Fulton Financial - 10-Q quarterly report FY

 

(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. Yes þ      No o

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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o      No þ

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Common Stock, $2.50 Par Value — 173,257,000 shares outstanding as of July 31, 2007.

The accompanying unaudited consolidated financial statements of Fulton Financial Corporation (the Corporation) have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by U.S. GAAP for complete financial statements. The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the amounts of assets and liabilities as of the date of the financial statements as well as revenues and expenses during the period. Actual results could differ from those estimates. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six-month periods ended June 30, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2007.

The Corporation’s basic net income per share is calculated as net income divided by the weighted average number of shares outstanding. For diluted net income per share, net income is divided by the weighted average number of shares outstanding plus the incremental number of shares added as a result of converting common stock equivalents, calculated using the treasury stock method. The Corporation’s common stock equivalents consist solely of outstanding stock options and restricted stock. Excluded from the calculation were 3.2 million anti-dilutive options for each of the three and six months ended June 30, 2007, respectively, and 2.1 million and 1.3 million for the three and six months ended June 30, 2006, respectively.

A reconciliation of the weighted average shares outstanding used to calculate basic net income per share and diluted net income per share follows:

Total comprehensive income was $33.6 million and $77.0 million for the three and six months ended June 30, 2007, respectively. Total comprehensive income was $31.5 million and $66.0 million for the three and six months ended June 30, 2006, respectively.

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). The interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes”. Specifically, the interpretation prescribes a

recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.

The Corporation adopted the provisions of FIN 48 on January 1, 2007. As a result of adoption, the Corporation recognized a $220,000 decrease in existing reserves for unrecognized tax positions, which was accounted for as an increase to the January 1, 2007 balance of retained earnings.

As of the adoption date, the Corporation had unrecognized income tax benefits of $4.1 million, all of which, if recognized, would impact the effective tax rate. Also as of the adoption date, the Corporation had $1.4 million in accrued interest related to unrecognized tax benefits. The Corporation recognizes interest accrued related to unrecognized tax benefits as a component of income tax expense. Penalties, if incurred, would also be recognized in income tax expense. There have been no material changes to unrecognized tax benefits as of June 30, 2007.

The Corporation, or one of its subsidiaries, files income tax returns in the U.S. Federal jurisdiction, and various states. In many cases, uncertain tax positions are related to tax years that remain subject to examination by the relevant taxable authorities. With few exceptions, the Corporation is no longer subject to U.S. Federal, state and local examinations by tax authorities for years before 2003.

As required by Statement of Financial Accounting Standards No. 123R, “Share-Based Payment”, the fair value of equity awards to employees is recognized as compensation expense over the period during which employees are required to provide service in exchange for such awards. The Corporation’s equity awards consist of stock options and restricted stock granted under its Stock Option and Compensation Plans (Option Plans) and shares purchased by employees under its Employee Stock Purchase Plan.

The following table presents compensation expense and the related tax impacts for equity awards recognized in the consolidated income statements:

Under the Option Plans, options are granted to key employees for terms of up to ten years at option prices equal to the fair market value of the Corporation’s stock on the date of grant. Options are typically granted annually on July 1^st and become fully vested after a three-year cliff-vesting period. Certain events, as specified in the Option Plans and agreements, would result in the acceleration of the vesting period. As of June 30, 2007, the Option Plans had 14.9 million shares reserved for the future grants through 2013. On July 1, 2007, the Corporation granted approximately 860,000 options under its Option Plans.

The Corporation maintains a defined benefit pension plan (Pension Plan) for certain employees. Contributions to the Pension Plan are actuarially determined and funded annually. Pension Plan assets are invested in money markets; fixed income securities, including corporate bonds, U.S. Treasury securities and common trust funds; and equity securities, including common stocks and common stock mutual

funds. The Pension Plan has been closed to new participants, but existing participants will continue to accrue benefits according to the terms of the plan until December 31, 2007.

On April 30, 2007, the Corporation amended the Pension Plan to discontinue the accrual of benefits for all existing participants, effective January 1, 2008. As a result of this amendment, the Corporation recorded a $58,000 curtailment loss, as determined by consulting actuaries, during the quarter ended June 30, 2007. The curtailment loss resulted from a $14.0 million gain from adjusting the funded status of the Pension Plan and an offsetting $14.0 million write-off of unamortized pension costs and related deferred tax assets.

The Corporation currently provides medical and life insurance benefits under a post-retirement benefits plan (Post-retirement Plan) to certain retired full-time employees who were employees of the Corporation prior to January 1, 1998. Certain other full-time employees may become eligible for these discretionary benefits if they reach retirement age while working for the Corporation. Benefits are based on a graduated scale for years of service after attaining the age of 40.

The net periodic benefit cost for the Corporation’s Pension Plan and Post-retirement Plan, as determined by consulting actuaries, consisted of the following components for the three and six-month periods ended June 30:

On February 1, 2006, the Corporation completed its acquisition of Columbia Bancorp (Columbia) of Columbia, Maryland. Columbia was a $1.3 billion bank holding company whose primary subsidiary was The Columbia Bank, which operates 21 full-service community-banking offices and five retirement community offices in Frederick, Howard, Montgomery, Prince George’s and Baltimore Counties and Baltimore City. The total purchase price was approximately $306.0 million, including $154.2 million in stock issued and stock options assumed, $149.4 million of Columbia stock purchased and options settled for cash and $2.4 million for other direct acquisition costs. The purchase price for shares issued was

determined based on the value of the Corporation’s stock on the date when the number of shares was fixed and determinable.

As a result of the acquisition, Columbia was merged into the Corporation, and The Columbia Bank became a wholly owned subsidiary. The acquisition was accounted for using purchase accounting, which requires the allocation of the total purchase price to the assets acquired and liabilities assumed, based on their respective fair values at the acquisition date, with any remaining purchase price being recorded as goodwill. Resulting goodwill balances are then subject to an impairment review on at least an annual basis. The results of Columbia’s operations are included in the Corporation’s financial statements prospectively from the February 1, 2006 acquisition date.

As of June 30, 2007, interest rate swaps with a notional amount of $278.0 million were used to hedge certain long-term fixed rate certificates of deposit. The terms of the certificates of deposit and the interest rate swaps are similar and were committed to simultaneously. Under the terms of the swap agreements, the Corporation is the fixed rate receiver and the floating rate payer (generally tied to the three-month London Interbank Offering Rate, or LIBOR, a common index used for setting rates between financial institutions). The interest rate swaps are classified as fair value hedges and both the interest rate swaps and the certificates of deposit are recorded at fair value, with changes in the fair values during the period recorded to other income or expense. For interest rate swaps accounted for as fair value hedges, ineffectiveness is the difference between the changes in the fair value of the interest rate swaps and the hedged items, in this case the certificates of deposit. The Corporation’s analysis of hedge effectiveness indicated the hedges were highly effective as of June 30, 2007. For the three and six months ended June 30, 2007, net losses of $145,000 and $241,000, respectively, were recorded in other expense, representing the net impact of the change in fair values of the interest rate swaps and the certificates of deposit, compared to net losses of $94,000 and $155,000, respectively, for the three and six months ended June 30, 2006.

The Corporation entered into a forward-starting interest rate swap with a notional amount of $150.0 million in October 2005 in anticipation of the issuance of trust preferred securities in January 2006. This swap was accounted for as a cash flow hedge as it hedged the variability of interest payments attributable to changes in interest rates on the forecasted issuance of fixed-rate debt. The Corporation settled this derivative on its contractual maturity date in January 2006 with a total payment of $5.5 million to the counterparty, including a $1.4 million charge to other comprehensive loss (net of a $751,000 tax effect) recorded during the first quarter of 2006. This charge was in addition to the $2.2 million that had been recorded as an other comprehensive loss, net of a $1.2 million tax effect, as of December 31, 2005. The total amount recorded in other comprehensive loss is being amortized to interest expense over the life of the related securities using the effective interest method. The amount of net losses in accumulated other comprehensive income that will be reclassified into earnings during the next twelve months is expected to be approximately $120,000.

In February 2007, the Corporation entered into a forward-starting interest swap with a notional amount of $100.0 million in anticipation of the issuance of subordinated debt in May 2007. This swap was accounted for as a cash flow hedge as it hedged the variability of interest payments attributable to changes in interest rates on the forecasted issuance of fixed-rate debt. The Corporation settled this derivative on its contractual maturity date in April 2007 with a total payment of $232,000 to the counterparty, including a $151,000 charge to other comprehensive loss (net of an $81,000 tax effect). The total amount recorded in other comprehensive loss is being amortized to interest expense over the life of the related securities using the effective interest method. The amount of net losses in accumulated other comprehensive income that will be reclassified into earnings during the next twelve months is expected to be approximately $15,000.

The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. Those financial instruments include commitments to extend credit and letters of credit, which involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the Corporation’s Consolidated Balance Sheets. Exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and letters of credit is represented by the outstanding amount of those instruments.

The outstanding amounts of commitments to extend credit and letters of credit were as follows:

During the three and six months ended June 30, 2007, the Corporation recorded contingent losses of $3.4 million and $8.9 million, respectively, that are expected to be incurred due to the potential repurchase of approximately $41 million of residential mortgage loans and home equity loans originated and sold in the secondary market by the Corporation’s Resource Bank affiliate. Certain residential mortgage loans and home equity loans are sold to secondary market purchasers under standard representations and warranties regarding the origination of the loans, as well as a standard agreement to repurchase the loans under specified circumstances, including failure of the borrower to timely make any of the first three payments following the sale of the loan.

In July 2007, the Corporation repurchased $34.7 million of these residential mortgage loans and home equity loans from one investor. Upon repurchase, the Corporation reclassified approximately $6.4 million of the $8.9 million of previously recorded contingent losses as a write-down of the repurchased loans to net realizable value. Approximately $25 million of the repurchased loans were recorded as residential mortgage loans and home equity loans outstanding, of which $21 million were placed on non-accrual status. In addition, approximately $9 million of repurchased loans were classified as other real estate owned.

From time to time, the Corporation and its subsidiary banks may be defendants in legal proceedings relating to the conduct of their banking business. Most of such legal proceedings are a normal part of the banking business and, in management’s opinion, the financial position and results of operations and cash flows of the Corporation would not be affected materially by the outcome of such legal proceedings.

The Corporation periodically repurchases shares of its common stock under repurchase plans approved by the Board of Directors. These repurchases have historically been through open market transactions and have complied with all regulatory restrictions on the timing and amount of such repurchases. Shares may also be repurchased through an “Accelerated Share Repurchase” Program (ASR), which allows shares to be purchased immediately from an investment bank. The investment bank, in turn, repurchases shares on

the open market over a period that is determined by the average daily trading volume of the Corporation’s shares, among other factors, with a purchase price adjustment made between the parties at the end of the program based on the cost of shares purchased by the investment bank. In 2006, the Corporation settled an ASR related to an approved stock repurchase plan by paying $3.4 million to an investment bank.

In 2006, the Corporation’s Board of Directors approved a stock repurchase plan for 2.1 million shares through June 30, 2007. During the first quarter of 2007, the Corporation repurchased 1.0 million shares, representing the remaining shares available under this plan.

In April 2007, the Corporation’s Board of Directors approved a stock repurchase plan for 1.0 million shares through December 31, 2007. There were no shares repurchased under this plan during the three months ended June 30, 2007. Repurchases under this plan are expected to occur through open market acquisitions.

In May 2007, the Corporation issued $100.0 million of ten-year subordinated notes, which mature on May 1, 2017 and carry a fixed rate of 5.75% and an effective rate of approximately 5.95% as a result of issuance costs. Interest is paid semi-annually in May and November of each year.

In September 2006, the FASB ratified Emerging Issues Task Force (EITF) 06-4, “Accounting for Deferred Compensation and Post-retirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements “ (EITF 06-4). EITF 06-4 addresses accounting for endorsement split-dollar life insurance arrangements that provide a benefit to an employee that extends to post-retirement periods. EITF 06-4 would require that the post-retirement benefit aspects of an endorsement-type split-dollar life insurance arrangement be recognized as a liability by the employer and that the obligation is not settled upon entering into an insurance arrangement. EITF 06-4 is effective for fiscal years beginning after December 15, 2007, or January 1, 2008 for the Corporation. The Corporation is currently evaluating the impact of EITF 06-4 on the consolidated financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurement” (Statement 157). Statement 157 defines fair value, establishes a framework for measuring fair value in U.S. GAAP, and expands disclosure requirements for fair value measurements. Statement 157 does not require any new fair value measurements and is effective for financial statements issued for fiscal years beginning after November 15, 2007, or January 1, 2008 for the Corporation. The Corporation is currently evaluating the impact of Statement 157 on the consolidated financial statements.

In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115” (Statement 159). Statement 159 permits entities to choose to measure many financial instruments and certain other items at fair value and amends Statement 115 to, among other things, require certain disclosures for amounts for which the fair value option is applied. Additionally, this standard provides that an entity may reclassify held-to-maturity and available-for-sale securities to the trading account when the fair value option is elected for such securities, without calling into question the intent to hold other securities to maturity in the future. This standard is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007, or January 1, 2008 for the Corporation. The Corporation has not completed its assessment of Statement 159 and the impact, if any, on the consolidated financial statements.

In March 2007, the FASB ratified EITF 06-10, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Collateral Assignment Split-Dollar Life Insurance Arrangements” (EITF 06-10). EITF 06-10 addresses accounting for collateral assignment split-dollar life insurance arrangements that provide a benefit to an employee that extends to post-retirement periods. EITF 06-10

provides guidance for determining the liability for the post-retirement benefit aspects of collateral assignment-type split-dollar life insurance arrangements, as well as the recognition and measurement of the associated asset on the basis of the terms of the collateral assignment agreement. EITF 06-10 is effective for fiscal years beginning after December 15, 2007, or January 1, 2008 for the Corporation. The Corporation is currently evaluating the impact of EITF 06-10 on the consolidated financial statements.

In May 2007, the FASB issued Interpretation No. FIN 48-1, “Definition of Settlement in FASB Interpretation No. 48” (Staff Position No. FIN 48-1). Staff Position No. FIN 48-1 provides guidance on how to determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. Staff Position No. FIN 48-1 is effective retroactively to January 1, 2007. The implementation of this standard did not have a material impact on the consolidated financial statements.

In June 2007, the FASB ratified EITF 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards” (EITF 06-11). EITF 06-11 requires that tax benefits associated with dividends on share-based payment awards be recorded as a component of additional paid-in capital. EITF 06-11 is effective, on a prospective basis, for fiscal years beginning after December 15, 2007, or January 1, 2008 for the Corporation. The Corporation is currently evaluating the impact of EITF 06-11 on the consolidated financial statements.

Certain amounts in the 2006 consolidated financial statements and notes have been reclassified to conform to the 2007 presentation.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (Management’s Discussion) concerns Fulton Financial Corporation (the Corporation), a financial holding company incorporated under the laws of the Commonwealth of Pennsylvania in 1982, and its wholly owned subsidiaries. This discussion and analysis should be read in conjunction with the consolidated financial statements and notes presented in this report.

The Corporation has made, and may continue to make, certain forward-looking statements with respect to its acquisition and growth strategies, management of net interest income and margin, the ability to realize gains on equity investments, allowance and provision for loan losses, expected levels of certain non-interest expenses and the liquidity position of the Corporation and Parent Company. The Corporation cautions that these forward-looking statements are subject to various assumptions, risks and uncertainties. Because of the possibility of changes in these assumptions, risks and uncertainties, actual results could differ materially from forward-looking statements.

In addition to the factors identified herein, the following risk factors could cause actual results to differ materially from such forward-looking statements:

The Corporation’s forward-looking statements are relevant only as of the date on which such statements are made. By making any forward-looking statements, the Corporation assumes no duty to update them to reflect new, changing or unanticipated events or circumstances.

The Corporation currently derives the majority of its earnings from traditional banking activities, with net interest income, or the difference between interest income earned on loans and investments and interest paid on deposits and borrowings, accounting for approximately 77% of revenues for the three and six months ended June 30, 2007. Growth in net interest income is dependent upon balance sheet growth or increasing the net interest margin, which is net interest income as a percentage of average interest-earning assets. The Corporation also generates revenue through fees earned on the various services and products offered to its customers and through sales of assets, such as loans, investments, or properties. Offsetting these revenue sources are provisions for credit losses on loans, other operating expenses and income taxes.

The following table presents a summary of the Corporation’s earnings and selected performance ratios:

The Corporation’s net income for the second quarter of 2007 decreased $6.9 million, or 14.7%, from $46.7 million in 2006 to $39.8 million in 2007 due to an increase in other expenses of $7.3 million, or 8.1%, a decrease in net interest income of $1.9 million, or 1.6%, and a $1.8 million increase in the provision for loan losses, offset by an increase in other income of $1.0 million, or 2.8%. The increase in other expenses was most notably due to a $3.4 million contingent loss related to the potential repurchase of residential mortgage loans and home equity loans that had been originated and sold in the secondary market. The decrease in net interest income was due to a 20 basis point decline in net interest margin, partially offset by balance sheet growth. The decrease in net interest margin was caused, in part, by customers shifting deposits from lower cost core demand and savings accounts to higher cost certificates of deposit. The loan loss provision increased due to an increase in net charge-offs during the second quarter of 2007 in comparison to the same period in 2006.

Net income for the first half of 2007 decreased $9.6 million, or 10.6%, from $90.6 million in 2006 to $81.0 million in 2007 due to increases in other expenses of $20.2 million, or 11.3%, and an increase of $1.8 million in the provision for loan losses, offset by an increase in net interest income of $4.8 million, or 2.0%, and other income of $3.5 million, or 4.8%. The increase in other expenses was primarily due to the accrual of $8.9 million of contingent losses related to the potential repurchase of residential mortgage loans and home equity loans that had been originated and sold in the secondary market and an $8.5 million, or 8.3%, increase in salaries and employee benefits, which included $1.7 million of severance charges.

The following summarizes some of the more significant factors that influenced the Corporation’s results for the three and six months ended June 30, 2007.

Interest Rates — Changes in the interest rate environment can impact both the Corporation’s net interest income and its non-interest income. The term “interest rate environment” generally refers to both the level of interest rates and the shape of the U. S. Treasury yield curve, which is a plot of the yields on treasury issues over various maturity periods. Typically, the shape of the yield curve is upward sloping, with longer-term rates exceeding short-term rates. For the past twelve months, the yield curve has remained relatively flat, and at times, downward sloping, with minimal differences between long and short-term rates, resulting in a negative impact to the Corporation’s net interest income and net interest margin.

Floating rate loans, short-term borrowings and savings and time deposit rates are generally influenced by short-term rates. The Federal Reserve Board (FRB) has not raised the Federal funds rate since June 30, 2006. The Corporation’s prime lending rate also has not increased since June 30, 2006. While there have not been increases in the Federal funds rate in the past twelve months, the Corporation has had to reprice to higher deposit rates due to competitive pressures. Additionally, as market rates on certificates of deposit accounts have increased over the past twelve months, customers have shifted funds from lower rate core demand and savings accounts to fixed rate certificates of deposit in order to lock into higher rates.

The Corporation manages its risk associated with changes in interest rates through the techniques described in the “Market Risk” section of Management’s Discussion.

Asset Quality — Asset quality refers to the underlying credit characteristics of borrowers and the likelihood that defaults on contractual payments will result in charge-offs of account balances. Asset quality is influenced by economic conditions and other factors, but can be managed through conservative underwriting and sound collection policies and procedures.

As of June 30, 2007, the Corporation’s non-performing assets increased $16.3 million, or 28.2%, in comparison to December 31, 2006. The increase was mainly due to general economic factors as opposed to specific risk concentrations within the Corporation’s loan portfolio and has resulted in non-performing asset levels which are closer to average historical levels, as opposed to the unusually low non-performing asset levels of recent years.

While not currently impacting the level of non-performing assets, the asset quality risks associated with the Corporation’s mortgage business, as evidenced by the 2007 contingent losses recorded in connection with the potential repurchase of residential mortgage loans and home equity loans, has resulted in the phase-out of the wholesale residential mortgage business at the Corporation’s Resource Bank affiliate. The strategy has resulted in lower mortgage loan sale volumes and gains on the sales of mortgage loans during the first half of 2007, in addition to potentially reducing the future risk that the Corporation may be required to repurchase additional loans that have been sold to secondary market investors, which in turn, could increase the level of non-performing assets.

Equity Markets — As noted in the “Market Risk” section of Management’s Discussion, equity valuations can have an impact on the Corporation’s financial performance. In particular, bank stocks account for a significant portion of the Corporation’s equity investment portfolio. Historically, realized gains on sales of these equities have been a recurring component of the Corporation’s earnings.

More recently, declines in the value of the bank stock portfolio have resulted in a decline in investment security gains. During the first half of 2007, the Corporation’s gains on investment securities decreased $1.7 million, or 40.8%. As of June 30, 2007, the Corporation’s bank stock portfolio had a net unrealized loss of $8.8 million, compared to a net unrealized loss of $100,000 at December 31, 2006. Future declines in the bank stock portfolio values could have a detrimental impact on the Corporation’s ability to realize gains in the future.

Interest-bearing Deposits — In comparison to the second quarter of 2006, the Corporation experienced a shift from lower cost interest-bearing demand and savings deposit accounts (46.8% of total interest-bearing deposits in 2007, compared to 49.8% in 2006) to higher cost certificates of deposit (53.2% in 2007, compared to 50.2% in 2006). During the second quarter of 2007 the shift to higher cost deposits and, to a lesser extent, the increase in deposit rates, resulted in a decline in net interest margin.

Earning Assets — During the second quarter of 2007 the Corporation’s interest-earning assets increased in comparison to the same period in 2006 and shifted slightly in composition from investments (19.8% of total average interest-earning assets in 2007, compared to 21.8% in 2006) to loans (78.6% in 2007, compared to 76.1% in 2006). The movement to higher-yielding loans has mitigated some of the factors that have had a negative effect on the Corporation’s net interest income and net interest margin. Slower growth in loans could result in a future shift in the composition of interest-earning assets from loans to investments.

Acquisitions — In February 2006, the Corporation acquired Columbia Bancorp (Columbia), of Columbia, Maryland, a $1.3 billion bank holding company whose primary subsidiary was The Columbia Bank.

Results for the first six months of 2007 in comparison to the first six months of 2006 were impacted due to a full six-month contribution by Columbia in 2007, compared to a five-month contribution in 2006. There is no such impact on comparisons between the second quarters of 2007 and 2006.

Acquisitions have long been a supplement to the Corporation’s internal growth. The Columbia acquisition has provided the opportunity for additional growth, as it has allowed the Corporation’s existing products and services to be sold in new markets. The Corporation’s acquisition strategy focuses on high growth areas with strong market demographics and targets organizations that have a comparable corporate culture, strong performance and sound asset quality, among other factors. Under the Corporation’s “super-community” banking philosophy, acquired organizations generally retain their status as separate legal entities, unless consolidation with an existing subsidiary bank is practical. Back office functions are generally consolidated to maximize efficiencies.

Merger and acquisition activity in the financial services industry has been very competitive in recent years, as evidenced by the prices paid for certain acquisitions. While the Corporation has been an active acquirer, management is committed to basing its pricing on rational economic models. Management will continue to focus on generating growth in the most cost-effective manner.

Net interest income decreased $1.9 million, or 1.6%, to $120.9 million in 2007 from $122.9 million in 2006. The decrease was due to a more pronounced increase in the costs of interest-bearing liabilities over the income received from interest-earning assets, resulting in a 20 basis point decrease in the net interest margin. The average cost of interest bearing liabilities increased 50 basis points (a 14.9% increase) over 2006, while the average fully taxable-equivalent (FTE) yield on interest-earning assets increased 25 basis points (a 3.7% increase) over 2006.

The following table provides a comparative average balance sheet and net interest income analysis for the second quarter of 2007 as compared to the same period in 2006. Interest income and yields are presented on an FTE basis, using a 35% Federal tax rate. The discussion following this table is based on these FTE amounts. All dollar amounts are in thousands.

The following table summarizes the changes in FTE interest income and expense due to changes in average balances (volume) and changes in rates:

Interest income increased $17.3 million, or 8.0%, due primarily to an increase in the average balances of interest-earning assets and partially due to an increase in interest rates. Interest income increased $11.6 million as a result of a $523.6 million, or 4.0%, increase in average balances, while an increase of $5.7 million was realized from a 25 basis point increase in average rates.

The increase in average interest-earning assets was due to loan growth. The following summarizes the growth in average loans, by type:

Loan growth was particularly strong in the commercial loan and commercial mortgage loan categories, which together increased $628.5 million, or 10.8%. Additional growth came from residential mortgage loans and home equity loans, which increased $101.0 million, or 4.9%. This growth was primarily due to increases in adjustable rate residential mortgages and second mortgages, offset by a decline in home equity lines of credit. The average yield on loans during the second quarter of 2007 was 7.54%, a 17 basis point, or 2.3%, increase over 2006.

Average investment securities decreased $163.3 million, or 5.8%. This decrease was due to the sale of approximately $250 million of lower yielding securities during the first quarter of 2007, offset slightly by the average balance impact of approximately $285 million of securities purchased near the end of the second quarter of 2007. Partially as a result of these transactions, the average yield on investment securities increased 28 basis points, or 6.5%, from 4.32% in 2006 to 4.60% in 2007.

The increase in interest income (FTE) was more than offset by an increase in interest expense of $18.8 million, or 20.9%, to $109.2 million in the second quarter of 2007 from $90.4 million in the second quarter of 2006. Interest expense increased $7.4 million as a result of a $583.9 million, or 5.4%, increase in average balances, while an increase $11.5 million was realized from a 50 basis point, or 14.9%, increase in the average cost of interest-bearing liabilities.

The following table summarizes the change in average deposits, by type:

The Corporation experienced significant growth in time deposits of $443.7 million due to favorable interest rates making time deposits an attractive investment alternative for customers. The net decrease in noninterest-bearing and interest-bearing demand and savings accounts of $177.7 million, or 3.0%, was due to customers shifting from these accounts to higher yielding time deposits.

Average borrowings increased $214.9 million, or 8.2%, from the second quarter of 2006 with average short-term borrowings decreasing $359.5 million, or 22.4%, to $1.2 billion, while average long-term debt increased $574.4 million, or 56.8%, to $1.6 billion. The decrease in short-term borrowings was due to the repayment of Federal funds purchased using the proceeds of investment security sales, as well as a shift in funding from short-term borrowings to long-term debt. The increase in long-term debt was due to an increase in FHLB advances as longer-term rates were locked in, and due to the Corporation’s issuance of $100.0 million of subordinated debt in May 2007. See Note J, “Long-term Debt” in the Notes to Consolidated Financial Statements for further discussion related to the Corporation’s issuance of long-term debt.

The following table presents ending balances of loans outstanding (net of unearned income):