UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
For the quarterly period ended March 31, 2004
OR
For the transition period from __________________ to
Commission file number 1-10706
Comerica Incorporated
Comerica Tower at Detroit CenterDetroit, Michigan48226
(800) 521-1190
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. $5 par value common stock: Outstanding as of April 30, 2004: 173,240,000 shares
COMERICA INCORPORATED AND SUBSIDIARIES
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEETSComerica Incorporated and Subsidiaries
See notes to consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF INCOME (unaudited)Comerica Incorporated and Subsidiaries
4
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (unaudited)Comerica Incorporated and Subsidiaries
5
CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)Comerica Incorporated and Subsidiaries
6
Notes to Consolidated Financial Statements (unaudited)Comerica Incorporated and Subsidiaries
Note 1 - Basis of Presentation and Accounting Policies
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results of operations for the three months ended March 31, 2004, are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. Certain items in prior periods have been reclassified to conform to the current presentation. For further information, refer to the consolidated financial statements and footnotes thereto included in the Annual Report of Comerica Incorporated and Subsidiaries (the “Corporation”) on Form 10-K for the year ended December 31, 2003.
Derivative and Foreign Exchange Contracts
The Corporation uses derivative financial instruments, including foreign exchange contracts, to manage the Corporation’s exposure to interest rate and foreign currency risks. All derivative instruments are carried at fair value as either assets or liabilities on the balance sheet. The accounting for changes in the fair value (i.e. gains or losses) of a derivative instrument is determined by whether it has been designated and qualifies as part of a hedging relationship and, further, on the type of hedging relationship. For those derivative instruments that qualify as hedging instruments, the Corporation designates the hedging instrument as, either a fair value hedge, cash flow hedge or a hedge of a net investment in a foreign operation. For further information, see Note 8.
Stock-Based Compensation
In 2002, the Corporation adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure”), which the Corporation is applying prospectively to all stock-based compensation awards granted to employees after December 31, 2001. Options granted prior to January 1, 2002 continue to be accounted for under the intrinsic value method, as outlined in APB Opinion No. 25, “Accounting for Stock Issued to Employees.” The effect on net income and earnings per share, if the fair value method had been applied to all outstanding and unvested awards in each period, is presented in the table below. For further information on the Corporation’s stock-based compensation plans, refer to Note 16 to the consolidated financial statements in the Corporation’s 2003 Annual Report.
7
Note 2 - Investment Securities
At March 31, 2004, investment securities having a carrying value of $1.9 billion were pledged, primarily with the Federal Reserve Bank and state and local government agencies. Securities are pledged where permitted or required by law to secure liabilities and public and other deposits, including deposits of the State of Michigan of $160 million at March 31, 2004.
Note 3 - Allowance for Loan Losses
The following summarizes the changes in the allowance for loan losses:
8
Note 3 - Allowance for Loan Losses (continued)
SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” considers a loan impaired when it is probable that interest and principal payments will not be made in accordance with the contractual terms of the loan agreement. Consistent with this definition, all nonaccrual and reduced-rate loans (with the exception of residential mortgage and consumer loans) are impaired. Impaired loans that are restructured and meet the requirements to be on accrual status are included with total impaired loans for the remainder of the calendar year of the restructuring. There were no loans included in the $484 million of impaired loans at March 31, 2004 that were restructured and met the requirements to be on accrual status. Impaired loans averaged $505 million for the three months ended March 31, 2004, compared to $599 million for the comparable period last year. The following presents information regarding the period-end balances of impaired loans:
Those impaired loans not requiring an allowance represent loans for which the fair value exceeded the recorded investments in such loans.
9
Note 4 - Medium- and Long-term Debt
Medium- and long-term debt consisted of the following at March 31, 2004 and December 31, 2003:
The carrying value of medium- and long-term debt has been adjusted to reflect the gain or loss attributable to the risk hedged.
Note 5 - Income Taxes
The provision for income taxes is computed by applying statutory federal income tax rates to income before income taxes as reported in the financial statements after deducting non-taxable items, principally income on bank-owned life insurance and interest income on state and municipal securities. State and foreign taxes are then added to the federal provision.
10
Note 6 - Accumulated Other Comprehensive Income
Other comprehensive income includes the change in net unrealized gains and losses on investment securities available-for-sale, the change in accumulated gains and losses on cash flow hedges, the change in the accumulated foreign currency translation adjustment and the change in accumulated minimum pension liability adjustment. The Consolidated Statements of Changes in Shareholders’ Equity on page 5 include only combined, net of tax, other comprehensive income. The following table presents reconciliations of the components of accumulated other comprehensive income for the three months ended March 31, 2004 and 2003. Total comprehensive income totaled $180 million and $131 million, for the three months ended March 31, 2004 and 2003, respectively. The $49 million increase in total comprehensive income in the three month period ended March 31, 2004 when compared to the same period in the prior year resulted principally from a decrease in net unrealized losses on cash flow hedges ($41 million) and an increase in net unrealized gains on investment securities available-for-sale ($25 million) due to changes in the interest rate environment, partially offset by a decrease in net income ($14 million).
11
Note 7 – Employee Benefit Plans
The components of net periodic benefit cost for the Corporation’s qualified pension plan, non-qualified pension plan and postretirement benefit plan are as follows:
For further information on the Corporation’s employee benefit plans, refer to Note 17 to the consolidated financial statements in the Corporation’s 2003 Annual Report.
12
Note 8 - Derivatives and Foreign Exchange Contracts
The following table presents the composition of derivative financial instruments and foreign exchange contracts, excluding commitments, held or issued for risk management and in connection with customer-initiated and other activities.
(1) Notional or contract amounts, which represent the extent of involvement in the derivatives market, are generally used to determine the contractual cash flows required in accordance with the terms of the agreement. These amounts are typically not exchanged, significantly exceed amounts subject to credit or market risk, and are not reflected in the consolidated balance sheets.
(2) Unrealized gains represent receivables from derivative counterparties, and therefore exposes the Corporation to credit risk. This risk is measured as the cost to replace, at current market rates, contracts in a profitable position. Credit risk is calculated before consideration is given to bilateral collateral agreements or master netting arrangements that effectively reduce credit risk.
(3) The fair values of derivatives and foreign exchange contracts generally represent the estimated amounts the Corporation would receive or pay to terminate or otherwise settle the contracts at the balance sheet date. The fair values of all derivatives and foreign exchange contracts are reflected in the consolidated balance sheets.
13
Note 8 - Derivatives and Foreign Exchange Contracts (continued)
Risk Management
Fluctuations in net interest income due to interest rate risk result from the composition of assets and liabilities and the mismatches in the timing of the repricing of these assets and liabilities. In addition, external factors such as interest rates, and the dynamics of yield curve and spread relationships can affect net interest income. The Corporation utilizes simulation analyses to project the sensitivity of the Corporation’s net interest income to changes in interest rates. Foreign exchange rate risk arises from changes in the value of certain assets and liabilities denominated in foreign currencies. The Corporation employs cash instruments, such as investment securities, as well as derivative financial instruments and foreign exchange contracts, to manage exposure to these and other risks, including liquidity risk.
As an end-user, the Corporation accesses the interest rate markets to obtain derivative instruments for use principally in connection with asset and liability management activities. As part of a fair value hedging strategy, the Corporation has entered into interest rate swap agreements for interest rate risk management purposes. The interest rate swap agreements effectively modify the Corporation’s exposure to interest rate risk by converting fixed-rate deposits and debt to a floating rate. These agreements involve the receipt of fixed rate interest amounts in exchange for floating rate interest payments over the life of the agreement, without an exchange of the underlying principal amount. For instruments that support a fair value hedging strategy, no ineffectiveness was required to be recorded in the statement of income.
As part of a cash flow hedging strategy, the Corporation has entered into predominantly 2 to 3 year interest rate swap agreements (weighted average original maturity of 2.5 years) that effectively convert a portion of its existing and forecasted floating-rate loans to a fixed-rate basis, thus reducing the impact of interest rate changes on future interest income over the next 2 to 3 years. Approximately 24 percent ($10 billion) of the Corporation’s outstanding loans were designated as the hedged items to interest rate swap agreements at March 31, 2004. During the three months ended March 31, 2004, interest rate swap agreements designated as cash flow hedges increased interest and fees on loans by $52 million, compared to $92 million for the comparable period last year. Ineffective cash flow hedge gains included in other noninterest income in the first quarter of 2004 were immaterial. If interest rates, interest yield curves and notional amounts remain at their current levels, the Corporation expects to reclassify $102 million of net gains on derivative instruments from accumulated other comprehensive income to earnings during the next twelve months due to receipt of variable interest associated with the existing and forecasted floating-rate loans.
In addition, the Corporation uses forward foreign exchange contracts to protect the value of its foreign currency investment in foreign subsidiaries. Realized and unrealized gains and losses from these hedges are not included in the statement of income, but are shown in the accumulated foreign currency translation adjustment account included in other comprehensive income, with the related amounts due to or from counterparties included in other liabilities or other assets. During the quarter ended March 31, 2004, the Corporation recognized an immaterial amount of net gains in accumulated foreign currency translation adjustment, related to the forward foreign exchange contracts.
Management believes these strategies achieve the desired relationship between the rate maturities of assets and their funding sources which, in turn, reduces the overall exposure of net interest income to interest rate risk, although, there can be no assurance that such strategies will be successful. The Corporation also uses various other types of financial instruments to mitigate interest rate and foreign currency risks associated with specific assets or liabilities, which are reflected in the preceding table. Such instruments include interest rate caps and floors, foreign exchange forward contracts, foreign exchange option contracts and foreign exchange cross-currency swaps.
14
The following table summarizes the expected maturity distribution of the notional amount of interest rate swaps used for risk management purposes and indicates the weighted average interest rates associated with amounts to be received or paid on interest rate swap agreements as of March 31, 2004. The swaps are grouped by the assets or liabilities to which they have been designated.
Remaining Expected Maturity of Risk Management Interest Rate Swaps as of March 31, 2004:
(1) Variable rates paid on receive fixed swaps are based on prime, LIBOR with various maturities or one-month Canadian Dollar Offered Rate (CDOR) rates in effect at March 31, 2004.
(2) Variable rates received are based on three-month and six-month LIBOR or one-month and three-month CDOR rates in effect at March 31, 2004.
15
The Corporation had commitments to purchase investment securities for its trading account and available-for-sale portfolios totaling $128 million at March 31, 2004 and $3 million at December 31, 2003. Commitments to sell investment securities related to the trading account totaled $28 million at March 31, 2004 and $2 million at December 31, 2003. Outstanding commitments expose the Corporation to both credit and market risk.
Customer-Initiated and Other
On a limited scale, fee income is earned from entering into various transactions, principally foreign exchange contracts and interest rate contracts at the request of customers. Market risk inherent in customer contracts is often mitigated by taking offsetting positions. The Corporation generally does not speculate in derivative financial instruments for the purpose of profiting in the short-term from favorable movements in market rates.
Fair values for customer-initiated and other derivative and foreign exchange contracts represent the net unrealized gains or losses on such contracts and are recorded in the consolidated balance sheets. Changes in fair value are recognized in the consolidated income statements. The following table provides the average unrealized gains and unrealized losses and noninterest income generated on customer-initiated and other interest rate contracts and foreign exchange contracts.
Derivative and Foreign Exchange Activity
The following table provides a reconciliation of the beginning and ending notional amounts for interest rate derivatives and foreign exchange contracts for the three months ended March 31, 2004.
Additional information regarding the nature, terms and associated risks of the above derivatives and foreign exchange contracts, can be found in the Corporation’s 2003 Annual Report on page 49 and in Notes 1 and 22 to the consolidated financial statements.
Note 9 - Standby and Commercial Letters of Credit and Financial Guarantees
The total contractual amounts of standby letters of credit and financial guarantees and commercial letters of credit at March 31, 2004 and December 31, 2003, which represents the Corporation’s credit risk associated with these instruments, are shown in the table below.
16
Note 9 - Standby and Commercial Letters of Credit and Financial Guarantees (continued)
Standby and commercial letters of credit and financial guarantees represent conditional obligations of the Corporation which guarantee the performance of a customer to a third party. Standby letters of credit and financial guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. These contracts expire in decreasing amounts through the year 2012. Commercial letters of credit are issued to finance foreign or domestic trade transactions and are short-term in nature. The Corporation may enter into participation arrangements with third parties, which effectively reduce the maximum amount of future payments which may be required under standby letters of credit. These risk participations covered $549 million of the $6,047 million of standby letters of credit outstanding at March 31, 2004. At March 31, 2004, the carrying value of the Corporation’s standby and commercial letters of credit and financial guarantees, which is included in “accrued expenses and other liabilities” on the consolidated balance sheet, totaled $71 million.
Note 10 – Business Segment Information
The Corporation has strategically aligned its operations into three major lines of business: the Business Bank, Small Business and Personal Financial Services, and Wealth and Institutional Management. These lines of business are differentiated based on the products and services provided. In addition to the three major lines of business, the Finance Division is also reported as a segment. Lines of business results are produced by the Corporation’s internal management accounting system. This system measures financial results based on the internal business unit structure of the Corporation. Information presented is not necessarily comparable with similar information for any other financial institution. The management accounting system assigns balance sheet and income statement items to each line of business using certain methodologies, which are constantly being refined. For comparability purposes, amounts in all periods are based on lines of business and methodologies in effect at March 31, 2004. These methodologies may be modified as management accounting systems are enhanced and changes occur in the organizational structure or product lines. For a description of the business activities of each line of business and the methodologies, which form the basis for these results, refer to Note 26 in the Corporation’s 2003 Annual Report.
The following table reflects the Corporation’s net income, excluding the Finance Division and Other, represented by the Business Bank, Small Business and Personal Financial Services, and Wealth and Institutional Management lines of business for the three months ended March 31, 2004 and 2003.
17
Note 10 – Business Segment Information (continued)
Lines of business/business segment financial results for the three months ended March 31, 2004 and 2003 are shown in the table below.
N/M – Not Meaningful
18
Note 10 - Business Segment Information (continued)
The Corporation’s management accounting system also produces market segment results for the Corporation’s four primary geographic regions: Midwest and Other Markets; Western; Texas; and Florida.
Midwest and Other Markets includes all markets in which the Corporation has operations except for the Western, Texas and Florida regions, as described below. Substantially all of the Corporation’s international operations are included in the Midwest and Other Markets segment. Currently, Michigan operations represent the significant majority of this geographic region.
The Western region consists of the states of California, Arizona, Nevada, Colorado and Washington. Currently, California operations represent the significant majority of the Western region.
The Texas and Florida regions consist of the states of Texas and Florida, respectively.
The Finance and Other Businesses segment includes the Corporation’s securities portfolio, asset and liability management activities, divested business lines, the income and expense impact of cash and loan loss reserves not assigned to specific business lines/market segments, and miscellaneous other items of a corporate nature. This segment includes responsibility for managing the Corporation’s funding, liquidity and capital needs, performing interest sensitivity gap and earnings simulation analysis and executing various strategies to manage the Corporation’s exposure to liquidity, interest rate risk, and foreign exchange risk.
The following table reflects the Corporation’s net income, excluding Finance and Other Businesses, represented by the Midwest and Other Markets, Western, Texas, and Florida regions for the three months ended March 31, 2004 and 2003.
19
Market segment results for the three months ended March 31, 2004 and 2003 are shown in the table below.
N/M - Not Meaningful
20
Note 11- Pending Accounting Pronouncements
In January 2004, the FASB issued a FASB Staff Position (FSP), “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” subsequently revised April 12, 2004. The FSP permits a sponsor of a postretirement health care plan that provides a prescription drug benefit to make a one-time election to defer accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) and requires certain disclosures pending further consideration of the underlying accounting issues. The Act introduces a Medicare prescription drug benefit as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to the Medicare benefit. The Corporation is in the process of analyzing the impact the Act will have on its employee benefit plans. The FSP is effective for financial statements of interim or annual periods ending after December 7, 2003. If an entity elects deferral, that election may not be changed, and the deferral continues to apply until authoritative guidance on the accounting for the federal subsidy resulting from the Act is issued, or until a significant event occurs that would ordinarily call for remeasurement of a plan’s assets and obligations (i.e. plan amendment, settlement or curtailment). The FASB plans to issue authoritative guidance on the accounting for subsidies in the second quarter of 2004, which could require the Corporation to modify its postretirement disclosures. In accordance with the FSP, the Corporation elected to defer accounting for the effects of the Act.
21
ITEM 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition
Results of Operations
Net income for the quarter ended March 31, 2004 was $162 million, down $14 million from $176 million reported for the first quarter of 2003. Quarterly diluted net income per share decreased to $0.92 from $1.00 a year ago. Return on average common shareholders’ equity was 12.71 percent and return on average assets was 1.28 percent, compared to 14.13 percent and 1.33 percent, respectively, for the comparable quarter last year. The decline in earnings in the first quarter of 2004 over the comparable quarter last year resulted primarily from a $66 million decline in net interest income. Partially offsetting the decline in net interest income was a $41 million decline in the provision for loan losses.
Net Interest Income
The rate-volume analysis in Table I details the components of the change in net interest income on a fully taxable equivalent (FTE) basis for the quarter ended March 31, 2004. On a FTE basis, net interest income decreased $66 million to $446 million for the three months ended March 31, 2004, from $512 million for the comparable quarter in 2003. Average earning assets decreased three percent when compared to the first quarter of last year. The net interest margin decreased to 3.83 percent for the three months ended March 31, 2004, from 4.30 percent for the comparable three months of 2003. The decline in net interest margin was the result of a restructuring of the investment portfolio, designed to achieve more consistent cash flows; the impact of interest rate swap maturities; spread compression, as a result of lower loan yields in a declining rate environment; and a higher short-term liquidity position held by the Corporation for the first three months of 2004 as compared to the same period in 2003. The decline in net interest income in the first quarter 2004, when compared to the first quarter 2003, resulted from both the decrease in average earning assets and the decline in the net interest margin. For further discussion of the effects of market rates on net interest income, refer to “Item 3. Quantitative and Qualitative Disclosures about Market Risk” on page 30.
The Corporation currently expects, on average, full year 2004 net interest margin to remain relatively unchanged from first quarter 2004 levels.
22
Table I - Quarterly Analysis of Net Interest Income & Rate/Volume (FTE)
23
Table I - Quarterly Analysis of Net Interest Income & Rate/Volume (FTE) (continued)
* Rate/Volume variances are allocated to variances due to volume.
24
Provision for Loan Losses
The provision for loan losses was $65 million for the first quarter of 2004 compared to $106 million for the same period in 2003. The Corporation establishes this provision to maintain an adequate allowance for loan losses, which is discussed in the section entitled “Allowance for Loan Losses and Nonperforming Assets.” The decrease in the provision for loan losses in the three months ended March 31, 2004 over the comparable period last year is primarily the result of improving credit quality trends, which are reflective of an improved business climate in the Michigan market, where the Corporation has a geographic concentration of credit. Upturns in the Southeast Michigan Purchasing Management survey and Michigan Business Activity Indices began in the fourth quarter of 2003, and our forward-looking indicators suggest this positive movement should continue in 2004.
Noninterest Income
Noninterest income remained unchanged at $220 million for the three months ended March 31, 2004 when compared to the same period in 2003. Net securities gains in the first quarter 2004 contributed $5 million to noninterest income compared with net securities gains in the first quarter 2003 of $13 million. Noninterest income from market-related revenue sources, defined as fiduciary income, foreign exchange income, investment advisory revenue and brokerage service fees, increased $6 million in the first quarter of 2004 compared to the first quarter of 2003. Also included in first quarter 2003 noninterest income were $6 million of cash flow ineffectiveness gains and a $6 million net write-down of venture capital and private equity securities.
Management currently expects low single digit noninterest income growth, excluding securities gains, in the full year 2004 compared to 2003.
Noninterest Expenses
Noninterest expenses were $369 million for the quarter ended March 31, 2004, an increase of $2 million, or one percent, from the comparable quarter in 2003. Increases in salary and employee benefits expenses that resulted from both annual merit increases and first quarter 2004 severance payments were largely offset by a full time equivalent employee reduction in staff size of approximately 240 employees from March 31, 2003 to March 31, 2004. Noninterest expenses in the first quarter 2004 also included a $2 million interest accrual related to settlement of a tax liability with the state of California, discussed further below.
Management currently expects full year 2004 noninterest expenses to hold flat with 2003; however, management is targeting up to an additional $20 million reduction in expenses should the pace of revenue growth be slower than expectations.
Provision for Income Taxes
The provision for income taxes for the first quarter of 2004 was $69 million, compared to $82 million for the same period a year ago. The effective tax rate was 30 percent for the first quarter of 2004 compared to 32 percent for the same quarter of 2003. Taxes in the first quarter 2004 were reduced by a $4 million (after-tax) adjustment to the state tax reserves that resulted from settlement of a tax liability with the state of California related to a registered investment company subsidiary that was liquidated in 2001. Management currently expects the effective tax rate to be 31 percent to 32 percent for the remainder of the year.
Financial Condition
Total assets were $54.5 billion at March 31, 2004 compared with $52.6 billion at year-end 2003 and $55.8 billion at March 31, 2003, as a result of an increase in short-term investments, partially offset by a decline in total loans. The Corporation experienced a one percent decline in total loans since December 31, 2003. The Corporation experienced growth, on an average basis, in the National Dealer Services (11 percent) and Private Banking (2 percent) loan portfolios, from the fourth quarter 2003 to the first quarter 2004. Average loans declined in the same periods in the Specialty Businesses (10 percent), Global Corporate Banking (6 percent), Middle Market (2 percent) and Commercial Real Estate (2 percent) loan portfolios. Short-term investments increased $1.7 billion from December 31, 2003 to March 31, 2004 as a result of the significant increase in short-term deposits discussed below.
25
Management currently expects slightly lower loans and total earning assets, on average, in 2004 when compared to 2003 levels.
Total liabilities increased $1.9 billion, or four percent, from $47.5 billion at December 31, 2003, to $49.4 billion at March 31, 2004. Total deposits increased five percent to $43.5 billion at March 31, 2004, from $41.5 billion at year-end. Noninterest-bearing deposits in the Corporation’s Financial Services Group, which benefit from high home mortgage financing and refinancing activity and are not expected to be long-lived, increased to $10.1 billion at March 31, 2004 from $7.0 billion at December 31, 2003, primarily due to strong mortgage business activity. Medium- and long-term debt decreased $204 million to $4.6 billion at March 31, 2004.
Allowance for Loan Losses and Nonperforming Assets
The allowance for loan losses represents management’s assessment of probable losses inherent in the Corporation’s loan portfolio. The allowance provides for probable losses that have been identified with specific customer relationships and for probable losses believed to be inherent, but that have not been specifically identified. Internal risk ratings are assigned to each business loan at the time of approval and are subject to subsequent periodic reviews by senior management. The Corporation performs a detailed credit quality review quarterly on large business loans that have deteriorated below certain levels of credit risk, and may allocate a specific portion of the allowance to such loans based upon this review. The Corporation defines business loans as those belonging to the commercial, real estate construction, commercial mortgage, lease financing and international loan portfolios. A portion of the allowance is allocated to the remaining business loans by applying projected loss ratios, based on numerous factors identified below, to the loans within each risk rating. In addition, a portion of the allowance is allocated to these remaining loans based on industry specific and geographic risks inherent in certain portfolios, including portfolio exposures to automotive suppliers; contractors; technology-related, entertainment, and healthcare industries, small business administration loans and certain Latin American transfer risks. The portion of the allowance allocated to non-business loans is determined by applying projected loss ratios to various segments of the loan portfolio. Projected loss ratios incorporate factors such as recent charge-off experience, current economic conditions and trends, trends with respect to past due and nonaccrual amounts, and are supported by underlying analysis, including information from migration and loss given default studies from each geographic market. The allocated portion of the allowance was $758 million at March 31, 2004, a decrease of $4 million from year-end 2003.
Actual loss ratios experienced in the future may vary from those projected. The uncertainty occurs because factors affecting the determination of probable losses inherent in the loan portfolio may exist which are not necessarily captured by the application of projected loss ratios or identified industry specific and geographic risks. An unallocated portion of the allowance is maintained to capture these probable losses. The unallocated allowance reflects management’s view that the allowance should recognize the margin for error inherent in the process of estimating expected loan losses. Factors that were considered in the evaluation of the adequacy of the Corporation’s unallocated allowance include the imprecision in the risk rating system and the risk associated with new customer relationships. The unallocated allowance was $40 million at March 31, 2004, a decrease of $1 million from December 31, 2003.
The total allowance, including the unallocated amount, is available to absorb losses from any segment within the portfolio. Unanticipated economic events, including political, economic and regulatory stability in countries where the Corporation has a concentration of loans, could cause changes in the credit characteristics of the portfolio and result in an unanticipated increase in the allocated allowance. Inclusion of other industry specific and geographic portfolio exposures in the allocated allowance, as well as significant increases in the current portfolio exposures, could also increase the amount of the allocated allowance. Any of these events, or some combination, may result in the need for additional provision for loan losses in order to maintain an adequate allowance.
At March 31, 2004, the allowance for loan losses was $798 million, a decrease of $5 million from $803 million at December 31, 2003. The allowance for loan losses as a percentage of total period-end loans remained unchanged at 1.99 percent at March 31, 2004 and December 31, 2003. The Corporation also had an allowance for credit losses on lending-related commitments of $32 million and $33 million, at March 31, 2004 and December 31, 2003, respectively, which is recorded in “accrued expenses and other liabilities” on the consolidated balance sheets. These lending-related commitments include unfunded loan commitments and letters of credit.
Nonperforming assets at March 31, 2004 were $522 million, as compared to $538 million at December 31, 2003, a decrease of $16 million, or three percent. The allowance for loan losses as a percentage of nonperforming assets increased slightly to 153 percent at March 31, 2004, from 149 percent at December 31, 2003.
26
Nonperforming assets at March 31, 2004 and December 31, 2003 were categorized as follows:
The following table presents a summary of changes in nonaccrual loans.
Loans with balances greater than $2 million transferred to nonaccrual status decreased $22 million, or 19 percent, to $92 million in the first quarter of 2004, compared with $114 million in the fourth quarter of 2003. There were three loans greater than $10 million transferred to nonaccrual during the quarter. These loans totaled $44 million and are to a contractor and companies in the automotive and technology-related sectors.
27
The following table presents a summary of total internally classified nonaccrual and watch list loans (generally consistent with regulatory defined special mention, substandard and doubtful loans) at March 31, 2004 and December 31, 2003. Consistent with the decrease in nonaccrual loans from December 31, 2003 to March 31, 2004, total nonaccrual and watch list loans declined both in dollars and as a percentage of the total loan portfolio.
The following table presents a summary of nonaccrual loans at March 31, 2004 and loans transferred to nonaccrual and net charge-offs during the three months ended March 31, 2004, based on the Standard Industrial Classification (SIC) code.
* Based on an analysis of nonaccrual loans with book balances greater than $2 million.
Shared National Credit Program (SNC) loans comprised approximately 16 percent of total nonperforming loans at March 31, 2004 and 20 percent at December 31, 2003. SNC loans are facilities greater than $20 million shared by three or more federally supervised financial institutions which are reviewed by regulatory authorities at the agent bank level. SNC loans comprised approximately 15 percent and 14 percent of total loans at March 31, 2004 and December 31, 2003, respectively. Of the $92 million of loans greater than $2 million transferred to nonaccrual status in the first quarter of 2004, $7 million were SNC loans. SNC loans comprised approximately $6 million of first quarter 2004 total net charge-offs.
Net charge-offs for the first quarter of 2004 were $70 million, or 0.69 percent of average total loans, compared with $96 million, or 0.88 percent, for the first quarter of 2003. The carrying value of nonaccrual loans as a percentage of contractual value was 56 percent at March 31, 2004 and 58 percent at December 31, 2003. The provision for loan losses was $65 million for the first quarter of 2004, compared to $106 million for the same period in 2003.
Management currently expects continued improvement in credit quality throughout 2004, with a full-year 2004 average net charge-offs expected to be approximately 60 basis points.
Capital
Common shareholders’ equity was $5.1 billion at March 31, 2004, unchanged since December 31, 2003. Common shareholders’ equity in the first quarter 2004 was affected by the retention of $72 million of retained earnings (net income less cash dividends declared), the recognition of stock-based compensation and the effect of employee stock plan activity, which increased common shareholder’s equity by $6 million and $20 million, respectively; an $18 million increase in accumulated other comprehensive income resulting from a decrease in net unrealized losses on investment securities available-for-sale due to changes in the interest rate environment; and a $133 million reduction resulting from the repurchase of approximately 2.4 million common shares in the open market. See “Part II. Item 2. Changes in Securities and Use of Proceeds” for information regarding the Corporation’s stock repurchases.
28
The Corporation’s capital ratios exceed minimum regulatory requirements as follows:
At March 31, 2004, the Corporation and its banking subsidiaries exceeded the ratios required to be considered “well capitalized” (total risk-based capital, tier 1 risk-based capital and leverage ratios greater than 10 percent, 6 percent and 5 percent, respectively).
Critical Accounting Policies
The Corporation’s consolidated financial statements are prepared based on the application of accounting policies, the most significant of which are described in Note 1 to the consolidated financial statements included in the Corporation’s 2003 Annual Report, as updated in Note 1 to the unaudited consolidated financial statements in this report. These policies require numerous estimates and strategic or economic assumptions, which may prove inaccurate or subject to variations. Changes in underlying factors, assumptions or estimates could have a material impact on the Corporation’s future financial condition and results of operations. The most critical of these significant accounting policies are the policies for allowance for loan losses, pension plan accounting and goodwill. These policies are reviewed with the Audit and Legal Committee of the Corporation’s Board of Directors and are discussed more fully on pages 53-55 of the Corporation’s 2003 Annual Report. As of the date of this report, the Corporation does not believe that there has been a material change in the nature or categories of its critical accounting policies or its estimates and assumptions from those discussed in its 2003 Annual Report.
29
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
Net interest income is the predominant source of revenue for the Corporation. Interest rate risk arises primarily through the Corporation’s core business activities of extending loans and accepting deposits. The Corporation actively manages its material exposure to interest rate risk. Management attempts to evaluate the effect of movements in interest rates on net interest income and uses interest rate swaps and other instruments to manage its interest rate risk exposure. The primary tool used by the Corporation in determining its exposure to interest rate risk is net interest income simulation analysis. The net interest income simulation analysis performed at the end of each quarter reflects changes to both interest rates and loan, investment and deposit volumes. The measurement of risk exposure at March 31, 2004 for a decline in short-term interest rates to zero percent identified approximately $43 million, or two percent, of forecasted net interest income at risk over the next 12 months. If short-term interest rates rise 200 basis points, forecasted net interest income would be enhanced by approximately $93 million, or five percent. Corresponding measures of risk exposure at December 31, 2003 were approximately $41 million of net interest income at risk for a decline in rates to zero percent and an approximately $82 million enhancement of net interest income for a 200 basis point rise in rates. Corporate policy limits adverse change to no more than five percent of management’s most likely net interest income forecast and the Corporation is operating within this policy guideline.
Secondarily, the Corporation utilizes an economic value of equity analysis and a traditional interest sensitivity gap measure as alternative measures of interest rate risk exposure. At March 31, 2004, all three measures of interest rate risk were within established corporate policy guidelines.
At March 31, 2004, the Corporation had a $118 million portfolio of indirect (through funds) private equity and venture capital investments, and had commitments of $63 million to fund additional investments in future periods. The value of these investments is at risk to changes in equity markets, general economic conditions and a variety other factors. The majority of these investments are not marketable, and are reported in other assets. The investments are individually reviewed for impairment on a quarterly basis, by comparing the carrying value to the estimated fair value. The Corporation bases estimates of fair value for the majority of its indirect private equity and venture capital investments on the percentage ownership in the fair value of the entire fund, as reported by the fund management. In general, the Corporation does not have the benefit of the same information regarding the fund’s underlying investments as does fund management. Therefore, after indication that fund management adheres to accepted, sound and recognized valuation techniques, the Corporation generally utilizes the fair values assigned to the underlying portfolio investments by fund management. For those funds where fair value is not reported by fund management, the Corporation derives the fair value of the fund by estimating the fair value of each underlying investment in the fund. In addition to using qualitative information about each underlying investment, as provided by the fund management, the Corporation gives consideration to information pertinent to the specific nature of the debt or equity investment, such as relevant market conditions, offering prices, operating results, financial conditions, exit strategy, and other qualitative information, as available. The uncertainty in the economy and equity markets may continue to affect the values of the fund investments.
Certain components of the Corporation’s noninterest income, primarily fiduciary income and investment advisory revenue, are at risk to fluctuations in the market values of underlying assets, particularly equity securities. Other components of noninterest income, primarily brokerage fees, are at risk to changes in the level of market activity.
For further discussion of market risk, see Note 8 and pages 46-52 of the Corporation’s 2003 Annual Report.
ITEM 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures. The Corporation’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Corporation’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this quarterly report (the “Evaluation Date”). Based on the evaluation, such officers have concluded that, as of the Evaluation Date, the Corporation’s disclosure controls and procedures are effective.
(b) Changes in Internal Controls. During the period to which this report relates, there have not been significant deficiencies and/or material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to materially affect the registrant’s ability to record, process, summarize and report financial information. There have not been any significant changes in the Corporation’s internal controls or in other factors that could significantly affect such controls.
30
Forward-looking statements
This report includes forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. All statements regarding the Corporation’s expected financial position, strategies and growth prospects and general economic conditions expected to exist in the future are forward-looking statements. The words, “anticipates,” “believes,” “feels,” “expects,” “estimates,” “seeks,” “strives,” “plans,” “intends,” “outlook,” “forecast,” “position,” “target,” “mission,” “assume,” “achievable,” “potential,” “strategy,” “goal,” “aspiration,” “outcome,” “continue,” “remain,” “maintain,” “trend” and variations of such words and similar expressions, or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions as they relate to the Corporation or its management, are intended to identify forward-looking statements.
The Corporation cautions that forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Forward-looking statements speak only as of the date the statement is made, and the Corporation does not undertake to update forward-looking statements to reflect facts, circumstances, assumptions or events that occur after the date the forward-looking statements are made. Actual results could differ materially from those anticipated in forward-looking statements and future results could differ materially from historical performance.
In addition to factors mentioned elsewhere in this report or previously disclosed in the Corporation’s SEC reports (accessible on the SEC’s website at www.sec.gov or on the Corporation’s website at www.comerica.com), the following factors, among others, could cause actual results to differ materially from forward-looking statements and future results could differ materially from historical performance:
31
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings.
The Corporation and certain of its subsidiaries are subject to various pending or threatened legal proceedings, including certain purported class actions, arising out of the normal course of business or operations. In view of the inherent difficulty of predicting the outcome of such matters, the Corporation cannot state what the eventual outcome of these matters will be. However, based on current knowledge and after consultation with legal counsel, management does not believe that the amount of any resulting liability arising from these matters will have a material adverse effect on the Corporation’s consolidated financial condition or results of operations.
ITEM 2. Changes in Securities and Use of Proceeds
On December 1, 2003, the Corporation announced it would resume its share repurchase program pursuant to its August 2001 Board of Directors’ resolutions, authorizing the repurchase of up to 10 million shares of the Corporation’s outstanding common stock. On March 23, 2004, the Board of Directors of the Corporation authorized the additional purchase of up to 10 million shares of Comerica Incorporated outstanding common stock. All share repurchases under the Corporation’s share repurchase program are transacted in the open market and are within the scope of Rule 10b-18, which provides a safe harbor for purchases in a given day if an issuer of equity securities satisfies the manner, timing, price and volume conditions of the rule when purchasing its own common shares in the open market. The following table summarizes the Corporation’s share repurchase activity for the three months ended March 31, 2004.
* Total remaining share repurchase authorization includes the 10 million share repurchase resolution announced on March 23, 2004.
32
ITEM 6. Exhibits and Reports on Form 8-K
33
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: May 5, 2004
34
EXHIBIT INDEX
35