Commerce Bancshares - 10-Q quarterly report FY

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Washington, D.C. 20549

For the transition period from                   to                                     

Commission File No. 0-2989

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(Exact name of registrant as specified in its charter)

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.

Large accelerated filer X         Accelerated filer              Non-accelerated filer      

March 31, 2006 (Unaudited)

      The accompanying consolidated financial statements include the accounts of Commerce Bancshares, Inc. and all majority-owned subsidiaries (the Company). The consolidated financial statements in this report have not been audited. All significant intercompany accounts and transactions have been eliminated. Certain reclassifications were made to 2005 data to conform to current year presentation. In the opinion of management, all adjustments necessary to present fairly the financial position and the results of operations for the interim periods have been made. All such adjustments are of a normal recurring nature. The results of operations for the three month period ended March 31, 2006 are not necessarily indicative of results to be attained for the full year or any other interim periods.

      The significant accounting policies followed in the preparation of the quarterly financial statements are disclosed in the 2005 Annual Report on Form 10-K.

      On April 4, 2006, Commerce Bank, N.A., (Missouri) (the Bank) a subsidiary of the Company, entered into an agreement with Boone National Savings and Loan Association (Boone) whereby the Bank will acquire the banking businesses of Boone. Boone operates four branches in Columbia, Missouri, and loan production offices in Ashland and Lake Ozark, Missouri. Under the terms of the agreement, the Bank will acquire loans and deposits of approximately $132 million and $108 million, respectively, assume other liabilities of approximately $30 million, and will pay a purchase price premium of approximately $16 million. Pending regulatory approval, the transaction is expected to close in July 2006.

      On April 13, 2006, the Company and West Pointe Bancorp, Inc. (West Pointe) signed a definitive merger agreement in which West Pointe will merge with the Company in a transaction valued at $80.9 million in stock and cash. Simultaneously, West Pointe’s wholly-owned subsidiary, West Pointe Bank And Trust Company, will merge into the Bank. The Company’s acquisition of West Pointe will add approximately $477 million in assets (including $256 million in loans), $402 million in deposits, and five branch locations and 25 ATMs in St. Clair County, Illinois (Southwestern Illinois region of Metropolitan St. Louis).

      Under terms of the agreement, shareholders of West Pointe will be entitled to elect to receive either cash or stock, with the cash portion of the transaction not to exceed 25% of the total consideration. Elections will be subject to proration procedures. It is anticipated that the transaction will be completed either late in the third quarter or in the fourth quarter of 2006, pending regulatory approvals and certain closing conditions. As part of the transaction, West Pointe has granted the Company an option to purchase 19.9% of its common stock under certain conditions.

      Major classifications of loans at March 31, 2006 and December 31, 2005 are as follows.

      Held for sale loans consisted of certain fixed rate residential mortgage loans, included in the “Real estate-personal” category above, and student loans. Total held for sale loans outstanding amounted to $337,742,000 at March 31, 2006 and $336,410,000 at December 31, 2005.

      The following is a summary of the allowance for loan losses for the three months ended March 31, 2006 and 2005.

      Investment securities, at fair value, consist of the following at March 31, 2006 and December 31, 2005.

      Available for sale equity securities included short-term investments in money market mutual funds of $93,226,000 at March 31, 2006 and $111,736,000 at December 31, 2005. Equity securities also included

FNMA and other corporate preferred stock of $29,700,000 at March 31, 2006 and $36,850,000 at December 31, 2005.

      Non-marketable securities included securities held for debt and regulatory purposes, which amounted to $45,014,000 and $45,417,000 at March 31, 2006 and December 31, 2005, respectively, in addition to venture capital and private equity investments, which amounted to $39,260,000 and $31,836,000 at the respective dates.

      The following table presents information about the Company’s intangible assets which have estimable useful lives.

      The Company does not have any intangible assets that are not currently being amortized. Aggregate amortization expense on intangible assets was $1,000 and $381,000, respectively, for the three month periods ended March 31, 2006 and 2005. Estimated annual amortization expense for the years 2006 through 2010 is as follows.

      The Company, as a provider of financial services, routinely issues financial guarantees in the form of financial and performance standby letters of credit. Standby letters of credit are contingent commitments issued by the Company generally to guarantee the payment or performance obligation of a customer to a third party. While these represent a potential outlay by the Company, a significant amount of the commitments may expire without being drawn upon. The Company has recourse against the customer for any amount it is required to pay to a third party under a standby letter of credit. The letters of credit are subject to the same credit policies, underwriting standards and approval process as loans made by the Company. Most of the standby letters of credit are secured and in the event of nonperformance by the customers, the Company has rights to the underlying collateral, which could include commercial real estate, physical plant and property, inventory, receivables, cash and marketable securities.

      Upon issuance of standby letters of credit, the Company recognizes a liability equivalent to the amount of fees received from the customer, which at March 31, 2006 amounted to $6,283,000. This amount will be amortized into income over the life of the commitment. The contract amount of these letters of credit, which represents the maximum potential future payments guaranteed by the Company, was $423,729,000 at March 31, 2006.

      The Company guarantees payments to holders of certain trust preferred securities issued by a wholly owned grantor trust. The securities are due in 2030 and may be redeemed beginning in 2010. The maximum potential future payments guaranteed by the Company, which include future interest and principal payments through maturity, was approximately $14,410,000 at March 31, 2006. At March 31,

2006, the Company had a recorded liability of $4,036,000 in principal and accrued interest to date, representing amounts owed to the security holders.

      The amount of net pension cost (income) for the three months ended March 31, 2006 and 2005 is as follows:

      Substantially all benefits under the Company’s defined benefit pension plan were frozen effective January 1, 2005. During the first three months of 2006, the Company made no funding contributions to its defined benefit pension plan, and made minimal funding contributions to a supplemental executive retirement plan (the CERP), which carries no segregated assets. The Company has no plans to make any further contributions, other than those related to the CERP, during the remainder of 2006. The income recognized for the defined benefit pension plan for the first three months of 2006 was primarily due to the greater than expected return on plan assets for the year ended September 30, 2005 (the valuation date).

      Presented below is a summary of the components used to calculate basic and diluted earnings per share.

      The Company’s only component of other comprehensive income (loss) during the periods presented below was the unrealized holding gains and losses on available for sale securities.

      The Company segregates financial information for use in assessing its performance and allocating resources among three operating segments. The Consumer segment includes the retail branch network, consumer finance, bank card, student loans, and discount brokerage services. The Commercial segment provides corporate lending, leasing, and international services, as well as business, government deposit, and cash management services. The Money Management segment provides traditional trust and estate tax planning services, and advisory and discretionary investment management services.

      The following table presents selected financial information by segment and reconciliations of combined segment totals to consolidated totals. There were no material intersegment revenues among the three segments. Management periodically makes changes to methods of assigning costs and income to its business segments to better reflect operating results. If appropriate, these changes are reflected in prior year information presented below.

      The information presented above was derived from the internal profitability reporting system used by management to monitor and manage the financial performance of the Company. This information is based on internal management accounting policies, which have been developed to reflect the underlying economics of the businesses. The policies address the methodologies applied in connection with funds transfer pricing and assignment of overhead costs among segments. Funds transfer pricing was used in the determination of net interest income by assigning a standard cost (credit) for funds used (provided) by assets and liabilities based on their maturity, prepayment and/or repricing characteristics.

      The performance measurement of the operating segments is based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institu-

tion. The information is also not necessarily indicative of the segments’ financial condition and results of operations if they were independent entities.

      The Company’s interest rate risk management strategy includes the ability to modify the re-pricing characteristics of certain assets and liabilities so that changes in interest rate do not adversely affect the net interest margin and cash flows. Interest rate swaps are used on a limited basis as part of this strategy. At March 31, 2006, the Company had entered into two interest rate swaps with a notional amount of $15,069,000, which are designated as fair value hedges of certain fixed rate loans. The Company also sells swap contracts to customers who wish to modify their interest rate sensitivity. These swaps are offset by matching contracts purchased by the Company from other financial institutions. Because of the matching terms of the offsetting contracts, the effect of these transactions on net income is minimal. The notional amount of these types of swaps at March 31, 2006 was $144,626,000.

      Through its International Department, the Company enters into foreign exchange contracts consisting mainly of contracts to purchase or deliver foreign currencies for customers at specific future dates. Also, mortgage loan commitments and forward sales contracts result from the Company’s mortgage banking operation, in which fixed rate personal real estate loans are originated and sold to other institutions.

      The Company’s derivative instruments are listed below.

      For the first quarter of 2006 income tax expense amounted to $25,846,000, compared to $26,032,000 in the first quarter of 2005. The effective income tax rate for the Company was 32.8% in the current quarter compared to 34.3% in the same quarter last year.

      During 2005 and previous years, stock-based awards were issued to key employees under several stock option and award plans, all of which had been approved by shareholders. During this period, awards were comprised of stock options and restricted stock. At December 31, 2005, these plans were replaced by the Company’s 2005 Equity Incentive Plan which was approved by shareholders on April 20, 2005. The new plan allows for issuance of various types of awards, including stock options, stock appreciation rights, restricted stock and restricted stock units, performance awards and stock-based awards. During the first quarter of 2006, stock-based compensation was issued in the form of stock appreciation rights (SARs) and restricted stock, and at March 31, 2006, 3,723,295 shares remained available for issuance under the new plan. The stock-based compensation expense that has been charged against income was $799,000 in the first three months of 2006 and $2,773,000 in the first three months of 2005. The total income tax benefit recognized in the income statement for share-based compensation arrangements was $300,000 in the first

three months of 2006 and $1,041,000 in the first three months of 2005. The decline in stock-based compensation occurred because of a change in the vesting period of certain awards granted in the first quarter of 2006, in addition to the effects of the forfeiture accounting requirements of Statement of Financial Accounting Standards No. 123 (revised), “Share-Based Payment”, both of which are discussed below.

      In determining compensation cost, the Black-Scholes option-pricing model is used to estimate the fair value of options and SARs on date of grant. The Black-Scholes model is a closed-end model that uses the assumptions in the following table. Expected volatility is based on historical volatility of the Company’s stock and a consideration of other factors. The Company uses historical exercise behavior and other factors to estimate the expected term of the options and SARs, which represents the period of time that the options and SARs granted are expected to be outstanding. The risk-free rate for the expected term is based on the U.S. Treasury zero coupon spot rates in effect at the time of grant.

      Below are the fair values of SARs and stock options granted, using the Black-Scholes option-pricing model, during the first three months of 2006 and 2005, including the model assumptions for those grants. SARs and stock options were granted with an exercise price equal to the market price of the Company’s stock at the date of grant and have10-year contractual terms. SARs, which were granted for the first time in 2006, vest on a graded basis over 4 years of continuous service. All SARs must be settled in stock under provisions of the plan. Stock options, which were granted in 2005 and previous years, vest on a graded basis over 3 years of continuous service.

      A summary of option activity during the first three months of 2006 is presented below.

      A summary of SAR activity during the first three months of 2006 is presented below.

      Additional information about stock options exercised is presented below. The SARs granted during the first quarter of 2006 are not exercisable until 2007.

      Restricted stock is awarded to key employees, by action of the Board of Directors. These awards generally vest after 5 years of continued employment. There are restrictions as to transferability, sale, pledging, or assigning, among others, prior to the end of the 5 year vesting period. Dividend and voting rights are conferred upon grant. A summary of the status of the Company’s restricted stock awards, or nonvested shares, as of March 31, 2006, and changes during the three month period then ended is presented below.

      As of March 31, 2006, there was $4,634,000 of total unrecognized compensation cost related to restricted nonvested shares. That cost is expected to be recognized over a weighted-average period of 3.6 years. The total fair value (at vest date) of shares vested during the three month periods ended March 31, 2006 and 2005 was $1,297,000 and $1,127,000, respectively.

      The Company adopted Financial Accounting Statement No. 123R on January 1, 2006. As a result of adoption, the Company recorded a reduction of $543,000 in stock-based compensation expense in the first quarter of 2006. This adjustment resulted from a change by the Company from its former policy of recognizing the effect of forfeitures only as they occurred to the Statement’s requirement to estimate the number of outstanding instruments for which the requisite service is not expected to be rendered. The adjustment was not considered to be material to the Company’s financial statements and, accordingly, was not presented separately as the cumulative effect of a change in accounting principle in the accompanying consolidated income statement.

      The Company has a stock repurchase program under which 5,000,000 shares of common stock were authorized for repurchase by the Board of Directors in October 2005. At March 31, 2006, 3,074,293 shares remain available to be purchased under this authorization. A portion of shares repurchased during the next twelve months will be used to satisfy share option exercises, which are expected to range from 700,000 to 800,000 shares.

      On April 21, 2006, the Company sold a parking garage, which included some retail space, located in downtown Kansas City. The sale price was $1,600,000, and a gain of $1,330,000 was recognized.

      The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes and with the statistical information and financial data appearing in this report as well as the Company’s 2005 Annual Report on Form 10-K. Results of operations for the three month period ended March 31, 2006 are not necessarily indicative of results to be attained for any other period.

      This report may contain “forward-looking statements” that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of the Company. This could cause results or performance to differ materially from those expressed in the forward-looking statements. Words such as “expects”, “anticipates”, “believes”, “estimates”, variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements. Readers should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed throughout this report. Forward-looking statements speak only as of the date they are made. The Company does not undertake to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made or to reflect the occurrence of unanticipated events. Such possible events or factors include: changes in economic conditions in the Company’s market area, changes in policies by regulatory agencies, governmental legislation and regulation, fluctuations in interest rates, changes in liquidity requirements, demand for loans in the Company’s market area, and competition with other entities that offer financial services.

      The Company’s consolidated financial statements are prepared based on the application of certain accounting policies, some of which 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 current period or future periods. The use of estimates, assumptions, and judgments are necessary 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, subjective and/or complex 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 discussion of the methodologies used in establishing the allowance is provided in the Provision and 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 $43.9 million at March 31, 2006. These private equity and venture capital securities are reported at estimated fair values in the absence of readily ascertainable fair values. 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.

      For the quarter ended March 31, 2006, net income amounted to $52.9 million, an increase of $3.1 million, or 6.2%, over the first quarter of the previous year. For the current quarter, the annualized return on average assets was 1.57%, the annualized return on average equity was 16.14%, and the efficiency ratio was 61.66%. The increase in net income over the first quarter of last year resulted mainly from an increase in net interest income of 1.9%, while non-interest income, excluding net securities gains, grew by 12.9%. Additionally, the provision for loan losses was $4.4 million for the quarter, while non-interest expense grew by 4.9%. Diluted earnings per share was $.78, an increase of 13.0% over $.69 per share in the first quarter of 2005.

      On April 4, 2006, Commerce Bank, N.A., (Missouri) (the Bank) a subsidiary of the Company, entered into an agreement with Boone National Savings and Loan Association (Boone) whereby the Bank will acquire the banking businesses of Boone. Boone operates four branches in Columbia, Missouri, and loan production offices in Ashland and Lake Ozark, Missouri. Under the terms of the agreement, the Bank will acquire loans and deposits of approximately $132 million and $108 million, respectively, assume other liabilities of approximately $30 million, and will pay a purchase price premium of approximately $16 million. Pending regulatory approval, the transaction is expected to close in July 2006.

      On April 13, 2006, the Company and West Pointe Bancorp, Inc. signed a definitive merger agreement in which West Pointe will merge with the Company in a transaction valued at $80.9 million in stock and cash. Simultaneously, West Pointe’s wholly-owned subsidiary, West Pointe Bank And Trust Company, will merge into the Bank. The Company’s acquisition of West Pointe will add approximately $477 million in assets (including $256 million in loans), $402 million in deposits, and five branch locations and 25 ATMs in St. Clair County, Illinois (Southwestern Illinois region of Metropolitan St. Louis).

      Under terms of the agreement, shareholders of West Pointe will be entitled to elect to receive either cash or stock, with the cash portion of the transaction not to exceed 25% of the total consideration. Elections will be subject to proration procedures. It is anticipated that the transaction will be completed either late in the third quarter or in the fourth quarter of 2006, pending regulatory approvals and certain closing conditions. As part of the transaction, West Pointe has granted the Company an option to purchase 19.9% of its common stock under certain conditions.

      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 for the first quarter of 2006 was $123.7 million, a 1.9% increase over the first quarter of 2005. The increase in net interest income was the result of higher rates earned on loans coupled with loan growth, partially offset by an increase in rates incurred on interest bearing deposits and short-term borrowings. Additionally, net interest income was decreased due to a reduction in investment securities income resulting from lower average balances, partially offset by higher rates earned. The net interest rate margin was 3.97% for the first quarter of 2006, compared to 3.79% in the first quarter of 2005 and 3.97% in the fourth quarter of 2005.

      Total interest income increased $27.8 million, or 17.3%, over the first quarter of 2005. The increase was the result of a 100 basis point increase in rates earned on loans and a $646.2 million increase in

average loan balances. The growth in average loans occurred mainly due to increases of $296.2 million in business loans and $213.1 million in business real estate loans. The increase in rates earned on loans contributed a $22.3 million increase in tax equivalent income in the first quarter of 2006. The rate increase was a result of a 200 basis point rate increase initiated by the Federal Reserve throughout 2005 and an additional 50 basis point increase initiated by the Federal Reserve in the first quarter of 2006. The increase in interest income earned on loans was partially offset by decreases in interest income on investment securities primarily due to a reduction in average balances of investment securities. Compared to the first quarter of 2005, investment securities declined on average by $957.9 million as maturities and pay downs were used to fund loan growth and reduce borrowings. This resulted in a decrease in tax equivalent interest income from securities of $8.0 million, which was partially offset by a 54 basis point increase in the average rate earned. The average tax equivalent yield on interest earning assets was 6.03% in the first quarter of 2006 compared to 5.02% in the first quarter of 2005.

      Total interest expense increased $25.5 million, or 64.8%, compared to the first quarter of 2005, primarily due to an 84 basis point increase in average rates paid on interest bearing deposits coupled with an increase in average balances. Certificates of deposit of less than $100,000 increased $216.5 million in average balances and incurred a 108 basis point increase in the average interest rate, resulting in an increase to interest expense of approximately $6.3 million. The average balance of certificates of deposit of $100,000 and over increased $307.1 million and the average interest rate increased 153 basis points, resulting in an increase in interest expense of $6.8 million. The increase in the average balance of certificates of deposit was a result of various campaigns and strategies to raise deposits to fund loan growth and reduce borrowings. Additionally, a 55 basis point increase in average rates paid on interest checking and money market accounts resulted in an increase in interest expense of approximately $9.2 million. Average balances of federal funds purchased and securities sold under agreements to repurchase decreased $428.2 million in the first quarter of 2006 compared to the first quarter of 2005, and incurred a 185 basis point increase in the interest rates. This resulted in a net increase of $3.2 million in interest expense. Increases in rates incurred on interest bearing liabilities were a result of the rate increases initiated by the Federal Reserve discussed above. Average rates incurred on all interest bearing liabilities increased to 2.25% in the first quarter of 2006 compared to 1.36% in the first quarter of 2005.

      Summaries of average assets and liabilities and the corresponding average rates earned/paid appear on the last page of this discussion.

     For the first quarter of 2006, total non-interest income amounted to $89.4 million compared with $80.7 million in the same quarter last year, which was an increase of $8.8 million, or 10.9%. Excluding net securities gains, non-interest income grew 12.9% over the same period last year. This growth over last year was mainly the result of higher deposit account fees, bank card fees and trust fee income. Deposit account fees in the first quarter of 2006 increased $3.2 million, or 13.2%, over the same quarter last year as a result of growth in deposit account overdraft fees, which grew $3.7 million, or 23.6%, this year. This growth over last year was the result of increasing transaction volumes during the year and pricing changes initiated in the third quarter of 2005. Offsetting this growth was a slight decline in corporate cash management fee income which continues to be affected by an increasing interest rate environment. Bank card fees for the quarter increased $2.2 million, or 11.3%, over the same period last year, primarily resulting from higher fees earned on debit, credit and corporate card transactions, which grew by 19.3%, 4.6% and 33.4%, respectively. Trust fees for the quarter increased $1.4 million, or 8.7%, compared to the same period last year mainly as a result of higher fees on both personal and institutional trust accounts. Bond trading income decreased slightly, while consumer brokerage services revenue declined $436 thousand, or 15.4%, mainly due to lower fixed annuity commissions. Loan fees and sales revenue increased $303 thousand, or 8.8%, mainly due to gains on the sales of student loans, which totaled $2.7 million in the first quarter of 2006 and compares with $2.3 million in the same period last year. Other non-interest income for the quarter included income from leasing activities which grew $1.1 million over the same quarter last year, and the receipt of $1.2 million in non-recurring income from a parent company equity investment.

      Net securities gains in the first quarter of 2006 amounted to $2.4 million compared with net securities gains of $3.6 million in the same period last year. The current quarter gains related entirely to realized gains and fair value adjustments on certain private equity investments held by the Company’s majority-owned venture capital subsidiaries. Minority interest pertaining to this income totaled $714 thousand and was reported in other non-interest expense. There were no other realized gains or losses on the Company’s investment securities portfolio.

      Non-interest expense for the first quarter of 2006 amounted to $130.0 million, an increase of $6.0 million, or 4.9%, compared with $123.9 million recorded in the first quarter of last year. Compared with the first quarter of last year, salaries and benefits expense increased $1.5 million, or 2.2%, mainly due to normal merit increases, higher incentives, payroll taxes and medical insurance costs. Full-time equivalent employees increased to 4,863 at March 31, 2006 compared to 4,836 at March 31, 2005. In the first quarter of previous years, the Company’s practice was to grant stock options to certain Company employees. This year, the Company issued stock appreciation rights with a slightly longer vesting period. This vesting change, combined with the adoption of FAS 123R estimated forfeiture accounting requirements, resulted in a reduction in stock-based compensation of $2.0 million. FAS 123R is discussed further in the Stock-Based Compensation note to the consolidated financial statements. Occupancy costs grew $1.2 million, or 12.3%, over the same period last year, mainly as a result of additional depreciation expense on two new office buildings and an impairment charge on a branch that is expected to be sold. Data processing and software costs increased $938 thousand, or 8.2%, mainly as a result of higher costs for bank card and online banking

processing fees. Smaller increases occurred in costs for equipment, supplies and communication, and marketing. Other non-interest expense increased $1.5 million, or 9.9%, over the same quarter last year primarily due to increases in travel and entertainment costs, charitable contributions and minority interest expense on venture capital investment gains.

     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. The Company combines estimates of the reserves needed for loans evaluated on an individual basis for impairment with estimates of the reserves needed for pools of loans with similar risk characteristics. This process to determine reserves uses such tools as the Company’s “watch loan list” and actual loss experience to identify both individual loans and pools of loans and the amount of reserves that are needed. Additionally, management determines the amount of reserves necessary to offset credit risk issues associated with loan concentrations, economic uncertainties, industry concerns, adverse market changes in estimated or appraised collateral values, and other subjective factors.

      In using this process and the information available, management must consider various assumptions and exercise considerable judgment to determine the overall level of the allowance for loan losses. Because of these subjective factors, actual outcomes of inherent losses can differ from original estimates. The process of determining adequate levels of the allowance for loan losses is subject to regular review by the Company’s Credit Administration personnel and outside regulators.

      Net loan charge-offs were $4.4 million in the first three months of 2006, compared to $12.8 million in the fourth quarter of 2005 and $3.8 million in the first quarter of 2005. Total annualized net charge-offs for the first three months of 2006 were .20% of total average loans, compared to ..58% in the fourth quarter of 2005 and .18% in the first quarter of 2005. Compared to the fourth quarter of 2005, net charge-offs were down this quarter due to a decrease in personal banking and credit card loan net charge-offs and an increase in business loan recoveries.

      For the first quarter of 2006, net charge-offs on average credit card loans amounted to 2.63%, compared with 6.02% in the fourth quarter of 2005 and 3.41% in the first quarter of 2005. Personal banking loan net charge-offs amounted to .32% of average personal banking loans this quarter compared to .68% in the fourth quarter of 2005 and .39% in the first quarter of 2005. Consistent with industry trends, higher charge-off levels occurred in the fourth quarter of 2005 in personal banking and credit card loans when the new bankruptcy legislation took effect.

      The provision for loan losses was $4.4 million in the first three months of 2006, compared to $2.4 million in the same period in 2005 and $12.0 million in the fourth quarter of 2005. The amount of the provision to expense in each quarter was determined by management’s review and analysis of the adequacy of the allowance for loan losses, involving all the activities and factors described above regarding that process. For comparative purposes, the provision in the first quarter of 2006 was $2.1 million higher than in the first quarter of 2005, but $7.5 million lower than the provision in the fourth quarter of 2005. For a similar comparison of net charge-offs, first quarter 2006 was $609 thousand higher than first quarter of 2005, but $8.4 million lower than net charge-offs during the fourth quarter of 2005. The increased expense in the fourth quarter of 2005 was greatly influenced by the high volume of bankruptcies experienced in that period, as discussed above.

      The allowance for loan losses at March 31, 2006 was $128.5 million, or 1.41% of total outstanding loans compared to $128.4 million, or 1.44%, at December 31, 2005 and $131.0 million, or 1.56%, at March 31, 2005. The decrease in the allowance for loan losses at March 31, 2006 compared to March 31, 2005 is a result of increased credit quality. The Company considers the allowance for loan losses adequate to cover losses inherent in the loan portfolio at March 31, 2006.

      The following table presents non-performing assets and loans which are past due 90 days and still accruing interest. Non-performing assets include non-accruing loans and foreclosed real estate. 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 principal and/or interest 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.

      Non-accrual loans, which are also considered impaired, totaled $8.8 million at March 31, 2006, and declined $8.6 million from March 31, 2005 and $1.1 million from December 31, 2005. The decline from March 31, 2005 was the result of decreases occurring in 2005 in non-accrual business real estate, business and lease-related loans. The decline from December 31, 2005 resulted mainly from a decrease in business and lease-related non-accrual loans. Lease-related loans comprised 27.8% of the March 31, 2006 non-accrual loan total, with the remainder primarily relating to other business loans (27.6%) and business real estate loans (34.2%).

      Total loans past due 90 days or more and still accruing interest amounted to $15.3 million as of March 31, 2006, which was $684 thousand lower than at March 31, 2005 and $1.2 million higher than at December 31, 2005. The increase in the past due totals at March 31, 2006 compared to December 31, 2005 resulted from growth of $763 thousand in credit card loan delinquencies and $349 thousand in business loan delinquencies.

      In addition to the non-accrual loans mentioned above, the Company also has identified loans for which management has concerns about the ability of the borrowers to meet existing repayment terms. They are primarily classified as substandard for regulatory purposes. The loans are generally secured by either real estate or other borrower assets, reducing the potential for loss should they become non-performing. Although these loans are generally identified as potential problem loans, they may never become non-

performing. These loans totaled $46.5 million at March 31, 2006 compared with $52.8 million at December 31, 2005 and $68.9 million at March 31, 2005. The lower balance at March 31, 2006 resulted primarily from customer payments or from changes in credit grade.

      Income tax expense was $25.8 million in the first quarter of 2006, compared to $20.2 million in the fourth quarter of 2005 and $26.0 million in the first quarter of 2005. The effective income tax rate on income from operations was 32.8% in the first quarter of 2006, compared with 26.4% in the fourth quarter of 2005 and 34.3% in the first quarter of 2005. The effective tax rate was lower in the first quarter of 2006 compared to the same period in the previous year because of earnings on higher average balances in state and municipal investment securities, coupled with higher levels of income from the Company’s real estate investment trust subsidiaries, which are not taxable in some states.

      Total assets of the Company were $13.7 billion at March 31, 2006 compared to $13.9 billion at December 31, 2005. Earning assets amounted to $12.8 billion at both March 31, 2006 and December 31, 2005, and at March 31, 2006 consisted of 72% loans and 28% investment securities.

      During the first quarter of 2006, average loans increased $223.1 million, or 2.5%, compared with the previous quarter, and were up $646.2 million, or 7.7%, compared to the same period last year. Compared to the fourth quarter of 2005, average business (includes commercial, lease and tax-free) and business real estate loans grew by $106.3 million and $94.4 million, respectively, as a result of both new business and additional borrowings from existing customers. Offsetting this growth was a decrease in average construction loans of $41.3 million due to pay downs or transfers to permanent status. Average student loans increased $34.8 million due to seasonal borrowing activity. Average credit card loans increased from the previous quarter by $17.0 million, but average personal real estate loans decreased from the previous quarter by $2.3 million due to a decline in loan originations.

      Available for sale investment securities, excluding fair value adjustments, decreased on average $347.6 million, or 9.0%, this quarter compared with the previous quarter. Investment securities continue to decrease as maturities and pay downs are used to fund loan growth. Purchases of available for sale investment securities during the current quarter totaled $57.9 million, and consisted of $20.5 million in treasury and agency securities and $31.2 million in tax free municipal obligations.

      Total average deposits grew by $339.5 million, or 3.2%, during the first quarter of 2006 compared to the fourth quarter of last year, and were up 2.7% compared to the same period last year. The increase over the fourth quarter of last year was the result of growth in certificates of deposit, primarily in jumbo certificates of deposit.

      During the first quarter of 2006, average borrowings decreased $416.5 million from the previous quarter, primarily due to a decrease in federal funds purchased of $417.9 million, or 36.8%, and a decrease in Federal Home Loan advances of $63.7 million, or 20.7%. The growth in deposits coupled with the decline in investment securities provided the liquidity to reduce this debt.

      The Company’s most liquid assets are comprised of available for sale marketable investment securities, federal funds sold, and securities purchased under agreements to resell (resale agreements). Federal funds sold and resale agreements totaled $89.4 million at March 31, 2006. These investments normally have overnight maturities and are used for general daily liquidity purposes. The fair value of the available for sale investment portfolio was $3.4 billion at March 31, 2006, and included an unrealized loss of $23.0 million. The portfolio includes maturities of approximately $610 million over the next 12 months,

which offer substantial resources to meet either new loan demand or reductions in the Company’s deposit funding base. The Company pledges portions of its investment securities portfolio to secure public fund deposits, securities sold under agreements to repurchase, trust funds, and borrowing capacity at the Federal Reserve. At March 31, 2006, total investment securities pledged for these purposes comprised 67% of the total investment portfolio, leaving $1.2 billion of unpledged securities.

      Liquidity is also available from the Company’s large base of core customer deposits, defined as demand, interest checking, savings, and money market deposit accounts. At March 31, 2006, such deposits totaled $7.9 billion and represented 70.5% of the Company’s total deposits. These core deposits are normally less volatile and are often tied to other products of the Company through long lasting relationships. Time open and certificates of deposit of $100,000 and over totaled $1.4 billion at March 31, 2006. These accounts are normally considered more volatile and higher costing, but comprise just 12.2% of total deposits at March 31, 2006.

      Other important components of liquidity are the level of borrowings from third party sources and the availability of future credit. The Company’s outside borrowings are comprised of federal funds purchased, securities sold under agreements to repurchase, and longer-term debt. Federal funds purchased and securities sold under agreements to repurchase are generally borrowed overnight, and amounted to $901.9 million at March 31, 2006. Federal funds purchased are obtained mainly from upstream correspondent banks with whom the Company maintains approved lines of credit, while securities sold under agreements to repurchase are comprised of non-insured customer funds secured by a portion of the Company’s investment portfolio. The Company’s long-term debt is relatively small compared to the Company’s overall liability position. It is comprised mainly of advances from the Federal Home Loan Bank of Des Moines (FHLB), which totaled $241.7 million at March 31, 2006. Most of these advances have floating rates and mature in 2006. Other outstanding long-term borrowings relate mainly to the Company’s leasing and venture capital operations.

      In addition to those mentioned above, several other sources of liquidity are available. The Company believes that its sound debt ratings of A-1from Standard & Poor’s andPrime-1 from Moody’s would ensure the ready marketability of its commercial paper, should the need arise. No commercial paper has been issued or outstanding during the past ten years. In addition, the Company has temporary borrowing capacity at the Federal Reserve discount window, for which it has pledged $335.7 million in loans and $796.8 million in investment securities. Also, because of its lack of significant long-term debt, the Company believes that it could generate additional liquidity through its Capital Markets Group from sources such as jumbo certificates of deposit or privately placed debt offerings. Future financing could also include the issuance of common or preferred stock.

      Cash and cash equivalents (defined as “Cash and due from banks” and “Federal funds sold and securities purchased under agreements to resell” as segregated in the accompanying balance sheets) was $573.8 million at March 31, 2006 compared to $674.1 million at December 31, 2005. The $100.3 million decline resulted from changes in the various cash flows resulting from the operating, investing and financing activities of the Company, as shown in the accompanying statement of cash flows for March 31, 2006. The cash flow provided by operating activities is considered a very stable source of funds and consists mainly of net income adjusted for certain non-cash items. Operating activities provided cash flow of $112.4 million during the current quarter. Investing activities, consisting mainly of purchases, sales and maturities of available for sale securities and changes in the level of the loan portfolio, used cash of $9.7 million. Most of the cash outflow was due to a $243.3 million increase in the loan portfolio and $66.4 million in purchases of investment securities, partly offset by $307.6 million in proceeds from sales and maturities of investment securities. Financing activities used cash of $203.0 million, mainly due to a $424.5 million decrease in overnight borrowings. In addition, cash of $51.1 million was required by the Company’s treasury stock repurchase program. These cash outflows were partly offset by a $295.2 million increase in deposits. Future short-term liquidity needs arising from daily operations are not expected to vary significantly, and the Company believes it will be able to meet these cash flow needs.

      The Company maintains strong regulatory capital ratios, including those of its principal banking subsidiaries, which exceed the well-capitalized guidelines under federal banking regulations. Information about the Company’s risk-based capital is shown below: