement benefits are based on the employee's length of
service and salary levels. Actuarially determined pension costs are charged to
current operations. It is Citizens' policy to fund pension costs in an amount
sufficient to meet or exceed the minimum funding requirements of applicable laws
and regulations, plus such additional amounts as Citizens deems appropriate up
to that allowable by federal tax regulations.
Citizens also maintains nonqualified supplemental benefit plans for certain key
employees. These plans are provided for by charges to earnings sufficient to
meet the projected benefit obligation. The defined pension benefits provided
under these plans are unfunded and any payments to plan participants are made by
Citizens. As part of the third quarter 2002 restructuring initiatives, Citizens
recognized a curtailment related to the termination of certain officers'
employment earlier than expected. The curtailment caused a charge of $891,870
for accelerated recognition of their prior service cost bases.
Effective January 1, 2002 the defined benefit plan for Citizens' Michigan and
Illinois employees (CBC Plan) was amended to provide for a new cash balance
pension benefit. This amendment increased the projected benefit obligation of
the CBC Plan at December 31, 2001 by $1.1 million. Full-time employees that
retire within the next five years with at least 10 years of service under the
CBC Plan may elect to receive a benefit under the old formula, which is, in
part, based on the employees' final five-year average base pay. The defined
benefit plan established for Citizens' F&M employees in 2000 also provides for a
cash balance pension benefit.
Citizens' postretirement benefit plan, as amended, is available to full-time
employees who retire at normal retirement age, were age 50 prior to January 1,
1993 and have at least 15 years of credited service under Citizens' defined
benefit pension plan. The medical portion of the plan is contributory to the
participants. The life insurance coverage is noncontributory and provided on a
reducing basis for 5 years. Those retired prior to January 1, 1993 receive
benefits provided by the plan prior to its amendment. That plan included dental
care, had some retiree contribution requirements, and had less restrictive
eligibility requirements.
84
An actuarial measurement date of December 31 was utilized to determine the
projected benefit obligations and fair value of plan assets as follows:
Pension Postretirement
Benefits Benefits
-------- --------
(in thousands) 2003 2002 2003 2002
---- ---- ---- ----
CHANGE IN BENEFIT OBLIGATION
Projected benefit obligation, beginning of year $ 81,428 73,530 $ 18,502 $ 15,714
Service cost 4,124 3,893 11 8
Interest cost 5,095 5,095 1,161 1,249
Participant contribution -- -- 409 779
Actuarial (gains) losses 1,517 4,698 535 2,702
Plan amendments 116 -- -- --
Special termination benefits 31 -- -- --
Benefits paid (7,364) (5,788) (1,864) (1,950)
-------- -------- -------- --------
Projected benefit obligation, end of year $ 84,947 $ 81,428 $ 18,754 $ 18,502
======== ======== ======== ========
Accumulated benefit obligation, end of year $ 83,216 $ 80,257 $ 18,754 $ 18,502
======== ======== ======== ========
CHANGE IN PLAN ASSETS
Fair value of plan assets, beginning of year $ 74,927 $ 63,127 $ -- $ --
Actual return on plan assets 17,234 (6,951) -- --
Employer contribution 243 24,780 1,455 1,171
Participant contribution -- -- 409 779
Expenses paid -- (241) -- --
Benefits paid (7,364) (5,788) (1,864) (1,950)
-------- -------- -------- --------
Fair value of plan assets, end of year $ 85,040 $ 74,927 $ -- $ --
======== ======== ======== ========
RECONCILIATION OF FUNDED STATUS
(Under)/Over funded $ 93 $ (6,501) $(18,754) $(18,502)
Unrecognized:
Net transition asset - 16 yr amortization (14) (24) -- --
Prior service cost (benefit) 1,678 1,785 (28) (33)
Net actuarial (gain) loss 14,849 22,724 3,899 3,510
Adjustment to recognize minimum liability (314) --- --- ---
-------- -------- -------- --------
Net amount recognized in the
consolidated balance sheets $ 16,292 $ 17,984 $(14,883) $(15,025)
======== ======== ======== ========
85
The components of net periodic benefit cost charged to operations each year for
all plans follow:
Year Ended December 31,
-----------------------
(in thousands) 2003 2002 2001
---- ---- ----
DEFINED BENEFIT PENSION PLANS
Service cost $ 4,124 $ 3,893 $ 2,988
Interest cost 5,095 5,095 4,878
Expected return on plan assets (7,901) (6,837) (6,873)
Curtailment loss
-- 892 --
Amortization of unrecognized:
Net transition asset (10) (18) (123)
Prior service cost 222 728 626
Net actuarial gain (loss) 61 6 (586)
------- ------- -------
Net pension cost (income) 1,591 3,759 910
------- ------- -------
POSTRETIREMENT BENEFIT PLANS
Service cost 11 8 12
Interest cost 1,161 1,249 1,148
Amortization of unrecognized:
Prior service cost
(4) (4) (5)
Net actuarial loss 146 120 --
------- ------- -------
Net postretirement benefit cost 1,314 1,373 1,155
------- ------- -------
DEFINED CONTRIBUTION RETIREMENT AND 401(K) PLANS
Employer contributions 3,033 3,271 2,850
------- ------- -------
Total periodic benefit cost $ 5,938 $ 8,403 $ 4,915
======= ======= =======
The assumptions used in determining the actuarial present value of the benefit
obligations and the net periodic pension expense follow:
Pension Postretirement
Benefits Benefits
-------- --------
December 31, 2003 2002 2003 2002
---- ---- ---- ----
ASSUMPTIONS USED TO COMPUTE PROJECTED BENEFIT OBLIGATION
Discount rate 6.25% 6.50% 6.25% 6.50%
Rate of compensation increase: -- --
Cash balance defined benefit plans (1) (1)
Nonqualified supplemental benefit plans 6.00% 5.00%
ASSUMPTIONS USED TO COMPUTE NET BENEFIT COSTS
Discount rate 6.50% 7.25% 6.50% 7.25%
Expected return on plan assets 9.25 9.75 -- --
Rate of compensation increase:
Cash balance defined benefit plans (1) (1)
Nonqualified supplemental benefit plans 5.00% 5.00%
(1) Scaled by age of plan participant - 9.0% at age 24 or under declining to
4.0% at age 50 or older.
At December 31, 2003, plan assets exceeded the accumulated plan benefits for all
plans except the supplemental benefit plans. The projected benefit obligation
and accumulated benefit obligation for these supplemental benefit plans were
approximately $7.1 million and $6.6 million, respectively, as of December 31,
2003. Except for the F&M cash balance plan, accumulated plan benefits exceeded
plan assets for all plans in 2002. The projected benefit obligation, accumulated
benefit obligation, and plan assets for the F&M plan at December 31, 2002 was
$9.1 million, $9.0 million and $9.3 million, respectively.
86
INVESTMENT POLICY AND STRATEGY: Citizens' investment policy and strategy for
managing the defined benefit plan assets is described as "growth with income"
which includes an asset allocation of 70% equities and 30% fixed income and
cash. The strategy includes optimization modeling to determine the investment
style weights to maximize the performance potential for the accepted level of
risk. The equity component at December 31, 2003 is weighted 70% domestic and 30%
international, with large cap stocks comprising two thirds of the domestic
equities. Intermediate term bonds comprise the majority of the fixed income
component. Implementation of this strategy also includes regular rebalancing of
the portfolio to the target asset allocation. Pension plan assets included
$517,000 of Citizens' common stock at December 31, 2002. Pension plan assets did
not include any common stock of Citizens at December 31, 2003. The plans' target
asset allocation and the actual asset allocation at December 31, 2003 and 2002
is presented below.
Percentage of
Target Plan Assets
December 31, Allocation 2003 2002
---------- ---- ----
ASSET CATEGORY:
Equity securities 70% 72% 48%
Debt securities 29 27 20
Cash and Cash Equivalents 1 1 32
--- --- ---
100% 100% 100%
The expected return on plan assets was determined using the long-term historical
returns of the various investment categories, weighted by target asset
allocations. The 2004 pension plan assumptions used to determine net periodic
benefit cost will be a discount rate of 6.25% and an expected long-term return
on plan assets of 8.75%. Estimated employer contributions for 2004 are
approximately $0.5 million. Employer contributions for 2004 could increase as a
result of changing market conditions and other factors that may affect actual
return on plan assets. At December 31, 2002 the plans' asset allocation differed
significantly from the target asset allocation due to a large employer
contribution of $24.1 million, or approximately 32% of the plan assets at that
date, received in late December 2002. Due to the large amount of the
contribution, the funds were held in money market funds and invested in various
stock and bond funds over a period of several months to achieve the targeted
asset allocation.
Prior service pension costs are amortized on a straight-line basis over the
average remaining service period of employees expected to receive benefits under
the plans. For postretirement health care benefit plans, Citizens assumed a 7.5%
annual health care cost trend rate in 2003, declining to 5.0% by 2008 and
remaining constant for all future years. This assumption can have a significant
effect on the amounts reported. A one-percentage-point change in assumed health
care cost trend rates would have the following effects:
One Percentage One Percentage
(in thousands) Point Increase Point Decrease
-------------- --------------
Effect on total of service and interest cost components $ 103 $ (91)
Effect on the postretirement benefit obligation 1,722 (1,511)
In December 2003, President Bush signed into law a bill that expands Medicare
benefits, primarily adding a prescription drug benefit for Medicare-eligible
retirees beginning in 2006. The law also provides a federal subsidy to companies
which sponsor postretirement benefit plans that provide prescription drug
coverage. FASB Staff Position 106-1, Accounting and Disclosure Requirements
Related to the Medicare Prescription, Drug, Improvement and Modernization Act of
2003 permits deferring the recognition of the new Medicare provisions' impact
due to lack of specific authoritative guidance on accounting for the federal
subsidy. The Corporation has elected to defer accounting for the effects of this
new legislation until the specific authoritative guidance is issued.
Accordingly, the postretirement benefit obligations and net periodic costs
reported in the accompanying financial statements and notes do not reflect the
impact of this legislation. The accounting guidance, when issued, could require
changes to previously reported financial information. The corporation
anticipates its benefit costs by 2006, or as early as guidance is issued, will
be somewhat lower as a result of the new Medicare provision, however, the
adoption of this standard is not expected to have a material impact on results
of operations, financial position, or liquidity.
87
DEFINED CONTRIBUTION SAVINGS AND RETIREMENT PLANS: Substantially all employees
are eligible to contribute a portion of their pre-tax salary to a defined
contribution 401(k) savings plan. Under the plan, employee contributions are
partially matched by Citizens. The employer matching contribution is 75 percent
of the first 6% (100 percent of the first 3% plus 50 percent of the next 3%) of
each eligible employee's qualifying salary contributed to the plan. In addition,
one third of these matching contributions are used to fund a postretirement
medical savings account established within the plan for each contributing
employee.
NOTE 14. INCOME TAXES
Significant components of income taxes are as follows:
- --------------------------------------------------------------------------
Year Ended December 31,
(in thousands) 2003 2002 2001
- --------------------------------------------------------------------------
Current tax expense:
Federal $ 17,309 $ 3,676 $ 42,926
State 341 371 568
-------- ------- --------
Total current tax expense 17,650 4,047 43,494
Deferred tax expense (credit) 1,526 (5,110) (279)
-------- ------- --------
Total income tax expense $ 19,176 $ (1,063) $ 43,215
======== ======== ========
- --------------------------------------------------------------------------
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
Citizens' deferred tax assets and liabilities as of December 31, 2003 and 2002
follow:
- -------------------------------------------------------------------------------
(in thousands) 2003 2002
------- -------
Deferred tax assets:
Allowance for loan losses $45,901 $40,629
Accrued postemployment benefits other than pensions 5,257 5,359
Alternative minimum tax -- 3,257
Accrued special charges -- 1,898
Other deferred tax assets 9,055 6,908
------- -------
Deferred tax assets 60,213 58,051
------- -------
Deferred tax liabilities:
Pension 8,159 8,414
Acquisition premium on loans 7,136 5,156
Tax over book depreciation 3,513 3,353
Net unrealized gains on securities 12,279 22,963
Other deferred tax liabilities 6,006 4,203
------- -------
Deferred tax liabilities 37,093 44,089
------- -------
Net deferred tax assets $23,120 $13,962
======= =======
- -------------------------------------------------------------------------------
A reconciliation of income tax expense to the amount computed by applying the
federal statutory rate of 35% to income before income taxes follows:
- -------------------------------------------------------------------------------------------------------------
Year Ended December 31,
(in thousands) 2003 2002 2001
-------- -------- --------
Tax at federal statutory rate applied to income before income taxes $ 29,794 $ 8,391 $ 51,755
Increase (decrease) in taxes resulting from:
Tax-exempt income (9,291) (8,623) (8,793)
Other (1,327) (831) 253
-------- -------- --------
Total income tax expense $ 19,176 $ (1,063) $ 43,215
======== ======== ========
- -------------------------------------------------------------------------------------------------------------
88
NOTE 15. EARNINGS PER SHARE
A reconciliation of the numerators and denominators of the basic and diluted
earnings per share computations follows:
- ----------------------------------------------------------------------------------------------------
Year Ended December 31,
(in thousands) 2003 2002 2001
-------- -------- --------
NUMERATOR:
Numerator for basic and dilutive earnings per share --
net income available to common shareholders $ 65,951 $ 25,038 $104,657
======== ======== ========
DENOMINATOR:
Denominator for basic earnings per share --
weighted average shares 43,304 44,657 46,085
Effect of dilutive securities -- potential conversion
of employee stock options 305 420 505
-------- -------- --------
Denominator for diluted earnings per share --
adjusted weighted-average shares and assumed conversions 43,609 45,077 46,590
======== ======== ========
BASIC EARNINGS PER SHARE $ 1.52 $ 0.56 $ 2.27
======== ======== ========
DILUTED EARNINGS PER SHARE $ 1.51 $ 0.56 $ 2.25
======== ======== ========
- ----------------------------------------------------------------------------------------------------
Basic net income per share is calculated by dividing net income by the
weighted-average number of shares outstanding for the period. Diluted net income
per share takes into consideration the pro forma dilution assuming all
in-the-money outstanding stock options were exercised. The average price of
Citizens' stock for the period is used to determine the dilutive effect of
outstanding stock options. See Note 16 for additional disclosures regarding
employee stock options.
NOTE 16. SHAREHOLDERS' EQUITY
RIGHTS AGREEMENT: Citizens is a party to a Rights Agreement, dated May 23, 2000,
designed to protect shareholders from unfair takeover offers by encouraging a
potential buyer to negotiate with Citizens' board prior to attempting a
takeover. Owners of Citizens' common shares have been granted rights under the
Rights Agreement to purchase one one-thousandth of a share of Series B Preferred
Stock at an exercise price of $65, subject to adjustment. The rights are not
exercisable or separately tradable until after a public announcement that a
person or group, without board approval, has acquired 15% or more of Citizens'
common shares or has commenced a tender offer to do so. If a person or group
acquires 15% or more of the common shares, the rights (other than those held by
the acquiror, which become void) become exercisable to purchase common shares
having a fair value of $130 for $65, or the board may exchange one common share
for each outstanding right (other than those held by the acquiror). If the
acquiror merges Citizens into another entity, the rights become exercisable for
common shares of the surviving entity having a fair value of $130 for $65. The
rights are redeemable by the board at any time prior to May 23, 2010 for $.001
per right. The Rights Agreement may be amended by the board without shareholder
or right holder approval at any time prior to the acquisition by a person or
group of 15% or more of the common shares. The rights will cause substantial
dilution to a person or group attempting to acquire Citizens without action by
Citizens' board to deactivate the rights.
STOCK REPURCHASE PLANS: Citizens purchased shares under a stock repurchase
program initiated in October 2001. This program authorizes Citizens to purchase
up to 3,000,000 shares for treasury. During the year, 810,800 shares were
purchased under this plan at an average price of $26.30. As of December 31,
2003, there were 254,600 shares available for purchase under the program. An
additional 3,000,000 shares are authorized for repurchase under a new plan,
approved in October 2003. The repurchased shares have been accorded the
accounting treatment as if retired.
STOCK OPTION PLAN: Citizens' Stock Compensation plan, effective January 18, 2002
and approved by shareholders on April 16, 2002, authorizes the granting of
incentive and nonqualified stock options, restricted stock, restricted stock
units and performance awards to employees and non-employee directors at any time
prior to January 18, 2012. Aggregate grants under the plan may not exceed
7,000,000 shares, and grants other than stock options are further limited to
2,000,000 shares. The
89
plan replaces the option plan for key employees that expired January 16, 2002
and the Stock Option Plan for Directors, which was terminated.
Options granted to employees expire ten years from the date of grant. Options
granted before the fourth quarter of 2002 are vested five years from the grant
date, but may vest sooner based on Citizens' achievement of certain earnings per
share targets. For options granted after the third quarter of 2002, the vesting
is 20% on each of the first five grant date anniversaries. At December 31, 2003,
options outstanding under the plan to employees (including those issued under
the expired plan) totaled 3,897,283 shares of which 1,037,266 shares are
currently vested and exercisable. Canceled or expired options become available
for future grants.
A total of 27,500 shares of options were granted to non-employee directors in
2003. The options vest 20% on each of the first five grant date anniversaries
and expire ten years from the date of grant. As of December 31, 2003, there were
55,500 shares of options that were issued to directors before 2003. These
options have a term of 5 years and are fully vested.
OTHER STOCK OPTIONS: On May 18, 2000, Citizens granted stock options to all
employees who did not receive grants under the key employee stock option plan.
Each full-time employee received 200 shares and each part-time employee received
100 shares. The $16.66 exercise price of the grant was the market price of
Citizens' stock on the grant date. The options became exercisable on May 18,
2003 and expire ten years from the date of grant. A total of 550,700 shares were
granted of which 164,050 shares were outstanding as of December 31, 2003. In
addition, there were also 28,895 shares of stock options from a previous
acquisition of a subsidiary outstanding at December 31, 2003.
Citizens has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock issued to Employees" (APB 25) and related Interpretations
in accounting for its employee stock options as permitted by Financial
Accounting Standards Board Statement No. 123, "Accounting for Stock-Based
Compensation." Under APB 25, no compensation expense is recognized by Citizens
because the exercise price of the stock options equals the market price of the
underlying stock on the date of grant.
Statement 123 requires certain pro forma disclosures regarding net income and
earnings per share as if Citizens had accounted for its stock options under the
fair value method of that statement. The following table provides these
disclosures along with significant assumptions used to estimate the fair value
of these options:
- --------------------------------------------------------------------------------
2003 2002 2001
---------- ---------- -----------
Pro forma amounts:
Net income (in thousands) $ 63,690 $ 22,637 $ 102,808
Net income per share:
Basic 1.47 0.51 2.23
Diluted 1.46 0.50 2.21
Weighted-average assumptions:
Dividend yield 3.5% 3.5% 3.5%
Expected volatility 28.0% 28.0% 28.0%
Risk-free interest rate 2.64% 4.18% 5.02%
Expected lives 5 yrs. 5 yrs. 5 yrs.
- --------------------------------------------------------------------------------
The weighted average fair values of stock options granted during 2003, 2002 and
2001 were $5.02, $6.75 and $5.77, respectively.
90
A summary of stock option transactions under the plans for 2003, 2002 and 2001
follows:
- -------------------------------------------------------------------------------------------------
Options Option Price
--------------------------- ---------------------------
Available Per Share
for Grant Outstanding Range Average
--------- ----------- ----- -------
January 1, 2001 252,580 3,191,004 $ 8.50-36.31 $ 21.36
Authorized 566,858 -- -- --
Granted (651,200) 651,200 25.42-25.72 25.43
Exercised -- (591,602) 8.50-28.21 18.07
Canceled 117,277 (207,729) 16.66-36.31 20.45
---------- --------- ------------- ---------
December 31, 2001 285,515 3,042,873 11.75-36.31 22.94
Old Plans Expired or Terminated (285,515) -- -- --
New Plan Authorized 7,000,000 -- -- --
Granted (901,200) 901,200 25.11-33.41 30.85
Restricted Stock Granted (25,000) -- -- --
Exercised -- (327,629) 11.77-30.50 20.13
Canceled 24,500 (182,277) 16.66-36.31 23.08
---------- --------- ------------- ---------
December 31, 2002 6,098,300 3,434,167 11.75-36.31 25.28
Granted (1,255,200) 1,255,200 23.10-33.66 26.27
Restricted Stock Granted (8,862) -- -- --
Exercised -- (341,485) 11.75-30.50 18.55
Canceled 49,200 (174,654) 16.66-36.31 25.90
---------- --------- ------------- ---------
December 31, 2003 4,883,438 4,173,228 $ 15.10-35.63 $ 26.10
========== ========= ============= =========
- -------------------------------------------------------------------------------------------------
The following table summarizes information on stock options outstanding as of
December 31, 2003:
- ----------------------------------------------------------------------------------------------------
Options Outstanding Options Exercisable
---------------------------------------------- --------------------------
Weighted- Weighted-
Average Weighted- Average
Remaining Average Exercise
Range Amount Life Exercise Price Amount Price
- ----------------------------------------------------------------------------------------------------
$ 15.10 - 21.99 970,014 5.0 years $ 17.92 611,057 $ 18.67
22.00 - 28.99 1,929,055 8.7 25.82 164,155 25.51
29.00 - 35.63 1,274,159 6.5 32.74 510,499 33.74
--------- ---------
$ 15.10 - 35.63 4,173,228 7.2 26.10 1,285,711 25.52
========= =========
- ----------------------------------------------------------------------------------------------------
NOTE 17. COMMITMENTS, CONTINGENT LIABILITIES AND GUARANTEES
The Consolidated Financial Statements do not reflect various loan commitments
(unfunded loans and unused lines of credit) and letters of credit originated in
the normal course of business. Loan commitments are made to accommodate the
financial needs of clients. Generally, new loan commitments do not extend beyond
90 days and unused lines of credit are reviewed at least annually. Letters of
credit guarantee future payment of client financial obligations to third
parties. They are issued primarily for services provided or to facilitate the
shipment of goods, and generally expire within one year. Both arrangements have
essentially the same level of credit risk as that associated with extending
loans to clients and are subject to Citizens' normal credit policies. Inasmuch
as these arrangements generally have fixed expiration dates or other termination
clauses, most expire unfunded and do not necessarily represent future liquidity
requirements. Collateral is obtained based on management's assessment of the
client and may include receivables, inventories, real property and equipment.
91
Amounts available to clients under loan commitments and letters of credit
follow:
- ----------------------------------------------------------------------
December 31,
(in thousands) 2003 2002
---------- ----------
LOAN COMMITMENTS AND LETTERS OF CREDIT:
Commitments to extend credit $1,593,426 $1,739,091
Standby letters of credit 48,868 36,396
Commercial letters of credit 183,665 138,679
---------- ----------
$1,825,959 $1,914,166
========== ==========
- ----------------------------------------------------------------------
Loan commitments outstanding include $45.8 million of credit card commitments
and $379.8 million of home equity credit lines in 2003. The same amounts for
2002 were $71.1 million and $298.3 million, respectively.
Citizens and its subsidiaries are parties to litigation arising in the ordinary
course of business. Management believes that the aggregate liability, if any,
resulting from these proceedings would not have a material effect on Citizens'
consolidated financial position or results of operations.
CONTINGENT GUARANTEES: Citizens has performance obligations upon the occurrence
of certain events under financial guarantees provided in certain contractual
arrangements. At December 31, 2003, Citizens had issued approximately $42.1
million of financial standby letters of credit and $6.8 million of performance
standby letters of credit. The same amounts at December 31, 2002 were $28.8
million and $7.6 million, respectively.
NOTE 18. DERIVATIVES AND HEDGING ACTIVITIES
SFAS 133, "Accounting for Derivative Instruments and Hedging Activities," as
amended by SFAS 138 and SFAS 149, "Accounting for Certain Derivative Instruments
and Certain Hedging Activities," (collectively referred to as "SFAS 133")
establish accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities. All derivatives, whether designated in hedging relationships
or not, are required to be recorded on the balance sheet at fair value.
Citizens designates its derivatives based upon criteria established by SFAS 133.
For a derivative designated as a fair value hedge, the derivative is recorded at
fair value on the consolidated balance sheet. Any difference between the fair
value change of the hedge versus the fair value change of the hedged item is
considered to be the "ineffective" portion of the hedge. The ineffectiveness of
the hedge is recorded in current earnings. For a derivative designated as a cash
flow hedge, the effective portion of the derivative's gain or loss is initially
reported as a component of accumulated other comprehensive income (loss) and
subsequently reclassified into earnings when the hedged exposure affects
earnings.
Citizens may use derivative instruments to hedge the variability in interest
payments or protect the value of certain assets and liabilities recorded in its
balance sheet from changes in interest rates. Citizens uses interest rate
contracts such as interest rate swaps to manage its interest rate risk. These
contracts are designated as hedges of specific assets or liabilities. The net
interest receivable or payable on swaps is accrued and recognized as an
adjustment to the interest income or expense of the hedged asset or liability.
The following table summarizes the derivative financial instruments held or
issued by Citizens.
92
- ----------------------------------------------------------------------------------------------------------------
DERIVATIVE FINANCIAL INSTRUMENTS: DECEMBER 31, DECEMBER 31,
2003 2002
---------------------------------------------------
Notional Fair Notional Fair
(dollars in thousands) Amount Value Amount Value
- ----------------------------------------------------------------------------------------------------------------
Received fixed swaps $190,000 $ 499 $ -- $ --
Interest rate lock commitments 14,683 109 66,787 1,176
Forward mortgage loan contracts 29,000 (161) 175,537 (2,700)
-------- ----- -------- -------
TOTAL $233,683 $ 447 $242,324 $(1,524)
======== ===== ======== =======
- ----------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------
DERIVATIVE CLASSIFICATIONS AND HEDGING RELATIONSHIPS: DECEMBER 31, DECEMBER 31,
2003 2002
--------------------------------------------------
Notional Fair Notional Fair
(dollars in thousands) Amount Value Amount Value
- ----------------------------------------------------------------------------------------------------------------
Derivatives Designated as Cash Flow Hedges:
Hedging commercial loans $ 25,000 $ 339 $ -- $ --
Derivatives Designated as Fair Value Hedges:
Hedging time deposits 40,000 31 -- --
Hedging long-term debt 125,000 129 -- --
-------- ----- --- ---
Total $190,000 $ 499 $ -- $ --
======== ===== === ===
- ----------------------------------------------------------------------------------------------------------------
At December 31, 2003, Citizens had outstanding $190 million of interest rate
swap agreements with an average receive rate of 4.78% and pay rate of 1.62%.
There were no interest rate swaps in 2002. Interest rate lock commitments on
mortgages held for sale were approximately $14.7 million at December 31, 2003
and $66.8 million at December 31, 2002. Citizens also had outstanding mandatory
forward commitments to sell $29 million of residential mortgage loans at
December 31, 2003, which hedged the year end balance of mortgage loans held for
sale. These outstanding forward commitments to sell mortgage loans are expected
to settle in the first quarter of 2004 with no material gain or loss. At
December 31, 2002, outstanding forward commitments to sell mortgage loans were
approximately $175.5 million. Citizens' policy to hedge its market rate risk
with mandatory forward commitments has been highly effective and has not
generated any material gains or losses.
93
NOTE 19. FAIR VALUES OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments is
made in accordance with the requirements of SFAS 107, "Disclosure About Fair
Value of Financial Instruments". Where quoted market prices are not available,
as is the case for a significant portion of Citizens' financial instruments, the
fair values are based on estimates using present value or other valuation
techniques. These techniques are significantly affected by the assumptions used,
including the discount rate and estimates of future cash flows. Accordingly, the
derived fair value estimates presented herein cannot be substantiated by
comparison to independent markets and are not necessarily indicative of the
amounts Citizens could realize in a current market exchange.
In addition, the fair value estimates are based on existing on- and off-balance
sheet financial instruments without attempting to estimate the value of
anticipated future business and the value of assets and liabilities that are not
considered financial instruments. For example, Citizens has a substantial trust
department that contributes net fee income annually. The trust department is not
considered a financial instrument and its value has not been incorporated into
the fair value estimates. Other significant assets and liabilities that are not
considered financial assets or liabilities include Citizens' brokerage network,
net deferred tax asset, premises and equipment, goodwill and deposit based
intangibles. In addition, tax ramifications related to the recognition of
unrealized gains and losses such as those within the investment securities
portfolio can also have a significant effect on estimated fair values and have
not been considered in the estimates. Accordingly, the aggregate fair value
amounts do not represent the underlying value of Citizens.
The estimated fair values of Citizens' financial instruments follow:
- ------------------------------------------------------------------------------------------------------------------
DECEMBER 31, 2003 DECEMBER 31, 2002
------------------------- -----------------------
CARRYING ESTIMATED CARRYING ESTIMATED
(in millions) AMOUNT FAIR VALUE AMOUNT FAIR VALUE
- ------------------------------------------------------------------------------------------------------------------
Financial assets:
Cash and money market investments $ 184.8 $ 184.8 $ 243.2 $243.2
Securities available-for-sale 1,965.2 1,965.2 1,457.3 1,457.3
Securities held-to-maturity 19.9 19.9 --- ---
Mortgage loans held for sale 44.7 44.6 160.7 160.9
Net loans 5,122.2 5,266.0 5,325.8 5,510.6
Financial liabilities:
Deposits 5,442.3 5,457.7 5,936.9 5,983.9
Short-term borrowings 631.7 632.0 302.4 302.5
Long-term debt 936.9 947.5 599.3 618.8
Off-balance sheet financial instrument liabilities:
Loan commitments to extend credit --- 2.6 --- 3.9
Standby and commercial letters of credit --- 1.2 --- 0.9
Interest rate swap agreements --- 0.5 --- ---
Interest rate lock commitments --- 0.1 --- 1.2
Forward commitments to sell mortgage loans --- (0.2) --- (2.7)
- -----------------------------------------------------------------------------------------------------------------
The various methods and assumptions used by Citizens in estimating fair value
for its financial instruments are set forth below:
CASH AND MONEY MARKET INVESTMENTS: The carrying amounts reported in the balance
sheet for cash and money market investments approximate those assets' fair
values because they mature within six months and do not present unanticipated
credit concerns.
INVESTMENT SECURITIES AVAILABLE FOR SALE AND HELD TO MATURITY: The carrying
amounts reported in the balance sheet for investment securities classified as
available-for-sale approximate those assets' fair values. SFAS 115 requires
securities carried in the available for sale category to be carried at fair
value - see Note 5. The carrying amounts for investment securities classified as
held-to-maturity are amortized costs. The fair values of both available-for-sale
and held-to-maturity
94
securities are based on quoted market prices, where available. If quoted market
prices are not available, fair values are based on quoted market prices of
comparable instruments.
MORTGAGE LOANS HELD FOR SALE: Fair values are determined by the current market
values of similar loans - see Net Loans Receivable below.
NET LOANS RECEIVABLE: Fair values are estimated for portfolios of loans with
similar financial characteristics. Loans are segregated by type such as
commercial, commercial real estate, residential mortgage, and home equity and
other consumer. Each loan category is further segmented into fixed and
variable-rate interest types and for certain categories by performing and
nonperforming. For performing variable-rate loans that reprice frequently
(within twelve months) and with no significant change in credit risk, fair
values are based on carrying values. Similarly, for credit card loans with no
significant credit concerns and average interest rates approximating current
market origination rates, the carrying amount is a reasonable estimate of fair
value. Fair values of other loans (e.g., fixed-rate commercial, commercial real
estate, residential mortgage and consumer loans) are estimated by discounting
the future cash flows using interest rates currently being offered by Citizens
for loans with similar terms and remaining maturities (new loan rates).
Management believes the risk factor embedded in the new loan rates adequately
represents the credit risk within the portfolios. Fair values for nonperforming
loans are estimated after giving consideration to credit risk and estimated cash
flows and discount rates based on available market and specific borrower
information. The carrying amount of accrued interest for all loan types
approximates its fair value.
DEPOSIT LIABILITIES: Under SFAS 107, the fair value of demand deposits (e.g.,
interest and noninterest checking, passbook savings and certain types of money
market accounts) are, by definition, equal to the amount payable on demand at
the reporting date (i.e., their carrying amounts). Fair values for certificates
of deposit are based on the discounted value of contractual cash flows. The
discount rate is estimated using the rates currently offered for certificates of
similar remaining maturities.
SHORT-TERM BORROWINGS: The carrying amounts of federal funds purchased,
securities sold under agreement to repurchase and other short-term borrowings
approximate their fair values.
LONG-TERM DEBT: The carrying value of Citizens' variable-rate long-term debt
approximates its fair value. The fair value of fixed-rate long-term debt is
estimated using discounted cash flow analyses, based on Citizens' current
incremental borrowing rates for similar types of borrowing arrangements.
LOAN COMMITMENTS AND LETTERS OF CREDIT: The fair value of loan commitments and
letter of credit guarantees is based on fees currently charged to enter into
similar agreements, taking into account the remaining terms of the agreements
and the counterparties' credit standing.
INTEREST RATE SWAP AGREEMENTS: Fair values are based on the estimated amount
Citizens would receive or pay to terminate the swap agreements, taking into
account the current interest rates and creditworthiness of the swap
counterparties.
INTEREST RATE LOCK COMMITMENTS AND FORWARD COMMITMENTS TO SELL MORTGAGES: The
estimated fair values are based on quoted market prices.
95
NOTE 20. LINES OF BUSINESS
The financial performance of Citizens is monitored by an internal profitability
measurement system, which provides line of business results and key performance
measures. The profitability measurement system is based on internal management
methodologies designed to produce consistent results and reflect the underlying
economics of the businesses. The development and application of these
methodologies is a dynamic process. Accordingly, these measurement tools and
assumptions may be revised periodically to reflect methodological, product,
and/or management organizational changes. Further, these policies measure
financial results that support the strategic objectives and internal
organizational structure of Citizens. Consequently, the information presented is
not necessarily comparable with similar information for other institutions.
Beginning in 2002, all activities formerly housed in our F&M business line were
integrated into our other lines of business: Commercial Banking, Retail Banking,
Financial Services and Other and the three major business lines were renamed
Business Banking, Consumer Banking and Wealth Management, respectively. In the
fourth quarter of 2003 we renamed Business Banking again as Commercial Banking,
to better reflect the broad range of services Citizens provides to both middle
market commercial and small business clients. The activities of the renamed
business lines remained the same.
A description of each business line, selected financial performance and the
methodologies used to measure financial performance are presented below.
Financial information for the year 2001 has been restated to reflect the new
organizational structure.
COMMERCIAL BANKING: Commercial Banking provides a full range of credit and
related financial services to middle market commercial, small business,
government and leasing clients. Products and services offered include commercial
loans, commercial mortgages, small business loans, letters of credit, deposit
accounts, treasury management and international trade services.
CONSUMER BANKING: Consumer Banking includes consumer lending and deposit
gathering, electronic banking and residential mortgage loan origination and
servicing. This line of business offers a variety of retail financial products
and services including deposit accounts, direct and indirect installment loans,
debit and credit cards, home equity lines of credit, residential mortgage loans,
fixed and variable annuities and ATM network services.
WEALTH MANAGEMENT: Wealth Management provides commercial and retail clients with
private banking, trust and investment, retirement plan, and brokerage and
insurance services. Private banking focuses on high net-worth customers and
offers a broad array of asset management, estate settlement and administration,
deposit and credit products. Trust and investment includes personal trust and
planning services, investment management services, estate settlement,
administration and advises the Golden Oak family of mutual funds. Retirement
plan services focus on investment management and fiduciary activities with
special emphasis on 401(k) plans. The brokerage and insurance businesses deliver
Citizens' retail mutual funds, other securities, variable and fixed annuities,
personal disability and life insurance products and discounted brokerage
services.
OTHER: All other includes activities that are not directly attributable to one
of the major lines of business. Included in this category is the parent company;
Citizens' Treasury unit, including the securities portfolio, wholesale funding
and asset liability management activities; inter-company eliminations; and the
economic impact of certain assets, capital and support functions not
specifically identifiable with the three primary lines of business.
The accounting policies of the individual business units are the same as those
of Citizens described in Note 1 to the Consolidated Financial Statements. Funds
transfer pricing is used in the determination of net interest income by
assigning a cost for funds used or credit for funds provided to assets and
liabilities within each business unit. Assets and liabilities are match-funded
based on their maturity, prepayment and/or repricing characteristics. As a
result, the Commercial, Consumer and Wealth Management units are largely
insulated from changes in interest rates. Changes in net interest income due to
changes in interest rates are reported in Citizens' Treasury unit. Noninterest
income and expenses directly attributable to a line of business are assigned to
that business. Expenses for centrally provided services are allocated to the
business lines as follows: product processing and technology expenditures are
allocated based on standard unit costs applied to actual volume measurements;
corporate overhead is allocated based on the ratio of a line of business'
noninterest expenses to total noninterest expenses incurred by all business
lines. The provision for loan losses was allocated in an amount based primarily
upon the actual net charge-offs of each respective line of business, adjusted
for loan growth and changes in risk profile.
96
Selected segment information is included in the following table.
- --------------------------------------------------------------------------------------------------------------------------
LINE OF BUSINESS INFORMATION
COMMERCIAL CONSUMER WEALTH
(IN THOUSANDS) BANKING BANKING MGMT OTHER TOTAL
- --------------------------------------------------------------------------------------------------------------------------
EARNINGS SUMMARY - 2003
Net interest income (taxable equivalent) $ 124,339 $ 154,190 $ 312 $ 20,925 $ 299,766
Provision for loan losses 47,347 15,615 -- -- 62,962
--------- --------- --------- --------- ---------
Net interest income after provision 76,992 138,575 312 20,925 236,804
Noninterest income 14,882 53,319 22,086 4,532 94,819
Noninterest expense 63,048 132,611 21,374 15,955 232,988
--------- --------- --------- --------- ---------
Income before income taxes 28,826 59,283 1,024 9,502 98,635
Income tax expense (taxable equivalent) 10,265 20,734 398 1,287 32,684
--------- --------- --------- --------- ---------
Net income $ 18,561 $ 38,549 $ 626 $ 8,215 $ 65,951
========= ========= ========= ========= =========
AVERAGE ASSETS (IN MILLIONS) $ 3,044 $ 2,415 $ 8 $ 2,227 $ 7,694
========= ========= ========= ========= =========
- --------------------------------------------------------------------------------------------------------------------------
EARNINGS SUMMARY - 2002
Net interest income (taxable equivalent) $ 140,926 $ 152,398 $ 273 $ 22,655 $ 316,252
Provision for loan losses 108,002 13,590 -- (1,392) 120,200
--------- --------- --------- --------- ---------
Net interest income after provision 32,924 138,808 273 24,047 196,052
Noninterest income 17,179 58,524 23,881 2,192 101,776
Noninterest expense 69,555 140,098 17,563 32,167 259,383
--------- --------- --------- --------- ---------
Income (loss) before income taxes (19,452) 57,234 6,591 (5,928) 38,445
Income tax expense (benefit) (taxable equivalent) (6,804) 20,034 2,307 (2,130) 13,407
--------- --------- --------- --------- ---------
Net income (loss) $ (12,648) $ 37,200 $ 4,284 $ (3,798) $ 25,038
========= ========= ========= ========= =========
AVERAGE ASSETS (IN MILLIONS) $ 3,388 $ 2,721 $ 7 $ 1,453 $ 7,569
========= ========= ========= ========= =========
- --------------------------------------------------------------------------------------------------------------------------
EARNINGS SUMMARY - 2001
Net interest income (taxable equivalent) $ 139,766 $ 166,312 $ 1,232 $ 15,506 $ 322,816
Provision for loan losses 17,380 8,881 -- 146 26,407
--------- --------- --------- --------- ---------
Net interest income after provision 122,386 157,431 1,232 15,360 296,409
Noninterest income 16,429 62,305 25,050 13,697 117,481
Noninterest expense 67,267 146,578 16,823 20,515 251,183
--------- --------- --------- --------- ---------
Income before income taxes 71,548 73,158 9,459 8,542 162,707
Income tax expense (taxable equivalent) 25,047 25,605 3,311 4,087 58,050
--------- --------- --------- --------- ---------
Net income $ 46,501 $ 47,553 $ 6,148 $ 4,455 $ 104,657
========= ========= ========= ========= =========
AVERAGE ASSETS (IN MILLIONS) $ 3,461 $ 3,075 $ 11 $ 1,389 $ 7,936
========= ========= ========= ========= =========
- --------------------------------------------------------------------------------------------------------------------------
97
NOTE 21. REGULATORY MATTERS
The Federal Reserve Bank requires Citizens' banking subsidiaries to maintain
certain noninterest-bearing deposits. These reserve balances vary depending upon
the level of client deposits in the subsidiary banks. During 2003 and 2002, the
average reserve balances were $36.4 million and $35.3 million, respectively.
The banking subsidiaries are also subject to limitations under banking laws on
extensions of credit to members of the affiliate group and on dividends that can
be paid to Citizens. Generally extensions of credit are limited to 10% to any
one affiliate and 20% in aggregate to all affiliates of a subsidiary bank's
capital and surplus (net assets) as defined. Unless prior regulatory approval is
obtained, dividends declared in any calendar year may not exceed the retained
net profit, as defined, of that year plus the retained net profit of the
preceding two years. As of January 1, 2004, Citizens' banking subsidiaries are
able to distribute dividends of $36.2 million without further regulatory
approval. During 2004, net income of Citizens' banking subsidiaries will also
become available for such dividends.
Citizens and its banking subsidiaries are subject to various regulatory capital
requirements administered by the federal banking agencies. Failure to meet
minimum capital requirements can initiate certain mandatory and possibly
additional discretionary actions by regulators that, if undertaken, could have a
direct material effect on the financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, specific
capital guidelines must be met that involve quantitative measures of the assets,
liabilities, and certain off-balance sheet items as calculated under regulatory
accounting practices. The capital amounts and classification are also subject to
qualitative judgments by the regulators about components, risk weightings, and
other factors.
Quantitative measures established by regulation to ensure capital adequacy
require Citizens and its banking subsidiaries to maintain minimum amounts and
ratios (set forth in the table below) of total and Tier 1 capital to
risk-weighted assets (as defined in the regulations), and of Tier 1 capital to
average assets (as defined). Management believes, as of December 31, 2003, that
Citizens and its banking subsidiaries meet all capital adequacy requirements to
which it is subject.
As of December 31, 2003, the most recent notification from the Federal Reserve
Board categorized Citizens and its banking subsidiaries as well capitalized
under the regulatory framework for prompt corrective action. To be categorized
as well capitalized Citizens and its banking subsidiaries must maintain minimum
total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in
the table. There are no conditions or events since that notification that
management believes would result in a change.
98
- --------------------------------------------------------------------------------------------------------------------------------
RISK BASED CAPITAL REQUIREMENTS To Be Well Capitalized
For Capital Under Prompt Corrective
Actual Adequacy Purposes Action Provisions
------------------- ---------------------- --------------------------
(in thousands) Amount Ratio Amount Ratio Amount Ratio
- --------------------------------------------------------------------------------------------------------------------------------
CITIZENS BANKING CORPORATION
AS OF DECEMBER 31, 2003:
Total Capital to risk weighted assets (1) $763,779 13.2% $466,052 >/= 8.0% $ 582,565 >/= 10.0%
Tier 1 Capital to risk weighted assets (1) 565,958 9.8 233,026 >/= 4.0 349,539 >/= 6.0
Tier 1 Leverage (2) 565,958 7.5 303,771 >/= 4.0 379,714 >/= 5.0
As of December 31, 2002:
Total Capital to risk weighted assets (1) $606,133 10.4% $464,714 >/= 8.0% $ 580,892 >/= 10.0%
Tier 1 Capital to risk weighted assets (1) 533,066 9.2 232,357 >/= 4.0 348,535 >/= 6.0
Tier 1 Leverage (2) 533,066 7.2 296,413 >/= 4.0 370,517 >/= 5.0
CITIZENS BANK
AS OF DECEMBER 31, 2003:
Total Capital to risk weighted assets (1) $470,505 11.3% $335,669 >/= 8.0% $ 419,586 >/= 10.0%
Tier 1 Capital to risk weighted assets (1) 418,057 10.0 167,834 >/= 4.0 251,752 >/= 6.0
Tier 1 Leverage (2) 418,057 7.7 215,918 >/= 4.0 269,897 >/= 5.0
As of December 31, 2002:
Total Capital to risk weighted assets (1) $427,868 10.6% $323,496 >/= 8.0% $ 404,370 >/= 10.0%
Tier 1 Capital to risk weighted assets (1) 377,195 9.3 161,748 >/= 4.0 242,622 >/= 6.0
Tier 1 Leverage (2) 377,195 7.6 199,460 >/= 4.0 249,325 >/= 5.0
- --------------------------------------------------------------------------------------------------------------------------------
(1)Total Capital is comprised of Tier 1 Capital, a portion of the allowance for
loan losses and qualifying subordinated debt. Tier 1 Capital consists of total
equity and trust preferred securities less unrealized gains and losses
accumulated in other comprehensive income, certain intangible assets and
adjustments related to the valuation of mortgage servicing assets.
(2) Tier 1 Capital to quarterly average assets
99
NOTE 22. CITIZENS BANKING CORPORATION (PARENT ONLY) STATEMENTS
- --------------------------------------------------------------------------------
BALANCE SHEETS
CITIZENS BANKING CORPORATION (PARENT ONLY)
December 31,
(in thousands) 2003 2002
- --------------------------------------------------------------------------------
ASSETS
Cash $ 5 $ 5
Money market investments 48,664 3,166
Investment securities 101 83
Investment in subsidiaries - principally banks 733,365 682,010
Goodwill - net 258 265
Other assets 6,966 3,850
-------- --------
Total assets $789,359 $689,379
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Short-term revolving credit $ -- $ 30,000
Long-term debt 148,835 --
Other liabilities 5,362 8,910
-------- --------
Total liabilities 154,197 38,910
Shareholders' equity 635,162 650,469
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $789,359 $689,379
======== ========
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
STATEMENTS OF INCOME
CITIZENS BANKING CORPORATION (PARENT ONLY)
Year Ended December 31,
(in thousands) 2003 2002 2001
- --------------------------------------------------------------------------------------------------------------------
INCOME
Dividends from subsidiaries - principally banks $ 24,000 $ 90,500 $ 107,400
Interest from bank subsidiary 540 -- 32
Service fees from bank subsidiaries 10,520 10,887 9,435
Equity security gain -- -- 11,017
Other 771 703 890
--------- --------- ---------
Total 35,831 102,090 128,774
--------- --------- ---------
EXPENSES
Interest 4,054 710 1,904
Amortization of goodwill -- -- 796
Salaries and employee benefits 12,104 14,352 9,955
Service fees paid to bank subsidiaries 2,883 1,168 1,265
Special charge -- 1,434 --
Other noninterest expense 1,717 3,042 3,888
--------- --------- ---------
Total 20,758 20,706 17,808
--------- --------- ---------
Income before income taxes and
equity in undistributed earnings of subsidiaries 15,073 81,384 110,966
Income tax benefit (provision) 4,508 3,465 (1,197)
Equity in undistributed (dividends in excess of) earnings of subsidiaries 46,370 (59,811) (5,112)
--------- --------- ---------
NET INCOME $ 65,951 $ 25,038 $ 104,657
========= ========= =========
- --------------------------------------------------------------------------------------------------------------------
100
- -------------------------------------------------------------------------------------------------------------------------
STATEMENTS OF CASH FLOWS
CITIZENS BANKING CORPORATION (PARENT ONLY)
Year Ended December 31,
(in thousands) 2003 2002 2001
--------- --------- ---------
OPERATING ACTIVITIES
Net income $ 65,951 $ 25,038 $ 104,657
Adjustments to reconcile net income to net cash
provided by operating activities:
Amortization of goodwill -- -- 796
Equity security gain -- -- (11,017)
Amortization of stock-based compensation expense 350 267 --
Stock-based compensation 200 -- --
Dividends in excess of (equity in undistributed) earnings of subsidiaries (46,370) 59,811 5,112
Other (5,538) 9,474 475
--------- --------- ---------
Net cash provided by operating activities 14,593 94,590 100,023
--------- --------- ---------
INVESTING ACTIVITIES
Net (increase) decrease in money market investments (45,498) (197) 4,947
Proceeds from sales and maturities of investment securities 5 -- --
Investments in and advances to subsidiaries (25,000) -- --
Proceeds from sale of NYCE stock -- -- 11,017
--------- --------- ---------
Net cash provided (used) by investing activities (70,493) (197) 15,964
--------- --------- ---------
FINANCING ACTIVITIES
Proceeds from short-term borrowings -- -- 6,000
Principal reductions in short-term borrowings (30,000) -- (24,000)
Proceeds from long-term borrowings 150,365 -- --
Cash dividends paid (49,476) (50,659) (50,158)
Proceeds from stock options exercised 6,334 6,562 10,662
Shares acquired for retirement (21,323) (50,296) (58,491)
--------- --------- ---------
Net cash used by financing activities 55,900 (94,393) (115,987)
--------- --------- ---------
Net increase in cash -- -- --
Cash at beginning of year 5 5 5
--------- --------- ---------
Cash at end of year $ 5 $ 5 $ 5
========= ========= =========
- --------------------------------------------------------------------------------------------------------------------------
101
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
BOARD OF DIRECTORS CITIZENS BANKING CORPORATION
We have audited the accompanying consolidated balance sheets of Citizens Banking
Corporation and subsidiaries as of December 31, 2003 and 2002, and the related
consolidated statements of income, changes in shareholders' equity, and cash
flows for each of the three years in the period ended December 31, 2003. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform our
audits to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Citizens Banking
Corporation and subsidiaries at December 31, 2003 and 2002, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2003, in conformity with accounting principles
generally accepted in the United States.
As discussed in Note 7 to the Consolidated Financial Statements, in 2002
Citizens Banking Corporation and subsidiaries changed their method of accounting
for goodwill and intangible assets.
/s/ Ernst & Young LLP
Detroit, Michigan
January 29, 2004
102
REPORT OF MANAGEMENT
Management is responsible for the preparation, integrity and fair presentation
of the Consolidated Financial Statements and all other financial information
appearing in this Annual Report. The Consolidated Financial Statements have been
prepared in accordance with generally accepted accounting principles in the
United States, and accordingly include some amounts that are based on
management's best estimates and judgements.
We, as management of Citizens Banking Corporation are responsible for
establishing and maintaining effective internal controls over financial
reporting that are designed to produce reliable financial statements in
conformity with accounting principles generally accepted in the United States.
The system of internal control over financial reporting is tested and evaluated
through a program of internal audits. Actions are taken to correct potential
deficiencies as they are identified. Management recognizes that the cost of a
system of internal controls should not exceed the benefits derived and that
there are inherent limitations to be considered in the potential effectiveness
of any system. Management believes Citizens' system provides the appropriate
balance between costs of controls and the related benefits.
The Audit Committee of the Board of Directors, comprised entirely of outside
directors, recommends the independent auditors who are engaged upon approval by
the Board of Directors. The committee meets regularly with management, internal
auditors and independent auditors to review timing and scope of audits and audit
results. Ernst & Young, LLP, independent auditors, and the internal auditors
have direct and confidential access to the Audit Committee to discuss the
results of their examinations.
Management assessed the Corporation's system of internal control over financial
reporting as of December 31, 2003, in relation to criteria for effective
internal control over financial reporting as described in "Internal Control -
Integrated Framework," issued by the Committee of Sponsoring Organizations of
the Treadway Commission. Based on this assessment, management believes that, as
of December 31, 2003, its system of internal control over financial reporting
met those criteria.
/s/ Charles D. Christy /s/ William R. Hartman
- --------------------------- ---------------------------
Charles D. Christy William R. Hartman
Executive Vice President Chairman, President
and Chief Financial Officer and Chief Executive Officer
103