Commerce Bancshares - 10-K annual report

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commerce Bancshares, Inc. (the “Company”), a bank holding company as defined in the Bank Holding Company Act of 1956, as amended, was incorporated under the laws of Missouri on August 4, 1966. The Company presently owns all of the outstanding capital stock of three national banking associations, which are headquartered in Missouri (the “Missouri bank”), Kansas (the “Kansas bank”), and Nebraska (the “Nebraska bank”). The Nebraska bank is limited in its activities to the issuance of credit cards. The remaining two banking subsidiaries engage in general banking business, providing a broad range of retail, corporate, investment, trust, and asset management products and services to individuals and businesses. The Company also owns, directly or through its banking subsidiaries, various non-banking subsidiaries. Their activities include owning real estate leased to the Company’s banking subsidiaries, underwriting credit life and credit accident and health insurance, selling property and casualty insurance (relating to consumer loans made by the banking subsidiaries), venture capital investment, securities brokerage, mortgage banking, and leasing activities. The Company owns a second tier holding company that is the direct owner of both the Missouri and Kansas banks. A list of the Company’s subsidiaries is included as Exhibit 21.

 

The Company is the largest independent bank holding company in the lower Midwest. At December 31, 2006, the Company had consolidated assets of $15.2 billion, loans of $10.0 billion, deposits of $11.7 billion, and stockholders’ equity of $1.4 billion. All of the Company’s operations conducted by subsidiaries are consolidated for purposes of preparing the Company’s consolidated financial statements. The Company does not utilize unconsolidated subsidiaries or special purpose entities to provide off-balance sheet borrowings.

 

The Company’s philosophy is to grow and prosper, building long-term relationships based on top quality service, high ethical standards and safe, sound assets. The Company operates under a super-community banking format with a local orientation, augmented by experienced, centralized support in select critical areas. The Company’s local market orientation is reflected in its financial centers and regional advisory boards, which are comprised of local business persons, professionals and other community representatives, that assist the Company in responding to local banking needs. Despite this local market, community-based focus, the Company offers sophisticated financial products available at much larger financial institutions.

 

The Missouri bank is the Company’s largest, with total assets of $13.9 billion and comprising approximately 92% of the Company’s total banking assets. The bank’s facilities are located throughout Missouri, eastern Kansas, and central Illinois, including major markets in Peoria and Bloomington. The Kansas bank has total assets of $1.3 billion. It has significant operations and banking facilities in the areas of Wichita, Hays, Hutchinson, and Garden City, Kansas.

 

The markets these banks serve, being centrally located in the Midwest, provide natural sites for production and distribution facilities and also serve as transportation hubs. The economy has been well-diversified with many major industries represented, including telecommunications, automobile manufacturing, aircraft manufacturing, health care, numerous service industries, food production, and agricultural production and related industries. In addition, several of the Illinois markets are located in areas with some of the most productive farmland in the world. The banks operate in areas with stable real estate markets, which in the past have avoided the volatile prices that other parts of the country have experienced.

 

The Company regularly evaluates the potential acquisition of, and holds discussions with, various financial institutions eligible for bank holding company ownership or control. In addition, the Company regularly considers the potential disposition of certain of its assets and branches. The Company seeks merger or acquisition partners that are culturally similar and have experienced management and possess either significant market presence or have potential for improved profitability through financial management, economies of scale and expanded services. In July 2006, the Company acquired certain assets and assumed certain liabilities of the banking business of Boone National Savings and Loan Association, located in Columbia, Missouri. In September 2006, the Company completed the acquisition of the outstanding stock of West Pointe Bancorp, Inc., located in Belleville, Illinois, adjacent to St. Louis, Missouri. In December 2006,

the Company announced a merger agreement with South Tulsa Financial Corporation, Tulsa, Oklahoma, which is expected to be completed in the second quarter of 2007. Prior to 2006, the Company’s most recent acquisition was in January 2003 when it purchased The Vaughn Group, Inc., a direct equipment lessor based in Cincinnati, Ohio, with a portfolio of direct financing, sales type and operating leases. For additional information on acquisition and branch disposition activity, refer to pages 15 and 62.

 

The Company is managed in three operating segments. The Consumer segment includes the retail branch network, consumer installment lending, personal mortgage banking, bank card activities, student lending, and discount brokerage services. It provides services through a network of 204 full-service branches, a widespread ATM network of 400 machines, and the use of alternative delivery channels such as extensive online banking and telephone banking services. In 2006 this retail segment contributed 57% of total segment pre-tax income. The Commercial segment provides a full array of corporate lending, leasing, and international services, as well as business and government deposit and cash management services. In 2006 it contributed 35% of total segment pre-tax income. The Money Management segment provides traditional trust and estate tax planning services, and advisory and discretionary investment portfolio management services to both personal and institutional corporate customers. This segment also manages the Company’s family of proprietary mutual funds, which are available for sale to both trust and general retail customers. Fixed income investments are sold to individuals and institutional investors through the Capital Markets group, which is also included in this segment. At December 31, 2006 the Money Management segment managed investments with a market value of $11.5 billion and administered an additional $9.7 billion in non-managed assets. Additional information relating to operating segments can be found on pages 42 and 81.

 

 

The Company, as a bank holding company, is primarily regulated by the Board of Governors of the Federal Reserve System under the Bank Holding Company Act of 1956 (BHC Act). Under the BHC Act, the Federal Reserve Board’s prior approval is required in any case in which the Company proposes to acquire all or substantially all of the assets of any bank, acquire direct or indirect ownership or control of more than 5% of the voting shares of any bank, or merge or consolidate with any other bank holding company. The BHC Act also prohibits, with certain exceptions, the Company from acquiring direct or indirect ownership or control of more than 5% of any class of voting shares of any non-banking company. Under the BHC Act, the Company may not engage in any business other than managing and controlling banks or furnishing certain specified services to subsidiaries and may not acquire voting control of non-banking companies unless the Federal Reserve Board determines such businesses and services to be closely related to banking. When reviewing bank acquisition applications for approval, the Federal Reserve Board considers, among other things, each subsidiary bank’s record in meeting the credit needs of the communities it serves in accordance with the Community Reinvestment Act of 1977, as amended (CRA). The Missouri, Kansas and Nebraska bank charters have current CRA ratings of “outstanding”.

 

The Company is required to file with the Federal Reserve Board various reports and such additional information as the Federal Reserve Board may require. The Federal Reserve Board also makes regular examinations of the Company and its subsidiaries. The Company’s three banking subsidiaries are organized as national banking associations and are subject to regulation, supervision and examination by the Office of the Comptroller of the Currency (OCC). All banks are also subject to regulation by the Federal Deposit Insurance Corporation (FDIC). In addition, there are numerous other federal and state laws and regulations which control the activities of the Company and its banking subsidiaries, including requirements and limitations relating to capital and reserve requirements, permissible investments and lines of business, transactions with affiliates, loan limits, mergers and acquisitions, issuance of securities, dividend payments, and extensions of credit. If the Company fails to comply with these or other applicable laws and regulations, it may be subject to civil monetary penalties, imposition of cease and desist orders or other written directives, removal of management and, in certain circumstances, criminal penalties. This regulatory framework is

intended primarily for the protection of depositors and the preservation of the federal deposit insurance funds, and not for the protection of security holders. Statutory and regulatory controls increase a bank holding company’s cost of doing business and limit the options of its management to employ assets and maximize income.

 

In addition to its regulatory powers, the Federal Reserve impacts the conditions under which the Company operates by its influence over the national supply of bank credit. The Federal Reserve Board employs open market operations in U.S. government securities, changes in the discount rate on bank borrowings, changes in the federal funds rate on overnight inter-bank borrowings, and changes in reserve requirements on bank deposits in implementing its monetary policy objectives. These instruments are used in varying combinations to influence the overall level of the interest rates charged on loans and paid for deposits, the price of the dollar in foreign exchange markets and the level of inflation. The monetary policies of the Federal Reserve have a significant effect on the operating results of financial institutions, most notably on the interest rate environment in recent years. In view of changing conditions in the national economy and in the money markets, as well as the effect of credit policies of monetary and fiscal authorities, no prediction can be made as to possible future changes in interest rates, deposit levels or loan demand, or their effect on the financial statements of the Company.

 

Under Federal Reserve policy, the Company is expected to act as a source of financial strength to each of its bank subsidiaries and to commit resources to support each bank subsidiary in circumstances when it might not otherwise do so. In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary banks. In the event of a bank holding company’s bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment.

 

Substantially all of the deposits of the Company’s subsidiary banks are insured up to the applicable limits by the Bank Insurance Fund of the FDIC, generally up to $100,000 per insured depositor and up to $250,000 for retirement accounts. The banks pay deposit insurance premiums to the FDIC based on an assessment rate established by the FDIC for Bank Insurance Fund member institutions. The FDIC has established a risk-based assessment system under which institutions are classified and pay premiums according to their perceived risk to the federal deposit insurance funds. The FDIC is not required to charge deposit insurance premiums when the ratio of deposit insurance reserves to insured deposits is maintained above specified levels. During the past several years, the ratio has been above the minimum level and, accordingly, the Company has not been required to pay premiums. However, in 2006 legislation was passed reforming the bank deposit insurance system. The reform act allowed the FDIC to raise the minimum reserve ratio and allowed eligible insured institutions an initial one-time credit to be used against premiums due. As a result, beginning in 2007 the Company will be assessed insurance premiums, which in years 2007 and 2008 may be partly or totally offset by the one-time credit. The Company’s one-time credit is approximately $12 million.

 

The principal source of the Company’s cash revenues is dividends from the subsidiary banks. The Federal Reserve Board may prohibit the payment of dividends by bank holding companies if their actions constitute unsafe or unsound practices. The OCC limits the payment of dividends by bank subsidiaries in any calendar year to the net profit of the current year combined with the retained net profits of the preceding two years. Permission must be obtained from the OCC for dividends exceeding these amounts. The payment of dividends by the bank subsidiaries may also be affected by factors such as the maintenance of adequate capital.

 

The Company is required to comply with the capital adequacy standards established by the Federal Reserve. These capital adequacy guidelines generally require bank holding companies to maintain total capital equal to 8% of total risk-adjusted assets and off-balance sheet items (the “Total Risk-Based Capital Ratio”), with at least one-half of that amount consisting of Tier I, or core capital, and the remaining amount consisting of Tier II, or supplementary capital. Tier I capital for bank holding companies generally consists of the sum of common shareholders’ equity, qualifying non-cumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less goodwill and other non-qualifying intangible assets. Tier II capital generally consists of hybrid capital instruments, term subordinated debt and, subject to limitations, general allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics.

 

In addition, the Federal Reserve also requires bank holding companies to comply with minimum leverage ratio requirements. The leverage ratio is the ratio of a banking organization’s Tier I capital to its total consolidated quarterly average assets (as defined for regulatory purposes), net of the allowance for loan losses, goodwill and certain other intangible assets. The minimum leverage ratio for bank holding companies is 4%. At December 31, 2006 all of the subsidiary banks were “well-capitalized” under regulatory capital adequacy standards, as further discussed on page 85.

 

These laws and regulations are under constant review by various agencies and legislatures, and are subject to sweeping change. The Gramm-Leach-Bliley Financial Modernization Act of 1999 (GLB Act) contained major changes in laws that previously kept the banking industry largely separate from the securities and insurance industries. The GLB Act authorized the creation of a new kind of financial institution, known as a “financial holding company” and a new kind of bank subsidiary called a “financial subsidiary”, which may engage in a broader range of investment banking, insurance agency, brokerage, and underwriting activities. The GLB Act also included privacy provisions that limit banks’ abilities to disclose non-public information about customers to non-affiliated entities. Banking organizations are not required to become financial holding companies, but instead may continue to operate as bank holding companies, providing the same services they were authorized to provide prior to the enactment of the GLB Act.

 

In 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (The “USA Patriot Act”) was signed into law. The USA Patriot Act substantially broadened the scope of U.S. anti-money laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The U.S. Treasury Department issued a number of regulations implementing the USA Patriot Act that apply certain of its requirements to financial institutions such as the Company’s broker-dealer subsidiary. The regulations impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing.

 

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, a major reform of the bankruptcy system, was passed by Congress and signed into law by President Bush in April 2005. Changes instituted by this new law took effect on October 17, 2005. Under the new bankruptcy law, bankruptcy applicants who wish to file under Chapter 7 must meet certain eligibility requirements under a “means test”. While the immediate impact on the banking industry was a surge in bankruptcy filings in the fourth quarter of 2005, the long-term effect of the change is expected to be a reduction in bankruptcy filings, thereby limiting bankruptcy-related loan charge-offs.

 

The Company’s locations in regional markets throughout Missouri, Kansas and central Illinois face intense competition from hundreds of financial service providers. The Company competes with national and

state banks for deposits, loans and trust accounts, and with savings and loan associations and credit unions for deposits and consumer lending products. In addition, the Company competes with other financial intermediaries such as securities brokers and dealers, personal loan companies, insurance companies, finance companies, and certain governmental agencies. The passage of the GLB Act, which removed barriers between banking and the securities and insurance industries, has resulted in greater competition among these industries. The Company generally competes on the basis of customer services and responsiveness to customer needs, interest rates on loans and deposits, lending limits and customer convenience, such as location of offices.

 

The Company and its subsidiaries employed 4,478 persons on a full-time basis and 664 persons on a part-time basis at December 31, 2006. The Company provides a variety of benefit programs including a 401K plan as well as group life, health, accident, and other insurance. The Company also maintains training and educational programs designed to prepare employees for positions of increasing responsibility.

 

The Company’s principal offices are located at 1000 Walnut, Kansas City, Missouri (telephone number816-234-2000).The Company makes available free of charge, through its web site at www.commercebank.com, reports filed with the Securities and Exchange Commission as soon as reasonably practicable after the electronic filing. These filings include the annual report onForm 10-K,quarterly reports onForm 10-Q,current reports onForm 8-K,and all amendments to those reports.

 

The information required by Securities Act Guide 3 – “Statistical Disclosure by Bank Holding Companies” is located on the pages noted below.

 

 

Making or continuing an investment in securities issued by Commerce Bancshares, Inc., including our common stock, involves certain risks that you should carefully consider. The risks and uncertainties described below are not the only risks that may have a material adverse effect on the Company. Additional risks and uncertainties also could adversely affect our business and our results. If any of the following risks actually occur, our business, financial condition or results of operations could be negatively affected, the market price for your securities could decline, and you could lose all or a part of your investment. Further, to the extent that any of the information contained in this Annual Report onForm 10-Kconstitutes forward-looking statements, the risk factors set forth below also are cautionary statements identifying important

factors that could cause the Company’s actual results to differ materially from those expressed in any forward-looking statements made by or on behalf of Commerce Bancshares, Inc.

 

The Company’s success is heavily influenced by the general economic conditions of the states of Missouri, Kansas and central Illinois and the specific local markets in which the Company operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides banking and financial services to customers in such metropolitan areas as Kansas City, St. Louis, and Springfield in Missouri, Peoria and Bloomington in Illinois, and Wichita, Kansas. Since the Company does not have significant presence in other parts of the country, a prolonged economic downturn in these markets could have a material adverse effect on the Company’s financial condition and results of operations.

 

The Company’s net interest income is the largest source of overall revenue to the Company, representing 59% of total revenue. Interest rates are beyond the Company’s control, and they fluctuate in response to general economic conditions and the policies of various governmental and regulatory agencies, in particular, the Federal Reserve Board. Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the purchase of investments, the generation of deposits, and the rates received on loans and investment securities and paid on deposits. Management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on the Company’s results of operations. However, any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on the Company’s financial condition and results of operations.

 

The Company operates in the financial services industry, a rapidly changing environment having numerous competitors including other banks and insurance companies, securities dealers, brokers, trust and investment companies and mortgage bankers. The pace of consolidation among financial service providers is accelerating and there are many new changes in technology, product offerings and regulation. In the past 12 months there have been several new entrants into our markets offering competitive products. The Company must continue to make investments in its products and delivery systems to stay competitive with the industry as a whole or its financial performance may suffer.

 

The Company maintains an allowance for possible loan losses that represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. The level of the allowance reflects management’s continuing evaluation of industry concentrations, specific credit risks, loan loss experience, current loan portfolio quality, present economic, political and regulatory conditions, and unidentified losses inherent in the current loan portfolio. Historical losses have been low and the Company’s credit ratios trend above industry averages, in part due to the low level of commercial credit losses. The industry has experienced very low levels of credit loss for an extended period. Should these trends change and losses increase, the statement of operations would be negatively impacted. See the section captioned “Allowance for Loan Losses” in Item 7 Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the Company’s process for determining the appropriate level of the allowance for possible loan loss.

 

The Company relies heavily on communications and information systems to conduct its business, and as part of our business we maintain significant amounts of data about our customers and the products they use. While the Company has policies and procedures designed to prevent or limit the effect of failure, interruption

or security breach of its information systems, there can be no assurances that any such failures, interruptions or security breaches will not occur, or if they do occur, that they will be adequately addressed. Should any of these systems become compromised, the reputation of the Company could be damaged, relationships with existing customers impaired and result in lost business and incur significant expenses trying to remedy the compromise.

 

The Company’s success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities engaged in by the Company can be intense and the Company may not be able to hire people or to retain them. The unexpected loss of the services of one or more the Company’s key personnel could have a material adverse impact on the Company’s business because of their skills, knowledge of the Company’s market, years of industry experience, and the difficulty of promptly finding qualified replacement personnel.

 

None

 

The bank subsidiaries maintain their main offices in various multi-story office buildings. The Missouri bank owns its main offices and leases unoccupied premises to the public. The larger offices include:

 

 

The Nebraska credit card bank leases its offices in Omaha, Nebraska. Additionally, certain other installment loan, trust and safe deposit functions operate out of leased offices in downtown Kansas City. The Company has an additional 198 branch locations in Missouri, Illinois and Kansas which are owned or leased, and 150 off-site ATM locations.

 

The information required by this item is set forth in Item 8 under Note 18, Commitments, Contingencies and Guarantees on page 89.

 

No matters were submitted during the fourth quarter of 2006 to a vote of security holders through the solicitation of proxies or otherwise.

 

The following are the executive officers of the Company, each of whom is designated annually, and there are no arrangements or understandings between any of the persons so named and any other person pursuant to which such person was designated an executive officer.

 

 

The following table sets forth the high and low prices of actual transactions for the Company’s common stock (CBSH) and cash dividends paid for the periods indicated (restated for the 5% stock dividend distributed in December 2006).

 

 

Commerce Bancshares, Inc. common shares are listed on The Nasdaq Stock Market LLC (NASDAQ), a national securities exchange and highly-regulated electronic securities market comprised of competing Market Makers whose trading is supported by a communications network linking them to quotation dissemination, trade reporting, and order execution systems. The Company had 4,739 shareholders of record as of December 31, 2006.

 

The following graph presents a comparison of Company (CBSH) performance to the indices named below. It assumes $100 invested12/31/2001with dividends invested on a Total Return basis.

 

Effective December 31, 2006, the Company selected a different index, the Nasdaq Bank Stocks index, to compare with its cumulative five year Total Return. In prior years the Company has used the Nasdaq Financial Stocks index, which is comprised of various financial institutions, including insurance agents and carriers and security and commodity brokers. The Company believes the Nasdaq Bank Stocks index, comprised solely of bank holding companies and commercial banks, provides a better comparison and a more appropriate benchmark against which to measure stock performance. In accordance with SEC regulations, the graph above presents both indices for the five year period.

The following table sets forth information about the Company’s purchases of its $5 par value common stock, its only class of stock registered pursuant to Section 12 of the Exchange Act, during the fourth quarter of 2006.

 

 

The Company’s stock purchases shown above were made under a 5,000,000 share authorization by the Board of Directors on October 21, 2005. Under this authorization, 1,383,115 shares remained available for purchase at December 31, 2006. On February 2, 2007, the Company’s Board of Directors approved a new authorization for the purchase of up to 4,000,000 shares of Company common stock.

 

The required information is set forth below in Item 7.

 

 

Commerce Bancshares, Inc. (the Company) operates as a super-community bank offering an array of sophisticated financial products delivered with high-quality, personal customer service. It is the largest bank holding company headquartered in Missouri, with its principal offices in Kansas City and St. Louis, Missouri. Customers are served from approximately 350 locations in Missouri, Kansas, and Illinois, using delivery platforms which include an extensive network of branches and ATM machines, full-featured online banking, and a central contact center.

 

The core of the Company’s competitive advantage is its focus on the local markets it services and its concentration on relationship banking, with high service levels and competitive products. In order to enhance shareholder value, the Company grows its core revenue by expanding new and existing customer relationships, utilizing improved technology, and enhancing customer satisfaction.

 

Various indicators are used by management in evaluating the Company’s financial condition and operating performance. Among these indicators are the following:

 

 

 

The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes. The historical trends reflected in the financial information presented below are not necessarily reflective of anticipated future results.

 

 

 

The Company’s fully diluted earnings per share amounted to $3.09 in 2006 compared to $3.01 in 2005, an increase of 2.7%. Net income for 2006 was $219.8 million, a 1.5% decline compared to 2005. The return on average assets amounted to 1.54% compared to 1.60% last year and the return on average equity totaled 15.96% compared to 16.19% last year. The efficiency ratio was 60.55% in 2006 compared with 59.30% in 2005.

 

Financial results for 2006 compared to 2005 included an increase in net interest income, growth in non-interest income, and a lower loan loss provision. These positive effects on net income were offset by higher non-interest expense and income tax expense. Net interest income increased $11.5 million, or 2.3%, reflecting the effects of higher average overall rates earned on loans and growth in average loan balances, partly offset by declining average balances in investment securities. Also, interest expense on deposit accounts and short-term borrowings rose, mainly related to increases in interest rates on virtually all deposit accounts and borrowings, coupled with growth in certificate of deposit balances. Non-interest income rose $20.4 million, or 6.0%, largely due to increases of 10.0% in bank card fees, 2.2% in deposit account fees, and 5.7% in trust revenues. Non-interest expense grew 5.8%, mainly the result of higher salaries and benefits (up 5.5%), with additional increases of 6.5% in occupancy, 10.6% in equipment, and 5.7% in data processing and software costs. The provision for loan losses decreased $3.1 million to $25.6 million, reflecting lower credit card and personal banking loan net charge-offs, partly offset by lower business loan net recoveries. Income tax expense increased 10.1% in 2006 and resulted in an effective tax rate of 32.1%, which increased from a tax rate of 29.7% in the prior year. The increase in income tax expense in 2006 occurred largely because tax benefits of $13.7 million, representing the effects of certain corporate restructuring initiatives, were recognized in 2005 and these benefits did not recur in 2006.

 

The increase in net income in 2005 compared to 2004 was due to growth in non-interest income and an improving net interest margin, combined with effective expense management and a lower loan loss provision. Non-interest income rose $14.3 million, or 4.4%, largely due to increases of 10.3% in bank card fees, 7.2% in deposit account fees, and 6.3% in trust revenues. The growth in non-interest expense was constrained to 2.8%, mainly the result of lower costs for supplies and communications (down 1.2%), coupled with increases in salaries and benefits (up 2.9%) and modest increases in occupancy, equipment, and data processing and software costs. Net interest income increased $4.4 million, reflecting similar trends in interest rates and loan growth mentioned above. The provision for loan losses decreased $1.6 million to $28.8 million, reflecting lower business loan net charge-offs, partly offset by higher credit card and personal banking net loan charge-offs. Income tax expense increased 3.9% in 2005 and resulted in an effective tax rate of 29.7%, which was comparable to 29.2% in the prior year. Income tax expense in 2005 included the recognition of tax benefits of $13.7 million mentioned above, which compared to $18.9 million of similar benefits recorded in 2004.

 

On July 21, 2006, Commerce Bank, N.A., (Missouri) (the Bank) a subsidiary of the Company, acquired certain assets and assumed certain liabilities comprising the banking business of Boone National Savings and Loan Association (Boone) through a purchase and assumption agreement, paying a cash premium of $16 million. Boone operated four branches in Columbia, Missouri, and loan production offices in Ashland and Lake Ozark, Missouri. The Bank acquired loans and deposits of $126.4 million and $100.9 million, respectively, and assumed debt of $26.7 million. Goodwill of $15.6 million, core deposit premium of $2.6 million, and $300 thousand of mortgage servicing rights were recorded as a result of the transaction.

 

On September 1, 2006, the Company completed the acquisition of the common stock of West Pointe Bancorp, Inc. (West Pointe) in Belleville, Illinois. West Pointe was purchased for $13.1 million in cash and

1.4 million shares of Company stock valued at $67.5 million. The Company’s acquisition of West Pointe was accounted for as a purchase and added $508.8 million in assets (including $255.0 million in loans), $381.8 million in deposits, and five branch locations. Intangible assets recognized as a result of the transaction consisted of approximately $37.0 million of goodwill, $17.4 million of core deposit premium, and $531 thousand of mortgage servicing rights.

 

The Boone and West Pointe transactions discussed above are collectively referred to as “bank acquisitions” throughout the remainder of this report.

 

On December 4, 2006, the Company and South Tulsa Financial Corporation (South Tulsa) signed a definitive merger agreement in which the Company will acquire all outstanding shares of South Tulsa. Simultaneously, South Tulsa’s wholly-owned subsidiary, Bank South, will merge into the Bank. The Company’s acquisition of South Tulsa will add approximately $124 million in assets (including $107 million in loans), $101 million in deposits, and two branch locations in Tulsa, Oklahoma. The acquisition will result in the Company’s first full-service banking facilities in Oklahoma.

 

The Company continually evaluates the profitability of its network of bank branches throughout Missouri, Kansas and Illinois. As a result of this evaluation process, the Company may periodically sell the assets and liabilities of certain branches, or may sell the premises of specific banking facilities. In 2006, the Company sold three bank facilities, realizing pre-tax gains of $579 thousand on the sales. The Company sold four bank facilities during 2005 and three facilities during 2004. The gains and losses realized on the sales of those premises in 2005 and 2004 were not significant. Also during 2004, the Company sold a bank branch with loans of $12.9 million and deposits of $16.5 million, realizing a pre-tax gain of $1.1 million.

 

The Company distributed a 5% stock dividend for the thirteenth consecutive year on December 13, 2006. All per share and average share data in this report has been restated to reflect the 2006 stock dividend.

 

The Company’s consolidated financial statements are prepared based on the application of certain accounting policies, the most significant of which are described in Note 1 to the consolidated financial statements. Certain of these policies require numerous estimates and strategic or economic assumptions that may prove inaccurate or be subject to variations which may significantly affect the Company’s reported results and financial position for the period or in future periods. The use of estimates, assumptions, and judgments are necessary most often when financial assets and liabilities are required to be recorded at, or adjusted to reflect, fair value. Assets and liabilities carried at fair value inherently result in more financial statement volatility. Fair values and the information used to record valuation adjustments for certain assets and liabilities are based on either quoted market prices or are provided by other independent third-party sources, when available. When such information is not available, management estimates valuation adjustments primarily by using internal cash flow and other financial modeling techniques. Changes in underlying factors, assumptions, or estimates in any of these areas could have a material impact on the Company’s future financial condition and results of operations.

 

The Company has identified several policies as being critical because they require management to make particularly difficult, subjectiveand/orcomplex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for loan losses, the valuation of certain non-marketable investments, and accounting for income taxes.

 

The Company performs periodic and systematic detailed reviews of its loan portfolio to assess overall collectability. The level of the allowance for loan losses reflects the Company’s estimate of the losses inherent in the loan portfolio at any point in time. While these estimates are based on substantive methods for determining allowance requirements, actual outcomes may differ significantly from estimated results, especially when determining allowances for business, lease, construction and business real estate loans. These loans are normally larger and more complex, and their collection rates are harder to predict. Personal loans, including personal mortgage, credit card and consumer loans, are individually smaller and perform in a more homogenous manner, making loss estimates more predictable. Further explanation of the

methodologies used in establishing the allowance is provided in the Allowance for Loan Losses section of this discussion.

 

The Company, through its direct holdings and its Small Business Investment subsidiaries, has numerous private equity and venture capital investments, which totaled $44.1 million at December 31, 2006. These private equity and venture capital securities are reported at fair value. The values assigned to these securities where no market quotations exist are based upon available information and management’s judgment. Although management believes its estimates of fair value reasonably reflect the fair value of these securities, key assumptions regarding the projected financial performance of these companies, the evaluation of the investee company’s management team, and other economic and market factors may affect the amounts that will ultimately be realized from these investments.

 

The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences, including the effects of IRS examinations and examinations by other state agencies, could materially impact the Company’s financial position and its results of operations. Further discussion of income taxes is presented in the Income Taxes section of this discussion and in Note 9 on Income Taxes in the consolidated financial statements.

 

Net interest income, the largest source of revenue, results from the Company’s lending, investing, borrowing, and deposit gathering activities. It is affected by both changes in the level of interest rates and changes in the amounts and mix of interest earning assets and interest bearing liabilities. The following table summarizes the changes in net interest income on a fully taxable equivalent basis, by major category of interest earning assets and interest bearing liabilities, identifying changes related to volumes and rates. Changes not solely due to volume or rate changes are allocated to rate.

 

 

Net interest income was $513.2 million in 2006, representing an increase of $11.5 million, or 2.3%, compared to $501.7 million in 2005. Net interest income increased $4.4 million, or less than 1.0%, in 2005 compared to $497.3 million in 2004. The increase in net interest income in 2006 was the result of growth of $144.3 million in tax equivalent loan interest income as a result of higher rates and higher average balances, partly offset by a decline of $18.1 million in tax equivalent interest earned on investment securities due primarily to lower average balances. Interest expense incurred on deposits increased $105.5 million, or 78.3%, due to higher rates and higher average balances. Additionally, interest expense on federal funds purchased and repurchase agreements increased $21.4 million primarily due to increased rates. These increases in interest expense were partially offset by a $3.6 million decrease in interest expense on other borrowings caused by a decrease in volume, which had a greater impact than the increase in interest rate. The increase in rates on both interest earning assets and interest bearing liabilities was the result of increases in the federal funds rate initiated by the Federal Reserve throughout 2005 and 2006. As a result of these rate changes and the change in the mix of assets and liabilities on the Company’s balance sheet, the net yield on interest earning assets was 3.92% in 2006 compared to 3.89% in 2005, remaining fairly constant during these periods.

 

During 2005, net interest income increased over 2004 primarily as a result of growth in loan interest income resulting from higher rates and higher average balances, partly offset by increases in interest expense due to increases in interest rates. The rise in interest rates was due to the increases in the federal funds rate initiated by the Federal Reserve throughout 2005. Yields on earning assets increased 73 basis points over 2004, while rates paid on deposits increased 47 basis points and rates paid on borrowings increased 172 basis points. As a result, the Company’s net interest margin increased to 3.89% from 3.81% in 2004.

 

Total interest income in 2006 was $832.3 million compared to $697.6 million in 2005 and $610.1 million in 2004. Interest income increased in 2006 by $134.7 million, or 19.3%, as a result of a $144.3 million increase in tax equivalent loan interest income, offset slightly by an $18.1 million decrease in interest income from investment securities. The tax equivalent average yield on interest earning assets was 6.32% in 2006 compared to 5.40% in 2005, representing a 92 basis point increase. Interest income on loans increased in 2006 over 2005 as a result of a 98 basis point increase in the average yield, coupled with an $859.9 million, or 10.0%, increase in average balances. The increase in average loan balances resulted from growth in the Company’s business and consumer lending products. Approximately $137.1 million of the increase in average loan balances was the result of bank acquisitions in 2006, which contributed $10.2 million to interest income earned on loans in 2006. Excluding the impact of the acquisitions, the increase in average loan balances compared to 2005 was $722.8 million, or 8.4%. The increase in interest income on loans was offset by a decrease in interest income on investment securities. The average yield on investment securities increased 36 basis points, which was offset by a $763.5 million, or 17.7%, decrease in investment securities average balances, resulting in an overall decrease of $18.1 million in interest income earned on the investment portfolio in 2006 compared to 2005. The Company has funded its loan growth principally by reducing its investment securities portfolio through both maturities and sales, in addition to growth in its overall deposit base.

 

Interest expense increased $123.2 million, or 62.9%, in 2006 compared to 2005 and was impacted by the rising rate environment noted above. Interest expense on deposits increased $105.5 million, or 78.3%, in 2006 over the previous year as a result of a 92 basis point average rate increase, coupled with a $607.9 million, or 6.2%, growth in average interest bearing deposit balances. Approximately $147.8 million of the increase in average interest bearing deposit balances was a result of bank acquisitions in 2006. Bank acquisitions incurred $5.1 million of deposit interest expense in 2006. Excluding the impact of bank acquisitions, the increase in average interest bearing deposits compared to 2005 was $460.1 million, or 4.7%. Average rates paid on interest checking and money market accounts increased 63 basis points in 2006 compared to 2005, while the average balances remained largely unchanged at $6.7 billion during 2006 and 2005. Excluding the 2006 bank acquisitions, these balances would have declined 1.1% from 2005. The average rate paid on certificates of deposit increased 128 basis points in 2006. The average balances of certificates of deposit increased $645.6 million, or 23.7%, from $2.7 billion in 2005 to $3.4 billion in 2006. Approximately $88.3 million of the increase in average certificates of deposit was due to the bank acquisitions in 2006. Additionally, interest expense on federal funds purchased and repurchase agreements increased $21.4 million, or 43.8%, resulting primarily from an increase of 179 basis points in rates paid. Average borrowings of federal funds purchased and repurchase agreements declined 9.6% primarily due to a decrease in federal funds purchased as a result of lower liquidity needs, offset by growth in average repurchase agreement balances. Contributing to the increase in repurchase agreements was the addition of $500.0 million in structured repurchase agreements which were purchased in the third quarter of 2006 to mitigate the risk of falling interest rates. Interest rates paid on interest bearing deposits and short-term borrowings will continue to be impacted by the changing interest rate environment as the Company competes for funding sources to support loan growth.

 

Total interest income increased $87.5 million, or 14.3%, in 2005 compared to 2004. The increase was primarily due to an increase in loan yields coupled with an increase in average loan balances, offset slightly by reduced interest income from investment securities. Average loan balances increased $431.4 million, or 5.3%, during 2005 compared to 2004 and this growth generated $22.0 million of interest income. The increase in average loan balances, coupled with an 86 basis point increase in rates, increased tax equivalent interest income by $96.2 million.

 

The average rate incurred on interest bearing liabilities was 1.65% in 2005 compared to 1.00% in 2004. Interest expense on deposits increased $53.0 million in 2005 over 2004 as a result of a 47 basis point average rate increase coupled with 9.2% growth in average interest bearing deposit balances. Average rates paid on premium money market accounts increased 99 basis points, and both average rates and average balances of short-term certificates of deposit increased. Additionally, interest expense on borrowings grew by $30.2 million, resulting mainly from an increase in rates of 184 basis points on federal funds purchased.

 

The provision for loan losses was $25.6 million in 2006, compared with $28.8 million in 2005 and $30.4 million in 2004. The $3.1 million decline in the 2006 provision for loan losses reflected lower personal banking loan net charge-offs and lower credit card net charge-offs. The provision for loan losses is recorded to bring the allowance for loan losses to a level deemed adequate by management based on the factors mentioned in the following “Allowance for Loan Losses” section of this discussion.

 

 

Non-interest income was $361.6 million in 2006, which was a $20.4 million, or 6.0%, increase over 2005. In 2006, deposit account fees rose $2.5 million, or 2.2%, as a result of higher deposit account overdraft fees, which grew $3.7 million, or 4.7%. This growth was partly offset by lower cash management fee income and lower deposit account service charges. The growth in overdraft fees was mainly due to higher unit prices, partly offset by lower transaction volumes. The decline in corporate cash management fees continued to be affected by the higher interest rate environment, which tends to reduce cash fees paid by corporate customers. Bank card fees rose $8.6 million, or 10.0% overall, primarily due to solid growth in corporate card and debit card fee income, which grew by 21.8% and 17.5%, respectively. The strong growth in corporate card fees was attributable to transaction fees from commercial businesses and non-profit enterprises who are utilizing these electronic transactions in greater proportions. Debit card transaction fees continue to grow as a result of greater utilization by consumers and acceptance by retail business, which increased volumes. Trust fees increased $3.9 million, or 5.7%, due to a 5.2% increase in private client account fees and a 6.4% increase in corporate and institutional trust account fees. Sales efforts in 2006 resulted in new annualized fees of $4.5 million for private client trust accounts and $1.5 million for corporate and institutional trust accounts. Total trust assets, which are the basis upon which fees are charged, grew to $21.2 billion, an increase of 7.7%. Bond trading income fell $1.5 million due to lower sales of fixed income securities to bank and corporate customers, while consumer brokerage income was relatively flat. Loan fees and sales decreased by $2.3 million as gains on sales of student loans declined from $8.0 million in 2005 to $6.3 million

in 2006, and fewer transactions occurred. Net gains on securities transactions amounted to $9.0 million, which was an increase of $2.7 million over the previous year. Included in these amounts were realized gains and fair value adjustments on venture capital and private equity investments, which totaled $8.3 million in 2006 compared to $1.3 million recorded in 2005. In addition, during 2006, the Company recorded a gain of $2.8 million on the sale of MasterCard Inc. restricted shares, which was partly offset by a $2.1 million loss on the sale of mortgage and asset-backed securities. Other non-interest income rose $6.6 million, which included growth of $2.2 million in operating lease-related income, in addition to $1.2 million in non-recurring income from a Parent company equity investment. Higher sweep fees and check sales income were also recorded.

 

In 2005, non-interest income increased $14.3 million, or 4.4%, to $341.2 million, and included net securities gains of $6.4 million in 2005 compared to $11.1 million in 2004. Excluding these net securities gains, non-interest income grew 6.0%. In 2005, deposit account fees increased 7.2%, or $7.6 million, due to a $15.5 million increase in overdraft and return item fees, partly offset by a $4.9 million decline in fees earned on commercial cash management accounts. The growth in overdraft and return item fees over 2004 was the result of increasing transaction volumes during 2005 and pricing changes initiated in the third quarter of 2005. The decline in corporate cash management fee income was largely the effect of the rising interest rate environment. Compared to 2004, bank card fees increased $8.1 million, or 10.3%, mainly due to higher fees earned on debit, credit and corporate card transactions, which grew by 14.3%, 10.3% and 16.3%, respectively. Trust fees increased $4.1 million, or 6.3%, as a result of increasing market values of trust account assets and new business, occurring largely in private client trust product lines. Trading account fees, consisting of fees from sales of fixed income securities, declined 21.5% in 2005 due to lower demand by business and correspondent bank customers. Consumer brokerage service fees increased slightly, mainly due to higher revenues from mutual fund and insurance sales, partly offset by lower annuity sales. Loan fees and sales declined $816 thousand as gains on student loan sales declined from $8.5 million in 2004 to $8.0 million in 2005. Net gains on securities transactions amounted to $6.4 million in 2005, which was a decrease of $4.7 million compared to the previous year. During 2005, the Company sold available for sale securities totaling $1.8 billion and recorded net gains of $5.1 million. These sales were comprised mainly of $533.9 million in U.S. government agency securities, $768.4 million in asset-backed securities, and $359.1 million in inflation-indexed treasury securities. Also included in 2005 activity were net gains of $1.3 million recognized on fair value adjustments and sales of private equity investments.

 

 

Non-interest expense rose 5.8% in 2006 to a total of $525.4 million, compared to $496.5 million in 2005. In total, salaries and benefits expense grew $15.1 million, or 5.5%, due to normal merit increases and higher costs for incentive compensation, medical insurance, and payroll taxes. In addition, the effects of the

previously mentioned bank acquisitions increased salaries and benefits by approximately $2.4 million in 2006. Partly offsetting these increases was a decline in stock-based compensation of $1.8 million, which resulted from the 2006 adoption of FAS 123R estimated forfeiture accounting requirements and a slightly longer vesting period for 2006 grants. FAS 123R is discussed further in the note on Stock-Based Compensation and Directors Stock Purchase Plan in the consolidated financial statements. Net occupancy costs grew $2.7 million, or 6.5%, compared to the prior year, mainly as a result of a full year of depreciation, real estate taxes and utilities expense incurred on two office buildings purchased in 2005, in addition to costs related to several branch facilities constructed during 2006. These increases were partly offset by lower net rent expense as certain banking offices were moved from leased facilities to the new buildings and office space was leased to outside tenants. In addition, in 2006, the Company recorded an asbestos abatement obligation on an office building in downtown Kansas City, which increased occupancy expense by $854 thousand. Equipment expense increased $2.5 million, or 10.6%, mainly due to higher equipment depreciation expense and the relocation of a check processing function in 2006. Data processing and software expense increased $2.7 million, or 5.7%, due to higher bank card processing fees, online banking fees and software amortization expense. Software amortization expense increased mainly due to the installation of new data system applications, while bank card processing fees increased commensurate with the increase in bank card fee income mentioned above. Smaller variances occurred in marketing, which increased slightly, while lower telephone and network costs resulted in a reduction in supplies and communication expense of $672 thousand. Other non-interest expense increased $6.6 million due to increases in legal and professional fees, operating lease depreciation, foreclosed property expense (related to a single property acquired and subsequently sold in 2006) and minority interest expense relating to investment gains recorded by venture capital affiliates. Partly offsetting these increases were lower processing losses and bank card fraud losses.

 

In 2005, non-interest expense was $496.5 million, an increase of $13.8 million, or 2.8%, over 2004. Compared with the prior year, salary and employee benefits expense increased $7.7 million, or 2.9%, as a result of higher staff salaries expense, partly offset by declines in retirement and medical insurance costs. Net occupancy expense rose 2.7% over the prior year, mainly as a result of higher depreciation and utilities expense on two new office buildings mentioned above. These increases were partly offset by lower net rent expense. Equipment expense increased 1.3%, with the slight increase due to higher costs for small equipment purchases and maintenance contract expense. Data processing costs increased $2.2 million, or 4.9%, due to higher bank card processing costs and higher online banking processing fees, partly offset by lower software license fees. Marketing expense increased only $606 thousand, or 3.6%, compared to the previous year. Other non-interest expense increased $2.3 million, or 3.9%, over the prior year mainly due to increases in proprietary mutual fund expense subsidies, bank card fraud losses, and minority interest expense relating to investment gains recorded by venture capital affiliates. These increases were partly offset by decreases in loan collection expense and professional fees, in addition to higher capitalized loan costs.

 

Income tax expense was $103.9 million, compared to $94.3 million in 2005 and $90.8 million in 2004. Income tax expense in 2006 increased 10.1% over 2005, compared to a 1.9% increase in pre-tax income. The effective tax rate on income from operations was 32.1%, 29.7% and 29.2% in 2006, 2005 and 2004, respectively. The Company’s effective tax rates were lower than the federal statutory rate of 35% mainly due to tax exempt interest on state and municipal obligations, state and federal tax credits realized and, in 2005 and 2004, the recognition of additional tax benefits from various corporate reorganization initiatives. These tax benefits amounted to $13.7 million in 2005, compared to similar tax benefits of $18.9 million in 2004. Such tax benefits did not reoccur in 2006.

 

 

A schedule of average balances invested in each category of loans appears on page 48. Classifications of consolidated loans by major category at December 31 for each of the past five years are as follows:

 

 

The contractual maturities of loan categories at December 31, 2006, and a breakdown of those loans between fixed rate and floating rate loans are as follows:

 

 

Total period end loans at December 31, 2006 were $10.0 billion, an increase of $1.1 billion, or 11.9%, over balances at December 31, 2005. Loan growth came principally from business, construction, business real estate, personal real estate and consumer loans, as demand for loan products remained solid during 2006. The 2006 bank acquisitions also contributed to the higher loan balances, adding approximately $361.3 million to the year end 2006 balance, consisting mainly of business loans ($64.3 million), construction loans

($75.8 million), business real estate loans ($125.1 million), and personal real estate loans ($68.6 million). Excluding these acquired loans, business loans grew $268.7 million, or 10.6%, and business real estate loans grew $104.1 million, or 5.4%, both mainly as a result of new customer activity and added borrowings from existing customers. Lease balances, included in the business category, increased $41.1 million, or 18.6%, compared with the previous year end balance. Construction loans rose $157.8 million, or 37.2%. Consumer loans grew $128.8 million, or 10.0%, during the year mainly as a result of continued growth in marine and recreational vehicle lending. Personal real estate loans grew by $66.3 million, or 4.9%. Credit card loans increased $55.9 million, or 9.4%, and saw solid growth, especially at year end when holiday activity is normally at its peak. Home equity loans decreased to $441.9 million, a decline of $6.7 million, or 1.5%, during 2006 due to lower activity in the housing market. Student loans declined by $66.5 million, or 20.1%, mainly due to planned loan sales from the portfolio, greater numbers of loan payoffs, and consolidations with other lenders during 2006.

 

Period end loans increased $593.8 million, or 7.1%, in 2005 compared to 2004, resulting from increases in business, business real estate and consumer loans.

 

The Company currently generates approximately 33% of its loan portfolio in the St. Louis regional market and 28% in the Kansas City regional market. The portfolio is diversified from a business and retail standpoint, with 57% in loans to businesses and 43% in loans to consumers. A balanced approach to loan portfolio management and an historical aversion toward credit concentrations, from an industry, geographic and product perspective, have contributed to low levels of problem loans and loan losses.

 

Total business loans amounted to $2.9 billion at December 31, 2006 and include loans used mainly to fund customer accounts receivable, inventories, and capital expenditures. This portfolio also includes sales type and direct financing leases totaling $262.4 million, which are used by commercial customers to finance capital purchases ranging from computer equipment to office and transportation equipment. These leases comprise 2.6% of the Company’s total loan portfolio. Business loans are made primarily to customers in the regional trade area of the Company, generally the central Midwest, encompassing the states of Missouri, Kansas, Illinois, and nearby Midwestern markets, including Iowa, Oklahoma and Indiana. The portfolio is diversified from an industry standpoint and includes businesses engaged in manufacturing, wholesaling, retailing, agribusiness, insurance, financial services, public utilities, and other service businesses. Emphasis is upon middle-market and community businesses with known local management and financial stability. The Company participates in credits of large, publicly traded companies when business operations are maintained in the local communities or regional markets and opportunities to provide other banking services are present. Consistent with management’s strategy and emphasis upon relationship banking, most borrowing customers also maintain deposit accounts and utilize other banking services. There were net loan recoveries in this category of $823 thousand in 2006 compared to net recoveries of $3.0 million in 2005, mainly due to two smaller lease-related recoveries in 2006 compared to a single large recovery in 2005. Non-accrual business loans were $5.8 million (.2% of business loans) at December 31, 2006 compared to $5.9 million at December 31, 2005. Included in these totals were lease-related loans of $1.2 million and $2.8 million at December 31, 2006 and 2005, respectively. Opportunities for growth in business loans will be based upon strong solicitation efforts in a highly competitive market environment for quality loans. Asset quality is, in part, a function of management’s consistent application of underwriting standards and credit terms through stages in economic cycles. Therefore, portfolio growth in 2007 will be dependent upon 1) the strength of the economy, 2) the actions of the Federal Reserve with regard to targets for economic growth, interest rates, and inflationary tendencies, and 3) the competitive environment.

 

The portfolio of loans in this category amounted to $658.1 million at December 31, 2006 and comprised 6.6% of the Company’s total loan portfolio. This group of loans includes residential construction loans totaling $182.9 million at December 31, 2006, or 28% of the category, and commercial construction and land development loans totaling $475.2 million, or 72%. These loans are predominantly made to businesses in

the local markets of the Company’s banking subsidiaries. Commercial construction loans are made during the construction phase for small and medium-sized office and medical buildings, manufacturing and warehouse facilities, apartment complexes, shopping centers, hotels and motels, and other commercial properties. Exposure to larger speculative office properties remains low. Residential construction and land development loans are primarily for projects located in the Kansas City and St. Louis metropolitan areas. Credit losses in this portfolio are normally low, as there were net charge-offs of $62 thousand in 2006 and there were no net charge-offs in 2005. At year end 2006, construction non-accrual loans were $120 thousand, while there were no construction loans in non-accrual status at year end 2005.

 

Total business real estate loans were $2.1 billion at December 31, 2006 and comprised 21.6% of the Company’s total loan portfolio. This category includes mortgage loans for small and medium-sized office and medical buildings, manufacturing and warehouse facilities, shopping centers, hotels and motels, and other commercial properties. Emphasis is placed on owner-occupied and income producing commercial real estate properties which present lower risk levels. The borrowersand/or the properties are generally located in the local and regional markets of the affiliate banks. At December 31, 2006, non-accrual balances amounted to $9.8 million, or .5% of the loans in this category, compared to $3.1 million at year end 2005. The Company experienced net recoveries of $36 thousand in 2006 compared to net charge-offs of $497 thousand in 2005.

 

At December 31, 2006, there were $1.5 billion in outstanding personal real estate loans, which comprised 15.0% of the Company’s total loan portfolio. The mortgage loans in this category are extended, predominately, for owner-occupied residential properties. The Company originates both adjustable rate and fixed rate mortgage loans. The Company retains adjustable rate mortgage loans, and may from time to time retain certain fixed rate loans (typically15-yearfixed rate loans) as directed by its Asset/Liability Management Committee. Other fixed rate loans in the portfolio have resulted from previous bank acquisitions. At December 31, 2006, 63% of the portfolio was comprised of adjustable rate loans while 37% was comprised of fixed rate loans. Levels of mortgage loan origination activity declined in 2006 compared to 2005, with originations of $352 million in 2006 compared with $367 million in 2005. Growth in mortgage loan originations was limited in 2006 as a result of the rising interest rate environment, slower housing starts, and lower resales within the Company’s markets. The Company typically does not experience significant loan losses in this category. There were net charge-offs of $92 thousand in 2006 compared to $30 thousand in 2005. The non-accrual balances of loans in this category increased to $384 thousand at December 31, 2006, compared to $261 thousand at year end 2005. The five year history of net charge-offs in the personal real estate loan category reflects nominal losses, and the credit quality of these loans is considered to be strong.

 

A portion of this portfolio, certain fixed rate loans, is categorized as held for sale. These are generally sold in the secondary market within three months of origination. Such loans were $14.8 million and $6.2 million at December 31, 2006 and 2005, respectively.

 

Total personal banking loans, which include consumer, revolving home equity and student loans, totaled $2.1 billion at December 31, 2006 and increased 3.6% during 2006. These categories comprised 21.5% of the total loan portfolio at December 31, 2006. Consumer loans consist of auto, marine, recreational vehicle (RV) and fixed rate home equity loans, and totaled $1.4 billion at year end 2006. Approximately 65% are originated indirectly from auto and other dealers, while the remaining 35% are direct loans made to consumers. Approximately 42% of the consumer portfolio consists of automobile loans, 35% in marine and RV loans and 9% in fixed rate home equity lending.

 

Revolving home equity loans, of which 98% are adjustable rate loans, totaled $441.9 million at year end 2006. An additional $646.7 million was outstanding in unused lines of credit, which can be drawn at the discretion of the borrower. Home equity loans are secured mainly by second mortgages (and less frequently, first mortgages) on residential property of the borrower. The underwriting terms for the home equity line

product permit borrowing availability, in the aggregate, generally up to 80% or 90% of the appraised value of the collateral property, although a small percentage may permit borrowing up to 100% of appraised value. Given reasonably stable real estate values over time, the collateral margin improves with the regular amortization of mortgages against the properties.

 

The Company originates loans to students attending colleges and universities, which totaled $263.8 million at year end 2006. These loans are categorized as held for sale and are normally sold to the secondary market when the students graduate and the loans enter into repayment status. Primary markets are the Missouri Higher Education Loan Authority and Sallie Mae. Nearly all of these loans are based on a variable rate.

 

Net charge-offs for total personal banking loans were $6.2 million in 2006 compared to $8.8 million in 2005. Net charge-offs decreased to .30% of average personal banking loans in 2006 compared to .43% in 2005. The decline in net charge-offs in 2006 compared to 2005 was mainly the result of higher bankruptcies and related personal banking loan charge-offs in the fourth quarter of 2005, corresponding with new bankruptcy legislation which took effect during the same quarter.

 

Total credit card loans amounted to $648.3 million at December 31, 2006 and comprised 6.5% of the Company’s total loan portfolio. The credit card portfolio is concentrated within regional markets served by the Company. The Company offers a variety of credit card products, including affinity cards, rewards cards, and standard and premium credit cards. It emphasizes its credit card relationship product, Special Connections, which allows the customer ATM access to their deposit accounts using the same card. The Company has found this product to be more profitable by incurring fewer credit losses than other card products, and it allows for better cross sale into other bank products. Approximately 61% of the households in Missouri that own a Commerce credit card product also maintain a deposit relationship with a subsidiary bank. Approximately 80% of the outstanding credit card loans have a floating interest rate. Net charge-offs amounted to $17.9 million in 2006, which was a $6.6 million decrease from 2005. The decrease in credit card loan net charge-offs occurred mainly due to the bankruptcy legislation mentioned above. The ratio of net loan charge-offs to total average loans of 3.0% in 2006 and 4.4% in 2005 remained below national loss averages. The Company refrains from national pre-approved mailing techniques which have caused some of the problems experienced by credit card issuers.

 

The Company has an established process to determine the amount of the allowance for loan losses, which assesses the risks and losses inherent in its portfolio. This process provides an allowance consisting of an allocated and an unallocated component. To determine the allocated component of the allowance, the Company combines estimates of the reserves needed for loans evaluated on an individual basis with estimates of reserves needed for pools of loans with similar risk characteristics.

 

Loans subject to individual evaluation are defined by the Company as impaired, and generally consist of commercial and commercial real estate loans on non-accrual status or graded substandard and delinquent 60 days or more. These loans are evaluated individually for the impairment of repayment potential and collateral adequacy, and in conjunction with current economic conditions and loss experience, allowances are estimated. Loans not individually evaluated are aggregated and reserves are recorded using a consistent methodology that considers historical loan loss experience by loan type, delinquencies, current economic factors, loan risk ratings and industry concentrations. Although management has allocated a portion of the allowance to specific loan categories, the adequacy of the allowance must be considered in its entirety.

 

The Company’s estimate of the allowance for loan losses and the corresponding provision for loan losses rests upon various judgments and assumptions made by management. Factors that influence these judgments include past loan loss experience, current loan portfolio composition and characteristics, trends in

portfolio risk ratings, levels of non-performing assets, prevailing regional and national economic conditions, and the Company’s ongoing examination process including that of its regulators. The Company has internal credit administration and loan review staffs that continuously review loan quality and report the results of their reviews and examinations to the Company’s senior management and Board of Directors. Such reviews also assist management in establishing the level of the allowance. The Company’s subsidiary banks continue to be subject to examination by the Office of the Comptroller of the Currency (OCC) and examinations are conducted throughout the year targeting various segments of the loan portfolio for review. In addition to the examination of subsidiary banks by the OCC, the parent holding company and its non-bank subsidiaries are examined by the Federal Reserve Bank.

 

The allowance for loan losses was $131.7 million and $128.4 million at December 31, 2006 and 2005, respectively, and was 1.32% and 1.44% of loans outstanding. The decline in the percentage of the allowance to loans outstanding resulted from loan growth compared to the allowance, which grew slightly in 2006. The increase in allowance resulted from bank acquisitions in 2006, which added $3.7 million to the allowance. Credit quality remained high during 2006, evidenced by a decrease in net loan charge-offs from 2005.

 

Net charge-offs totaled $26.1 million in 2006, and decreased $6.7 million, or 20.4%, compared to $32.7 million in 2005. The decrease primarily related to decreases in net personal loan charge-offs of $2.6 million and net credit card loan charge-offs of $6.6 million, offset by a $2.2 million increase in net business loan charge-offs. The decrease in personal and credit card net charge-offs was partially a result of the accelerated bankruptcies experienced in 2005 caused by the change in the bankruptcy laws. The higher bankruptcies in the fourth quarter of 2005 led to lower charge-offs in the personal and credit card portfolio in the first two quarters of 2006. Personal and credit card loan net charge-offs were returning to normal levels in the third and fourth quarter of 2006. The increase in business loan net charge-offs was due to lower recoveries in 2006 than in 2005, primarily the result of one large recovery in 2005 of $2.4 million. The ratio of net charge-offs to average loans outstanding in 2006 was .28% compared to .38% in 2005 and .41% in 2004. The provision for loan losses was $25.6 million, compared to a provision of $28.8 million in 2005 and $30.4 million in 2004.

 

Approximately 68.5% of total net loan charge-offs during 2006 were related to credit card loans. Net credit card charge-offs decreased to 3.0% of average credit card loans in 2006 compared to 4.4% in 2005. The decrease was a result of higher bankruptcies claimed in 2005 due to the new bankruptcy legislation discussed above. The delinquency rate on credit card loans at year end 2006 was 3.1% compared to 2.8% at year end 2005.

 

The Company considers the allowance for loan losses of $131.7 million adequate to cover losses inherent in the loan portfolio at December 31, 2006.

 

The schedule which follows summarizes the relationship between loan balances and activity in the allowance for loan losses:

 

 

The following schedule provides a breakdown of the allowance for loan losses by loan category and the percentage of each loan category to total loans outstanding at year end:

 

 

Management reviews the loan portfolio continuously for evidence of problem loans. During the ordinary course of business, management becomes aware of borrowers that may not be able to meet the contractual requirements of loan agreements. Such loans are placed under close supervision with consideration given to placing the loan on non-accrual status, the need for an additional allowance for loan loss, and (if appropriate) partial or full loan charge-off. Loans are placed on non-accrual status when management does not expect to collect payments consistent with acceptable and agreed upon terms of repayment. Loans that are 90 days past due as to principaland/orinterest payments are generally placed on non-accrual, unless they are both well-secured and in the process of collection, or they are 1-4 family first mortgage loans or consumer loans that are exempt under regulatory rules from being classified as non-accrual. Accrual of interest on consumer installment loans is suspended when any payment of principal or interest is more than 120 days delinquent. Credit card loans and the related accrued interest are charged off when the receivable is more than 180 days past due. After a loan is placed on non-accrual status, any interest previously accrued but not yet collected is reversed against current income. Interest is included in income only as received and only after all previous loan charge-offs have been recovered, so long as management is satisfied there is no impairment of collateral values. The loan is returned to accrual status only when the borrower has brought all past due principal and interest payments current and, in the opinion of management, the borrower has demonstrated the ability to make future payments of principal and interest as scheduled.

 

The following schedule shows non-performing assets and loans past due 90 days and still accruing interest.