BOK Financial - 10-Q quarterly report FY2011 Q1

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

 

 

OR

 

 

Commission File No. 0-19341

BOK FINANCIAL CORPORATION

 

(918) 588-6000

(Registrant’s telephone number, including area code)

BOK Financial Corporation

Form 10-Q

Quarter Ended March 31, 2011

Index

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Performance Summary

BOK Financial Corporation (“the Company”) reported net income of $64.8 million or $0.94 per diluted share for the first quarter of 2011 compared to $60.1 million or $0.88 per diluted share for the first quarter of 2010 and $58.8 million or $0.86 per diluted share for the fourth quarter of 2010.  Net income for the first quarter of 2010 included a $6.5 million or $0.10 per diluted share gain from the purchase of the rights to service $4.2 billion of residential mortgage loans on favorable terms.

Highlights of the first quarter of 2011 included:

Results of Operations

Net Interest Revenue and Net Interest Margin

Net interest revenue is the interest earned on debt securities, loans and other interest-earning assets less interest paid for interest-bearing deposits and other borrowings.  The net interest margin is calculated by dividing net interest revenue by average interest-earning assets.  Net interest spread is the difference between the average rate earned on interest-earning assets and the average rate paid on interest-bearing liabilities.  Net interest margin is typically greater than net interest spread due to interest income earned on assets funded by non-interest bearing liabilities such as demand deposits and equity.

Net interest revenue totaled $170.6 million for the first quarter of 2011, down $11.9 million or 7% from the first quarter of 2010 and up $7.0 million over the fourth quarter of 2010.  The decrease in net interest revenue from the first quarter of 2010 was due primarily to lower yield on our securities portfolio, partially offset by lower funding costs.  The increase in net interest revenue over the fourth quarter of 2010 resulted from improved yield on the securities portfolio.

Net interest margin was 3.46% for the first quarter of 2011, 3.68% for the first quarter of 2010 and 3.19% for the fourth quarter of 2010.

The decrease in net interest margin compared to the first quarter of 2010 was due largely to lower yield on our securities portfolio.  The tax-equivalent yield on earning assets was 4.09% for the first quarter of 2011, down 32 basis points from the first quarter of 2010.  The securities portfolio yield decreased 53 basis points to 3.25%.  Cash flows from our securities portfolio are reinvested at lower current rates.  Loan yields decreased 6 basis points to 4.75%.  Funding costs were down 7 basis points from the first quarter of 2010.  The cost of interest-bearing deposits

decreased 22 basis points.

Net interest margin improved 27 basis points over the fourth quarter of 2010.  Yield on average earning assets increased 25 basis points to 4.09%.  Yield on the securities portfolio improved by 52 basis points.  As intermediate and long-term interest rates increased near the end of the fourth quarter of 2010 and stabilized throughout the first quarter of 2011, premium amortization slowed and reinvestment rates improved.  Yield on the loan portfolio decreased by 1 basis point.  The cost of interest-bearing liabilities decreased 1 basis point from the previous quarter.

Changes in the average earning asset and average interest-bearing liabilities had little effect on changes in net interest revenue.  Average earning assets for the first quarter of 2011 increased less than 1% over the first quarter of 2010.  Average available for sale securities, which consist largely of U.S. government agency issued residential mortgage-backed securities, increased $652 million.  We purchased these securities to supplement earnings, especially in a period of declining loan demand, and to manage interest rate risk.  Average loans, net of allowances for loan losses, decreased $519 million.  All major loan categories decreased largely due to reduced customer demand and normal repayment trends.

Average deposits increased $2.3 billion over the first quarter of 2010, including a $1.6 billion increase in average interest-bearing transaction accounts and a $780 million increase in average demand deposits.  Average time deposits decreased $155 million compared with the first quarter of 2010.  Average borrowed funds decreased $2.8 billion compared to the first quarter of 2010.

Average earning assets for the first quarter of 2011 decreased $491 million compared to the fourth quarter of 2010.  Average securities decreased $319 million due to a $239 million decrease in available for sale securities and a $78 million decrease in mortgage trading securities which are used as an economic hedge of our mortgage servicing rights.  Average outstanding loans, net of allowance for loan losses, were flat with the previous quarter.  Average commercial loan balances increased in the first quarter 2011, offset by lower commercial real estate, residential mortgage and consumer loan balances.  Average deposits increased $428 million over the fourth quarter of 2010, including a $307 million increase in average interest-bearing transaction accounts, a $94 million increase in average demand deposits and a $15 million increase in average time deposits.  Average borrowed funds decreased $779 million.

Our overall objective is to manage the Company’s balance sheet to be relatively neutral to changes in interest rates as is further described in the Market Risk section of this report.  Approximately two-thirds of our commercial and commercial real estate loan portfolios are either variable rate or fixed rate that will re-price within one year.  These loans are funded primarily by deposit accounts that are either non-interest bearing, or that re-price more slowly than the loans.  The result is a balance sheet that would be asset sensitive, which means that assets generally re-price more quickly than liabilities.  Among the strategies that we use to manage toward a relatively rate-neutral position, we purchase fixed-rate residential mortgage-backed securities issued primarily by U.S. government agencies and fund them with market rate sensitive liabilities.  The liability-sensitive nature of this strategy provides an offset to the asset-sensitive characteristics of our loan portfolio.  We may also use derivative instruments to manage our interest rate risk.  Interest rate swaps were used to convert fixed rate liabilities to floating rate based on LIBOR.  Net interest revenue increased $437 thousand in the first quarter of 2011, $658 thousand in the first quarter of 2010 and $1.1 million in the fourth quarter of 2010 from periodic settlements of these contracts.  This increase in net interest revenue contributed 1 basis point to the net interest margin in the first quarter of 2011, 1 basis point in the first quarter of 2010, and 2 basis points in the fourth quarter of 2010.  Derivative contracts are carried on the balance sheet at fair value.  Changes in fair value of these contracts are reported in income as derivatives gains or losses in the Consolidated Statements of Earnings.  No interest rate swaps used to convert fixed rate liabilities to floating rate based on LIBOR were outstanding at March 31, 2011.

The effectiveness of these strategies is reflected in the overall change in net interest revenue due to changes in interest rates as shown in Table 1 and in the interest rate sensitivity projections as shown in the Market Risk section of this report.

Table 1 – Volume/Rate Analysis

 (In thousands)

Other Operating Revenue

Other operating revenue was $117.6 million for the first quarter of 2011 compared to $113.9 million for the first quarter of 2010.   Fees and commissions revenue increased $8.0 million or 7%.  Net gains on securities, derivatives and other assets decreased $3.9 million.  Other-than-temporary impairment charges recognized in earnings in the first quarter of 2011 were $374 thousand greater than charges recognized in the first quarter of 2010.

Other operating revenue increased $5.7 million over the fourth quarter of 2010.  Fees and commissions revenue decreased $12.7 million and net gains on securities, derivatives and other assets increased $16.3 million.  Other-than-temporary impairment charges recognized in earnings were $2.0 million lower compared with the fourth quarter of 2010.

Table 2 – Other Operating Revenue

 (In thousands)

Certain percentage increases (decreases) in non-fees and commissions revenue are not meaningful for comparison purposes based on the nature of the item.

Fees and commissions revenue

Diversified sources of fees and commission revenue are a significant part of our business strategy and represented 42% of total revenue for the first quarter of 2011, excluding provision for credit losses and gains and losses on asset sales, securities and derivatives.  We believe that a variety of fee revenue sources provide an offset to changes in interest rates, values in the equity markets, commodity prices and consumer spending, all of which can be volatile.  We expect continued growth in other operating revenue through offering new products and services and by expanding into markets outside of Oklahoma.  However, current and future economic conditions, regulatory constraints, increased competition and saturation in our existing markets could affect the rate of future increases.

Brokerage and trading revenue increased $4.3 million or 21% over the first quarter of 2010.  Securities trading revenue totaled $14.6 million for the first quarter of 2011, up $3.6 million or 33% compared to the first quarter of 2010 on increased customer activity.  Customer hedging revenue totaled $1.1 million for the first quarter of 2011, a $2.2 million decrease from the first quarter of 2010 due primarily to a $2.6 million credit loss on certain mortgage banking customer risk management derivative contracts.  This loss was largely offset by a decrease in related accrued incentive compensation expense.  Retail brokerage revenue increased $1.4 million over the first quarter of 2010 to $7.1 million and investment banking revenue increased $1.5 million over the first quarter of 2010 to $2.8 million.

Brokerage and trading revenue decreased $3.3 million compared to the fourth quarter of 2010.  Investment banking revenue decreased $1.7 million primarily due to decreased loan syndication volume in the first quarter of 2011.  Securities trading revenue decreased $573 thousand compared to the fourth quarter of 2010 and customer hedging revenue decreased $1.6 million compared to the fourth quarter of 2010.  The $2.6 million credit loss on certain mortgage banking customer risk management derivative contracts was partially offset by increased energy derivative activity over the fourth quarter of 2010.  Retail brokerage increased $554 thousand over the fourth quarter of 2010.

Transaction card revenue depends largely on the volume and amount of transactions processed, the number of ATM locations and the number of merchants served.  Transaction card revenue totaled $28.4 million for the first quarter of 2011, up $2.8 million or 11% over the first quarter of 2010.  Merchant discount fees increased $1.2 million or 18% to $7.9 million on increased transaction volumes.  Check card revenue increased $886 thousand or 12% to $8.6

million and ATM network revenue increased $678 thousand or 6% over the first quarter of 2010.  Increased ATM transaction volumes were partially offset by a decrease in the average rate charged per transaction.  Transaction card revenue decreased $1.1 million compared to the fourth quarter of 2010 primarily due lower ATM network revenue.  Merchant discount fees and check card revenue were flat with the prior quarter.

Interchange fee limits proposed by the Federal Reserve Bank as required by the Dodd-Frank Act (the “Act”) would significantly reduce our transaction card revenue.  Based on the $0.12 per transaction cap proposed in December 2010 to be effective as of July 21, 2011, we would expect a decline of $12 million to $15 million in our transaction card revenue in 2011.  On March 29, 2011, the Federal Reserve Bank announced that it would not be able to issue final interchange fee standards by April 21, 2011 as required by the Act.  In addition, legislation that would repeal or delay interchange fee limits is being considered.  The ultimate effect of the Act on interchange fees is uncertain.

Trust fees and commissions increased $2.1 million or 13% over the first quarter of 2010 to $18.4 million primarily due to an increase in the fair value of trust assets, partially offset by lower balances in our proprietary mutual funds.  We continue to voluntarily waive administration fees on the Cavanal Hill money market funds in order to maintain positive yields on these funds in the current low short-term interest rate environment.  Waived fees totaled $1.2 million for the first quarter of 2011, $1.1 million for the fourth quarter of 2010 and $951 thousand for the first quarter of 2010.  The fair value of trust assets administered by the Company totaled $32.0 billion compared to $32.8 billion at December 31, 2010 and $30.7 billion compared to March 31, 2010.  Trust fees and commissions also increased $277 thousand over the fourth quarter of 2010.

Deposit service charges and fees decreased $4.3 million or 16% compared to the first quarter of 2010.  Overdraft fees decreased $4.7 million or 28% to $12.3 million.  The decrease in overdraft fees was primarily due to changes in federal regulations concerning overdraft charges that were effective July 1, 2010 and was partially mitigated by a new service charge imposed beginning the second quarter of 2010 on accounts that remain overdrawn for more than five days.  Commercial account service charge revenue also decreased $363 thousand or 5% compared to the first quarter of 2010 to $7.3 million.  Customers kept larger commercial account balances, which increases the earnings credit, a non-cash method for commercial customers to avoid incurring charges for deposit services based on account balances.  Service charges on retail deposit accounts decreased $293 thousand or 21% to $1.1 million.  Deposit service charges and fees decreased $1.3 million compared to the prior quarter.  The decrease was primarily due to a $1.4 million seasonal decrease in overdraft fees partially offset by a $210 thousand increase in commercial service charges.  Overdraft volumes historically are lower in the first quarter of each year.

Mortgage banking revenue was up $2.5 million or 17% over the first quarter of 2010.  Revenue from originating and marketing mortgage loans increased $1.0 million over the first quarter of 2010 primarily due to a $69 million increase in mortgage loans funded for sale in the secondary market.  Mortgage servicing revenue increased $1.5 million or 18% over the first quarter of 2010 and the outstanding principal balance of mortgage loans serviced for others increased $225 million.  Mortgage banking revenue decreased $7.8 million compared to the fourth quarter of 2010, primarily due to a $7.6 million decrease in revenue from originating and marketing mortgage loans.  Funding of residential mortgage loans for sale totaled $452 million in the first quarter of 2011 and $822 million in the fourth quarter of 2010.

Net gains on securities, derivatives and other assets

We recognized $4.9 million of net gains on sales of $793 million of available for sale securities in the first quarter of 2011, excluding securities held as an economic hedge of mortgage servicing rights.  Securities were sold either because they had reached their expected maximum potential return or to mitigate exposure from rising interest rates.  We recognized net gains of $953 thousand on sales of $536 million of available for sale securities in the fourth quarter of 2010 and $4.1 million on sales of $286 million of available for sale securities in the first quarter of 2010.

We also maintain a portfolio of securities and derivative contracts designated as an economic hedge of the changes in the fair value of our mortgage servicing rights.  The fair value of our mortgage servicing rights fluctuate due to changes in prepayment speeds and other assumptions as more fully described in Note 5 to the Consolidated Financial Statements.  As benchmark mortgage interest rates increase, prepayment speeds slow and the value of our mortgage servicing rights increase.  As benchmark mortgage interest rates fall, prepayment speeds increase and the value of our mortgage servicing rights decrease.

Table 4 – Gain (Loss) on Mortgage Servicing Rights, Net of Economic Hedge

 (In thousands)

As more fully discussed in Note 2 to the Consolidated Financial Statements, we recognized other-than-temporary impairment losses on certain private-label residential mortgage-backed securities of $4.6 million in earnings during the first quarter of 2011 related to additional declines in projected cash flows as a result of increased delinquencies and foreclosures.  We recognized other-than-temporary impairment losses in earnings of $6.6 million and $4.2 million in the fourth and first quarter of 2010, respectively.

Other Operating Expense

Other operating expense for the first quarter of 2011 totaled $178.4 million, up $14.7 million or 9% over the first quarter of 2010.  Changes in the fair value of mortgage servicing rights decreased other operating expenses by $3.1 million in the first quarter of 2011 and decreased other operating expenses by $13.9 million in the first quarter of 2010.  Excluding changes in the fair value of mortgage servicing rights, other operating expenses increased $3.9 million or 2% over the first quarter of 2010.  Personnel expenses increased $3.2 million or 3% and non-personnel expenses increased $744 thousand or 1%.

Excluding the change in the fair value of mortgage servicing rights, other operating expenses decreased $21.9 million compared to the fourth quarter of 2010.  Personnel expenses decreased $6.8 million and non-personnel expenses decreased $15.1 million.

During the first quarter of 2010, the Company purchased the rights to service more than 34 thousand residential mortgage loans with unpaid principal balances of $4.2 billion.  The loans to be serviced are primarily concentrated in the New Mexico market and predominately held by Fannie Mae, Freddie Mac and Ginnie Mae.  The cash purchase price for these servicing rights was approximately $32 million.  The day-one fair value of the servicing rights purchased, based on independent valuation analyses, which were further supported by assumptions and models we regularly use to value our portfolio of servicing rights, was $11.8 million higher than the purchase price.  This amount is included in the change in fair value of mortgage servicing rights for the first quarter of 2010.  The discounted purchase price can be directly attributed to the distressed financial condition of the seller, which was subsequently closed by federal banking regulators.

Table 5 – Other Operating Expense

 (In thousands)

Certain percentage increases (decreases) are not meaningful for comparison purposes.

Personnel expense

Regular compensation, which consists of salaries and wages, overtime pay and temporary personnel costs increased $3.0 million or 5% over the first quarter of 2010 primarily due to increased average headcount and standard annual merit increases which were effective in the second quarter of 2010.  The Company generally awards annual merit increases effective April 1st for a majority of its staff.

Incentive compensation was $1.1 million or 23% lower compared to the first quarter of 2010.  Cash-based incentive compensation plans are either intended to provide current rewards to employees who generate long-term business opportunities to the Company based on growth in loans, deposits, customer relationships and other measurable metrics or are intended to compensate employees with commissions on completed transactions.  Total cash-based incentive compensation increased $878 thousand over the first quarter of 2010 including a $422 thousand decrease in commissions related to brokerage and trading revenue offset by a $1.3 million increase in cash-based incentive compensation for other business lines.

The Company also provides stock-based incentive compensation plans.  Stock-based compensation plans include both equity and liability awards.  Compensation expense related to liability awards decreased $1.6 million compared with the first quarter of 2010 due to changes in the market value of BOK Financial common stock and other investments.  The market value of BOK Financial common stock decreased $1.72 per share in the first quarter of 2011 and increased $4.91 per share in the first quarter of 2010.  Compensation expense for equity awards increased $595 thousand compared with the first quarter of 2010.  Expense for equity awards is based on the grant-date fair value of the awards and is unaffected by subsequent changes in fair value.

Employee benefit expense increased $301 thousand or 2% over the first quarter of 2010 primarily due to increased expenses related to employee retirement plans, payroll taxes, employee training expenses and other benefits costs, partially offset by medical insurance costs.  Medical insurance costs were $1.2 million or 22% lower compared to the first quarter of 2010.  The Company self-insures a portion of its employee health care coverage and these costs may be volatile.

Personnel expense decreased $6.8 million compared with the fourth quarter of 2010 primarily due to reduced incentive compensation partially offset by a seasonal increase in payroll taxes.  Incentive compensation decreased $8.5 million, including a $6.9 million decrease in cash-based incentive compensation and a $1.6 million decrease in stock-based compensation expense.  Stock-based compensation decreased in the first quarter primarily due to changes in the market value of BOK Financial common stock and other investments during the first quarter of 2011.

Non-personnel operating expenses

Non-personnel operating expenses, excluding changes in the fair value of mortgage servicing rights, increased $744 thousand or 1% over the first quarter of 2010.  Increase data processing costs, professional fees and other expenses were primarily offset by lower mortgage banking costs and net losses and operating expenses related to repossessed assets.

Non-personnel operating expenses, excluding changes in the fair value of mortgage servicing rights, decreased $15.1 million compared to the fourth quarter of 2010.  Mortgage banking expenses decreased $5.5 million primarily due to lower provisions for losses on loans sold with recourse and foreclosure costs on loans serviced for others.  Other expenses decreased $5.3 million due largely to a reduction in depreciation expenses on equipment used in our leasing business.  All other non-personnel expenses decreased by $4.3 million primarily due to decreases in professional fees, data processing costs and net losses and expenses on repossessed assets.

Income tax expense was $38.8 million or 37% of book taxable income for the first quarter of 2011 compared with $30.3 million or 33% of book taxable income for the first quarter of 2010 and $31.1 million or 34% of book taxable income for the fourth quarter of 2010.  Income tax expense increased largely due to increased book taxable income and lower recognition of federal and state tax credits in the first quarter of 2011.

BOK Financial operates in numerous jurisdictions, which requires judgment regarding the allocation of income, expense and earnings under various laws and regulations of each of these taxing jurisdictions.  Each jurisdiction may

audit our tax returns and may take different positions with respect to these allocations.  The reserve for uncertain tax positions was $14 million at March 31, 2011 and $12 million at December 31, 2010.

 

Lines of Business

We operate three principal lines of business: commercial banking, consumer banking and wealth management.  Commercial banking includes lending, treasury and cash management services and customer risk management products to small businesses, middle market and larger commercial customers.  Commercial banking also includes the TransFund network.  Consumer banking includes retail lending and deposit services and all mortgage banking activities. Wealth management provides fiduciary services, brokerage and trading, private bank services and investment advisory services in all markets.  Wealth management also originates loans for high net worth clients.

In addition to our lines of business, we have a funds management unit.  The primary purpose of this unit is to manage our overall liquidity needs and interest rate risk. Each line of business borrows funds from and provides funds to the funds management unit as needed to support their operations.  Operating results for funds management and other include the effect of interest rate risk positions and risk management activities, securities gains and losses including impairment charges, the provision for credit losses in excess of net loans charged off to the business lines, tax planning strategies and certain executive compensation costs that are not attributed to the lines of business.

We allocate resources and evaluate the performance of our lines of business after allocation of funds, certain indirect expenses, taxes based on statutory rates, actual net credit losses and capital costs. The cost of funds borrowed from the funds management unit by the operating lines of business is transfer priced at rates that approximate market for funds with similar duration.  Market is generally based on the applicable LIBOR or interest rate swap rates, adjusted for prepayment risk.  This method of transfer-pricing funds that support assets of the operating lines of business tends to insulate them from interest rate risk.

The value of funds provided by the operating lines of business to the funds management unit is also based on rates which approximate the wholesale market for funds with similar duration and repricing characteristics.  Market is generally based on LIBOR or interest rate swap rates.  The funds credit formula applied to deposit products with indeterminate maturities is established based on their repricing characteristics reflected in a combination of the short-term LIBOR rate and a moving average of an intermediate term swap rate, with an appropriate spread applied to both.  Shorter duration products are weighted towards the short term LIBOR rate and longer duration products are weighted towards the intermediate term swap rates. The expected duration ranges from 30 days for certain rate-sensitive deposits to five years.

Economic capital is assigned to the business units by a capital allocation model that reflects management’s assessment of risk.  This model assigns capital based upon credit, operating, interest rate and market risk inherent in our business lines and recognizes the diversification benefits among the units.  The level of assigned economic capital is a combination of the risk taken by each business line, based on its actual exposures and calibrated to its own loss history where possible.  Average invested capital includes economic capital and amounts we have invested in the lines of business.

As shown in Table 6, net income attributable to our lines of business increased $7.4 million over the first quarter of 2010.  Excluding the day-one gain from the purchase of mortgage servicing rights on favorable terms in the first quarter of 2010, net income for the first quarter of 2011 attributed to our lines of business was up $13.9 million or 54% over the first quarter of 2010.  The gain on mortgage servicing rights was attributed to the consumer banking line of business in the Oklahoma geographic market.    The increase in net income attributed to our lines of business was due primarily to a decrease in net loans charged off and an increase in other operating revenue compared to the first quarter of 2010, partially offset by a decrease in net interest revenue.  Net income attributed to funds management and other decreased compared to the first quarter of 2010 primarily due to an increase in the provision for income taxes.  The decline in net interest revenue earned by funds management and other was primarily offset by a decrease in the loan loss provision in excess of charge-offs to the business lines.

Table 6 – Net Income by Line of Business

 (In thousands)

Commercial Banking

Commercial banking contributed $29.6 million to consolidated net income in the first quarter of 2011, up $18.0 million over the first quarter of 2010.  The increase in commercial banking net income was primarily due a $21.6 million decrease in net loans charged off and increased net interest revenue and other operating revenue.

Table 7 – Commercial Banking

 (Dollars in thousands)

Net interest revenue increased $3.3 million or 5% over the first quarter of 2010 primarily due to a $2.0 billion increase in average deposits attributed to our commercial banking unit.  Improving loan yield was partially offset by a $234 million decrease in average loan balances compared to the first quarter of 2010.

Other operating revenue increased $5.8 million or 20% over the first quarter of 2010.  Most categories of other operating revenue increased including a $1.8 million increase in transaction card revenues on increased customer activity.  Energy derivative trading revenue, loan syndication fees, lease financing fees and service charges on commercial deposit accounts all increased over the prior year.

Operating expenses increased $2.7 million or 5% over the first quarter of 2010 primarily due to increased data processing costs related to higher transaction card volumes, increased personnel costs as a result of annual merit

increases and increased deposit insurance expenses related to the increase in average deposit balances.

The average outstanding balance of loans attributed to commercial banking was $8.1 billion for the first quarter of 2011, down $234 million or 3% compared to the first quarter of 2010.  See Loans section following for additional discussion of changes in commercial and commercial real estate loans which are primarily attributed to the commercial banking segment.  Net commercial banking loans charged off decreased $21.6 million compared to the first quarter of 2010 to $6.8 million or 0.34% of average loans attributed to this line of business on an annualized basis.  The decrease in net loans charged off was primarily due to a decrease in losses on commercial real estate loans.

 
 

Average deposits attributed to commercial banking were $7.7 billion for the first quarter of 2011, up $2.0 billion or 35% over the first quarter of 2010.  Average deposit balances attributed to our commercial & industrial customers increased $841 million or 43% and average treasury services deposit balances increased $671 million or 46%.  Average deposit balances attributable to our small business customers increased $287 million or 27% and average balances attributed to our energy customers increased $109 million or 17%.  We believe that commercial customers are building cash reserves due to continued economic uncertainty.

Consumer Banking

Consumer banking services are provided through four primary distribution channels:  traditional branches, supermarket branches, the 24-hour ExpressBank call center, internet banking and mobile banking.

Consumer banking contributed $5.9 million to consolidated net income for the first quarter of 2011, down $11.5 million compared to the first quarter of 2010.  Net income attributed to the consumer banking unit for the first quarter of 2010 included the $6.5 million day-one gain from the purchase of rights to service $4.2 billion of residential mortgage loans on favorable terms.  Excluding the impact of this gain, net income attributed to consumer banking decreased $4.9 million compared to the first quarter of 2010 primarily due to decreased net interest revenue and deposit service charges, partially offset by increased mortgage banking revenue.

Table 8 – Consumer Banking

 (Dollars in thousands)

 

 

 

1 Includes outstanding principal for loans serviced for affiliates

Net interest revenue from consumer banking activities decreased $3.3 million or 11% compared to the first quarter of 2010 primarily due to a decrease in interest earned on securities held as an economic hedge of our mortgage servicing rights and a $139 million decrease in average loan balances.  Average loan balances declined due to a decrease in average residential mortgage balances as well as the continued paydown of indirect automobile loans.  The Company previously disclosed its decision to exit the indirect automobile loan business in the first quarter of 2009.  Net interest revenue also decreased due to a reduction in average balances sold to the funds management unit.

Other operating revenue was flat compared to the first quarter of 2010.   Deposits service charges decreased $4.2 million primarily due to lower overdraft fees as a result of changes in banking regulations that became effective in the third quarter of 2010, offset by a $2.5 million increase in mortgage banking revenue and a $953 thousand increase in transaction card revenues.

Operating expenses decreased $1.0 million or 2% compared to the first quarter of 2010.  Mortgage banking expenses decreased due to lower provisions for losses on loans sold with recourse and foreclosure costs on loans serviced for others.  Corporate expenses allocated to the consumer banking division also decreased, partially offset by increased personnel costs related to increased mortgage activity.

Net loans charged off by the consumer banking unit decreased $107 thousand or 3% compared to the first quarter of 2010.  Net consumer banking charge-offs include residential mortgage loans, indirect automobile loans, overdrawn deposit accounts and other direct consumer loans.

Average consumer deposits decreased $126 million or 2% compared to the first quarter of 2010.  Average balances of higher-costing time deposits decreased $262 million or 11%, partially offset by a $102 million or 4% increase in average interest-bearing transaction accounts balances and a $10 million or 1% increase in average demand deposit account balances over the first quarter of 2010.  Movement of funds among the various types of consumer deposits was largely based on interest rates and product features offered.

Our Consumer Banking division originates, markets and services conventional and government-sponsored mortgage loans for all of our geographical markets.  During the first quarter of 2011, a total of $457 million of mortgage loans were funded compared to $432 million funded in the first quarter of 2010.  These amounts include loans funded for sale in the secondary market and loans funded for retention by the Company.  Approximately 43% of our mortgage loans funded were in the Oklahoma market, 12% in the Texas market, 16% in New Mexico and 14% in the Colorado market.  In addition to the $11.2 billion of mortgage loans serviced for others, the Consumer Banking division also services $892 million of loans for affiliated entities.  Approximately 97% of the mortgage loans serviced was to borrowers in our primary geographical market areas.  Mortgage servicing revenue increased to $9.9 million in the first quarter of 2011 compared to $8.3 million in the first quarter of 2010, primarily due to mortgage servicing rights purchased in the first quarter of 2010.

Changes in the fair value of our mortgage loan servicing rights, net of economic hedge, decreased Consumer Banking pre-tax net income by $2.8 million in the first quarter of 2011.  Excluding the $11.8 million pre-tax day-one gain on the purchase of mortgage servicing rights during the first quarter, changes in fair value of our mortgage loan servicing rights, net of economic hedge, increased consumer banking net income by $1.2 million in the first quarter of 2010.  Changes in the fair value of mortgage servicing rights and securities held as an economic hedge are due to movements in interest rates, actual and anticipated loan prepayment speeds and related factors.  Net interest revenue on mortgage trading securities totaled $3.1 million for the first quarter of 2011 compared to $4.2 million for the first quarter of 2010.

Wealth Management

Wealth Management contributed consolidated net income of $4.0 million in the first quarter of 2011 compared to $3.1 million in the first quarter of 2010.

Table 9 – Wealth Management

 (Dollars in thousands)

Net interest revenue for the first quarter of 2011 decreased $1.4 million or 12% compared to the first quarter of 2010 primarily due to a decrease in the yield and average balances of securities and loans, partially offset by a $328 million increase in average deposit balances.

Other operating revenue increased $2.5 million or 7% over the first quarter of 2010 primarily due to a $2.1 million or 13% increase in trust fees and commission primarily due to increases in the fair value of trust assets.  Brokerage and trading revenue increased primarily offset by a decrease in other revenues.

Other operating revenue includes fees earned from state and municipal bond underwriting and financial advisory services, primarily in the Oklahoma and Texas markets.  In the first quarter of 2011, the wealth management unit participated in 35 underwritings that totaled $773 million.  Our interest in these underwritings totaled approximately $212 million.  In the first quarter of 2010, the wealth management unit participated in 32 underwritings that totaled $1.3 billion.  Our interest in those underwriting totaled approximately $114 million.

Operating expenses increased $2.1 million or 5% over the first quarter of 2010.  Personnel expenses increased $1.1 million primarily due to increased headcount.  Non-personnel expenses increased $1.0 million over the first quarter of 2010 due to increased professional fees, deposit insurance expense, net occupancy and equipment costs and other expenses.

Growth in average assets was largely due to funds sold to the funds management unit.  Average deposits attributed to the wealth management unit increased $328 million of 10% over the first quarter of 2010 including a $255 million increase in interest bearing transaction accounts and an $87 million increase in average demand deposit accounts, partially offset by a $15 million decrease in average time deposit balances.

 

Geographical Market Distribution

The Company also secondarily evaluates performance by primary geographical market.  Loans are generally attributed to geographical markets based on the location of the customer and may not reflect the location of the underlying collateral.  Brokered deposits and other wholesale funds are not attributed to a geographical market.  Funds management and other also include insignificant results of operations in locations outside our primary geographic regions.

Table 10 – Net Income by Geographic Market

 (In thousands)

Oklahoma Market

Our Oklahoma offices are located primarily in the Tulsa and Oklahoma City metropolitan areas.  Oklahoma is a significant market to the Company, representing 49% of our average loans, 53% of our average deposits and 40% of our consolidated net income in the first quarter of 2011.  In addition, all of our mortgage servicing activity and 74% of our trust assets are attributed to the Oklahoma market.

Table 11 – Oklahoma

 (Dollars in thousands)

Net income generated in the Oklahoma market in the first quarter of 2011 decreased $7.0 million or 21% compared to the first quarter of 2010.  Excluding the impact of the $6.5 million day-one gain from the rights to service $4.2 billion of residential mortgage loans on favorable terms in the first quarter of 2010, net income generated in the Oklahoma market would have been down $424 thousand or 2% compared to the first quarter of 2010.

Net interest revenue decreased $3.6 million or 6% compared to the first quarter of 2010.  Net interest revenue decreased primarily due to a $349 million decrease in average loan balances and a decrease in the yield on funds sold to the funds management unit, partially offset by a $1.1 billion increase in average deposit balances.

 

Other operating revenue increased $4.8 million or 7% compared to the first quarter of 2010.  Mortgage banking revenue increased $2.5 million and all other operating revenues were up $5.2 million including increases in transaction card revenues, brokerage and trading revenue, trust fees and commissions and other revenues.  Deposit service charges and fees decreased $2.8 million due to lower overdraft fees as a result of changes in banking regulations that became effective in the third quarter of 2010.

 

Other operating expenses decreased $449 thousand or 1% compared to the first quarter of 2010.  Personnel expenses increased $1.6 million offset by a $1.9 million decrease in non-personnel expenses primarily due to lower data processing costs and decreased corporate expense allocations.

Average deposits in the Oklahoma market for the first quarter of 2011 increased $1.1 billion over the first quarter of 2010.  The increase came primarily from the commercial and wealth management units, including trust,

broker/dealer and private banking.  The increase was partially offset by a decrease in deposits attributable to consumer banking.

Texas Market

Our Texas offices are located primarily in the Dallas, Fort Worth and Houston metropolitan areas.  Texas is our second largest market with 31% of our average loans, 25% of our average deposits and contributing 16% of our consolidated net income in the first quarter of 2011.

Table 12 – Texas

 (In thousands)

Net income in the Texas market increased $4.8 million or 83% over the first quarter of 2010 primarily due to a decrease in net loans charged off.

Net interest revenue increased $1.1 million or 3% over the first quarter of 2010.  Average assets increased $615 million due primarily to a $609 million or 16% increase in deposits which were sold to the funds management unit.  Average outstanding loans decreased $70 million or 2% compared to the first quarter of 2010.

Other operating revenue increased $909 thousand or 6% over the first quarter of 2010 primarily due to increased trust fees and commissions, transaction card revenue and trading and brokerage fees.  Deposit service charges decreased primarily due to lower overdraft fees as a result of changes in banking regulations that became effective in the third quarter of 2010.  Mortgage banking revenue also decreased due to lower mortgage origination volume.

Operating expenses increased $776 thousand or 2% over the first quarter of 2010.  Higher corporate expenses allocated to the Texas market and personnel costs were partially offset by decreased non-personnel expenses.

Net loans charged off improved to $1.2 million or 0.15% of average loans for the first quarter of 2011 on an annualized basis compared to $6.5 million or 0.80% of average loans for the first quarter of 2010 on an annualized basis.

Other Markets

Net income attributable to our New Mexico market increased $2.5 million over the first quarter of 2010 to $2.7 million and represented 4% of consolidated net income for the first quarter of 2011 compared to contributing less than 1% of consolidated net income in the first quarter of 2010.  Net interest income increased $472 thousand or 6% over the first quarter of 2010.  Average deposits increased $58 million.  Net interest revenue earned on those deposits and improved loan yields were partially offset by a decrease in average loan balances attributed to the New Mexico market and lower yields earned on funds sold to the funds management unit.  Operating revenue increased over the first quarter of 2010 primarily due to increased mortgage banking and transaction card revenues partially offset by lower overdraft fees and trading and brokerage revenue.  Net charge-offs improved to $608 thousand or 0.35% of average loans on an annualized basis in the first quarter of 2011 from $2.8 million or 1.55% of average loans on an annualized basis in the first quarter of 2010.

Net income in the Arkansas market increased $499 thousand over the first quarter of 2010.  Net interest revenue decreased $644 thousand primarily due to a $77 million decrease in average loans.  Average deposits in our Arkansas market were up $48 million or 27% over the first quarter of 2010 due primarily to increased commercial banking deposits, partially offset by decreases in consumer and wealth management deposits.  Other operating revenue decreased compared to the first quarter of 2010 primarily due to lower brokerage and trading revenue and decreased mortgage banking revenue.  Other operating expenses were flat with the prior year.  Net loans charged off improved to $336 thousand or 0.47% of average loans on an annualized basis compared to $2.0 million or 2.22% on an annualized basis in the first quarter of 2010.

Net income in the Colorado market increased $1.3 million over the first quarter of 2010 primarily due to a $2.7 million decrease in net loans charged off.  The Colorado market experienced a net recovery of $44 thousand in the first quarter of 2011 compared to a net charge-off of $2.7 million or 1.32% of average loans on an annualized basis for the first quarter of 2010.  Net interest income decreased $435 thousand primarily due to a $50 million decrease in average outstanding loan balances attributed to the Colorado market.  Other operating revenues increased primarily due to increased trust fees and commission and brokerage and trading revenue partially offset by decreased mortgage banking revenue and overdraft charges.  Operating expenses increased primarily due to increased personnel expenses.  Average deposits attributed to the Colorado market increased $97 million over the first quarter of 2010 primarily related to an increase in commercial and wealth management deposits, partially offset by a decrease in consumer deposit balances.

The net loss attributed to the Arizona market totaled $3.1 million in the first quarter of 2011 down from $8.3 million in the first quarter of 2010.  Net loans charged off during the first quarter of 2011 improved to $1.9 million or 1.39% of average loans on an annualized basis compared to $10.1 million or 7.98% of average loans on an annualized basis in the first quarter of 2010.  First quarter of 2011 performance included losses of $3.2 million on repossessed assets, up $2.9 million from the first quarter of 2010.  Average loan balances increased $40 million over the first quarter of 2010 and average deposits increased $39 million over the first quarter of 2010 primarily due to commercial deposit growth.  Period end commercial loans increased $42 million, residential mortgage loans increased $21 million and commercial real estate loans increased by $11 compared to period end balances at March 31, 2010.

We continue to focus on growth in commercial and small business lending in the Arizona market and have significantly scaled back commercial real estate lending activities which were not contemplated in our initial expansion into this market.  Loan and repossessed asset losses are largely due to commercial real estate lending.  Assets attributable to the Arizona market included $16 million of goodwill that may be impaired in future periods if our commercial and small business lending growth plans are unsuccessful.

Net income attributed to the Kansas/Missouri market decreased $167 thousand compared to the first quarter of 2010.   Net loans charged off increased to $908 thousand or 1.02% of average loans on an annualized basis for the first quarter of 2011 compared to a net recovery of $54 thousand in the first quarter of 2010.  Net interest revenue increased $751 thousand or 36%.   Total average loan balances increased $72 million or 25% over the first quarter of 2010 and average deposits balances increased $190 million.  Operating revenue increased $584 thousand over the first quarter of 2010 primarily due to increased mortgage banking revenue, trust fees and commission and transaction card revenues, partially offset by a decrease in brokerage and trading revenue and overdraft charges.  Operating expenses increased $647 thousand primarily due to increased personnel expenses, repossession expenses and corporate expense allocations.

Table 13 – New Mexico

 (Dollars in thousands)

 
 

Table 14 –Arkansas

(In thousands)

 

Table 15 – Colorado

Table 16 – Arizona

 (Dollars in thousands)

 

(Dollars in thousands)

Financial Condition

Securities

We maintain a securities portfolio to enhance profitability, support interest rate risk management strategies, provide liquidity and comply with regulatory requirements.  Securities are classified as held for investment, available for sale or trading.  See Note 2 to the consolidated financial statements for the composition of the securities portfolio as of March 31, 2011.

Investment (held-to-maturity) securities consist primarily of long-term, fixed-rate Oklahoma municipal bonds and Texas school construction bonds.  Substantially all of these bonds are general obligations of the issuer.  Approximately, $92 million of the Texas school construction bonds are also guaranteed by the Texas Permanent School Fund Guarantee Program.  At March 31, 2011, investment securities were carried at $343 million and had a fair value of $355 million.

Available for sale securities, which may be sold prior to maturity, are carried at fair value.  Unrealized gains or losses, less deferred taxes, are recorded as accumulated other comprehensive income in shareholders’ equity.  The amortized cost of available for sale securities totaled $9.5 billion at March 31, 2011, up $395 million over December 31, 2010.  At March 31, 2011, residential mortgage-backed securities represented 98% of total available for sale securities.

A primary risk of holding mortgage-backed securities comes from extension during periods of rising interest rates or prepayment during periods of falling interest rates.  We evaluate this risk through extensive modeling of risk both before making an investment and throughout the life of the security.  Current interest rates are historically low and prices for residential mortgage-backed securities are historically high resulting in very low effective durations.  Our best estimate of the duration of the residential mortgage-backed securities portfolio at March 31, 2011 is 2.6 years.  Management estimates that the expected duration would extend to approximately 3.5 years assuming an immediate 200 basis point upward rate shock.  The estimated duration contracts to 1.1 years assuming a 50 basis point decline in the current low rate environment.

Residential mortgage-backed securities also have credit risk from delinquency or default of the underlying loans.  We mitigate this risk by primarily investing in securities issued by U.S. government agencies.  Principal and interest payments on the underlying loans are either partially or fully guaranteed.  At March 31, 2011, approximately $8.7 billion of the amortized costs of the Company’s residential mortgage-backed securities were issued by U.S. government agencies.   The fair value of these mortgage-backed securities totaled $8.9 billion at March 31, 2011.

We also hold amortized cost of $630 million in residential mortgage-backed securities privately issued by publicly-owned financial institutions, a decline of $85 million from December 31, 2010.  The decline was primarily due to $80 million of cash received and $4.6 million of other-than-temporary losses charged against earnings during the first quarter of 2011.  The fair value of our portfolio of privately issued residential mortgage-backed securities totaled $573 million at March 31, 2011.   The net unrealized loss on the below investment grade residential mortgage-backed securities decreased for the ninth consecutive quarter to $57 million at March 31, 2011 from $70 million at December 31, 2010.

The amortized cost of our portfolio of privately issued residential mortgage-backed securities included $421 million of Jumbo-A residential mortgage loans and $209 million of Alt-A residential mortgage loans.  Jumbo-A residential mortgage loans generally meet government underwriting standards, but have loan balances that exceed agency maximums.  Alt-A residential mortgage loans generally do not have sufficient documentation to meet government agency underwriting standards.  Credit risk on securities backed by Alt-A loans is mitigated by investment in senior tranches with additional collateral support.  None of these securities are backed by sub-prime mortgage loans, collateralized debt obligations or collateralized loan obligations.  Approximately 94% of our Alt-A residential mortgage-backed securities were issued with credit support from additional layers of loss-absorbing subordinated tranches including 100% of our Alt-A residential mortgage-backed securities originated in 2007 and 2006.  The weighted average original credit enhancement of the Alt-A residential mortgage backed securities was 10.3% and currently stands at 6.4%.  The Jumbo-A residential mortgage backed securities had original credit enhancement of 8.5% and the current level is 8.8%.  Approximately 82% of our Alt-A mortgage-backed securities represents pools of fixed-rate mortgage loans.  None of the adjustable rate mortgages are payment option adjustable rate mortgages (“ARMs”).  Approximately 75% of our Jumbo-A residential mortgage backed securities represent pools of fixed rate residential mortgage loans and none of the adjustable rate mortgages are payment option ARMs.

Privately issued residential mortgage-backed securities with a total amortized cost of $498 million were rated below investment grade at March 31, 2011 by at least one of the nationally-recognized rating agencies.  Net unrealized losses on the below investment grade residential mortgage-backed securities totaled $51 million at March 31, 2011.  The net unrealized loss on these securities decreased $11 million during the first quarter of 2011.

The aggregate gross amount of unrealized losses on available for sale securities totaled $75 million at March 31, 2011.  On a quarterly basis, we perform separate evaluations on debt and equity securities to determine if the unrealized losses are temporary as more fully described in Note 2 of the Consolidated Financial Statements.  Other-than-temporary impairment charges of $4.6 million were recognized in earnings in the first quarter of 2011 on certain privately issued residential mortgage backed securities we do not intend to sell.

Certain government agency issued residential mortgage-backed securities, identified as mortgage trading securities, have been designated as economic hedges of mortgage servicing rights.  These securities are carried at fair value with changes in fair value recognized in current period income.  These securities are held with the intent that gains or losses will offset changes in the fair value of mortgage servicing rights.

We also maintain a separate trading portfolio with the intent to sell at a profit for the Company that is also carried at fair value with changes in fair value recognized in current period income.

Bank-Owned Life Insurance

We have approximately $258 million of bank-owned life insurance at March 31, 2011.  This investment is expected to provide a long-term source of earnings to support existing employee benefit programs.  Approximately $226 million is held in separate accounts.  Our separate account holdings are invested in diversified portfolios of investment-grade fixed income securities and cash equivalents, including U.S. Treasury and Agency securities, residential mortgage-backed securities, corporate debt, asset-backed and commercial mortgage-backed securities.  The portfolios are managed by unaffiliated professional managers within parameters established in the portfolio’s investment guidelines.  The cash surrender value of certain life insurance policies is further supported by a stable

value wrap, which protects against changes in the fair value of the investments.  At March 31, 2011, the cash surrender value represented by the underlying fair value of investments held in separate accounts was approximately $238 million.  As the underlying fair value of the investments held in a separate account at March 31, 2011 exceeded the net book value of the investments, no cash surrender value was supported by the stable value wrap.  The stable value wrap is provided by a highly-rated, domestic financial institution.  The remaining cash surrender value of $32 million primarily represented the cash surrender value of policies held in general accounts and other amounts due from various insurance companies.

Loans

The aggregate loan portfolio before allowance for loan losses totaled $10.6 billion at March 31, 2011, a $53 million decrease since December 31, 2010.

Table 18 – Loans

 (In thousands)

 
 

Commercial loan balances were up $114 million over December 31, 2010, primarily in the manufacturing, energy and healthcare sectors.  Construction and land development loans decreased $54 million, residential mortgage loans decreased $51 million and consumer decreased $62 million.  A breakdown by geographical market follows on Table 19 along with discussion of changes in the balance by portfolio and geography.

Table 19 –Loans by Principal Market