First Horizon Corporation - 10-Q quarterly report FY

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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

(Mark one)

(X) QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2002

OR

(   ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the transition period from _____________ to ______________

Commission file number 000-4491

CIK number 0000036966

FIRST TENNESSEE NATIONAL CORPORATION

(901) 523-4444
(Registrant’s telephone number, including area code)

None
(Former name, former address and former fiscal year,
if changed since last report)

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 [x] No [  ]

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.

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FIRST TENNESSEE NATIONAL CORPORATION

INDEX

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PART I.

FINANCIAL INFORMATION

Item 1. Financial Statements.

This financial information reflects all adjustments which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations for the interim periods presented.

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Note 1 — Financial Information

The unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles. In the opinion of management, all necessary adjustments have been made for a fair presentation of financial position and results of operations for the periods presented. The operating results for the six-month period ended June 30, 2002, are not necessarily indicative of the results that may be expected going forward. For further information, refer to the audited consolidated financial statements and footnotes included in the financial appendix to the 2002 Proxy Statement.

On January 1, 2002, First Tennessee adopted the final provisions of Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations” which requires that all business combinations initiated after June 30, 2001, be accounted for using the purchase method. The impact of adopting this standard was immaterial to First Tennessee.

On January 1, 2002, First Tennessee adopted the preliminary provisions of SFAS No. 142, “Goodwill and Other Intangible Assets”. Under SFAS No. 142, goodwill is no longer subject to amortization over its estimated useful life, but is subject to an assessment for impairment using a fair-value-based test at least annually. First Tennessee has completed the initial analysis of impairment as required by the new standard and has not recognized any impairment of the goodwill currently on its books during 2002. See Note 7 — Intangible Assets and Note 8 — Mortgage Servicing Rights for additional information.

On January 1, 2002, First Tennessee adopted SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 addresses accounting and reporting issues related to the impairment of long-lived assets and for long-lived assets to be disposed of. This standard is effective for fiscal years beginning after December 15, 2001, which for First Tennessee was January 1, 2002. The impact of adopting this standard was immaterial to First Tennessee.

On January 1, 2001, First Tennessee adopted SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and EITF Issue 99-20: Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets. SFAS No. 133 establishes accounting standards requiring that every derivative instrument (including certain instruments embedded in other contracts) be recorded on the balance sheet as either an asset or liability measured at its fair value. It requires that changes in the instrument’s fair value be recognized currently in earnings (or other comprehensive income). If certain criteria are met, changes in the fair value of the asset or liability being hedged are also recognized currently in earnings. Upon adoption of SFAS No. 133 all derivative instruments were measured at fair value with differences between the previous book value and fair value reported as part of a cumulative effect adjustment, except to the extent that they related to hedges of the variable cash flow exposure of forecasted transactions. To the extent the adoption adjustment related to hedges of the variable cash flow exposure of a forecasted transaction, the remainder of the accounting adjustment, a $1.4 million gain (after-tax) was reported as a cumulative effect adjustment of comprehensive income in first quarter 2001. Offsetting gains and losses on hedged assets and liabilities were recognized as adjustments of their respective book values at the adoption date as part of this cumulative effect adjustment. Additionally, EITF Issue 99-20, which provides impairment and interest income recognition and measurement guidance for interests retained in a securitization transaction accounted for as a sale, was adopted. The initial impact of adopting SFAS No. 133 and EITF Issue 99-20 was an $8.2 million loss (after-tax) net transition adjustment that was recognized as the cumulative effect of a change in accounting principle in first quarter 2001.

Fair value is determined on the last business day of a reporting period. This point in time measurement of derivative fair values and the related hedged item fair values may be well suited to the measurement of hedge effectiveness, as well as reported earnings, when hedge time horizons are short. The same measurement however may not consistently reflect the effectiveness of longer-term hedges and, in First Tennessee’s view, can distort short-term measures of reported earnings. First Tennessee uses a combination of derivative financial instruments to hedge certain components of the interest rate risk associated with its portfolio of capitalized mortgage servicing rights, which currently have an average life of five to seven years. Over this long-term time horizon this combination of derivatives can be effective in significantly mitigating the effects of interest rate changes on the value of the servicing portfolio. However, these derivative financial instruments can and do demonstrate significant price volatility depending upon prevailing conditions in the financial

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Note 1 — Financial Information (continued)

markets. If a reporting period ends during a period of volatile financial market conditions, the effect of such point in time conditions on reported earnings does not reflect the underlying economics of the transactions or the true value of the hedges to First Tennessee over their estimated lives. The fact that the fair value of a particular derivative is unusually low or high on the last day of the reporting period is meaningful in evaluating performance during the period only if First Tennessee sells the derivative within the period of time before fair value changes and does not replace the hedge coverage with another derivative. First Tennessee believes the effect of such volatility on short-term measures of earnings ($5.8 million pre-tax loss for the six-month period ending June 30, 2002, as compared to a $3.6 million pre-tax gain for the six-month period ending June 30, 2001) is not indicative of the expected long-term performance of this hedging practice.

Certain provisions of SFAS No. 133 continue to undergo significant discussion and debate by the Financial Accounting Standards Board (FASB). One such potential issue involves the assessment of hedge effectiveness (and its impact on qualifying for hedge accounting) when hedging fair value changes of prepayable assets due to changes in the benchmark interest rate. As the FASB continues to deliberate interpretation of the new rules, the potential exists for a difference between First Tennessee’s interpretation and that of the FASB, the effects of which cannot presently be anticipated but failure to obtain hedge accounting treatment could be significant to results of operations.

On April 30, 2002, the Financial Accounting Standards Board issued SFAS No. 145, Recision of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 rescinds Statement 4, which required all gains and losses from extinguishment of debt to be classified as an extraordinary item, net of related income tax effect, if material in the aggregate. Due to the recision of SFAS No. 4, the criteria in Opinion 30 will now be used to classify those gains and losses. SFAS No. 64 amended SFAS No. 4, and is no longer necessary because of the recision of SFAS No. 4. SFAS No. 44, which established accounting requirements for the effects of transition provisions of the Motor Carrier Act of 1980, is no longer necessary because the transition has been completed. SFAS No. 145 also amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. In addition this Statement also makes technical corrections to existing pronouncements which are generally not substantive in nature. The provisions of SFAS No. 145 that relate to the recision of SFAS No. 4 are effective for fiscal years beginning after May 15, 2002. Any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods presented that does not meet the criteria for classification as an extraordinary item will be reclassified. The provisions of SFAS No. 145 that relate to SFAS No. 13 are effective for transactions occurring after May 15, 2002. All other provisions of this Statement shall be effective for financial statements issued on or after May 15, 2002. First Tennessee estimates the impact of adopting these new standards to be immaterial.

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Note 2 — Divestitures/Acquisitions

On June 1, 2002, First Horizon Home Loans, a wholly owned subsidiary of First Tennessee, acquired certain assets and assumed certain liabilities of Real Estate Financial Services (REFS), a mortgage lending company based in Alpharetta, Georgia for approximately $2.2 million in cash. This transaction was immaterial to First Tennessee.

On April 1, 2002, First Tennessee acquired First Premier Financial Services, Inc. (First Premier), a South Dakota based merchant processor, for approximately $11.9 million in cash. First Premier was merged into First Horizon Merchant Services, Inc., a wholly owned subsidiary of First Tennessee. The acquisition was immaterial to First Tennessee.

On December 31, 2001, First Tennessee Bank National Association (FTBNA), the primary banking subsidiary of First Tennessee, acquired Synaxis Group, Inc., a Nashville-based insurance broker operating through a network of major regional and community-based insurance agencies in Georgia, Kentucky and Tennessee. This transaction was completed for approximately $29.0 million and was immaterial to First Tennessee.

On June 6, 2001, FTBNA, along with its partner, International Business Machines completed the sale of its interests in Check Solutions Company to Carreker Corporation of Dallas, Texas. First Tennessee recognized a divestiture gain of $42.7 million.

On April 27, 2001, First Tennessee completed the sale of its wholly owned subsidiary, Peoples and Union Bank, of Lewisburg, Tennessee to First Farmers & Merchants National Bank, of Columbia, Tennessee. First Tennessee recognized a divestiture gain of $13.1 million.

On April 2, 2001, FTBNA sold its existing portfolio of education loans totaling $342.1 million to Educational Funding of the South, Inc. The transaction resulted in a divestiture gain of $11.8 million.

On January 17, 2001, FTBNA completed the sale of $31.4 million of its affinity, co-branded, and certain single relationship credit card accounts and assets to MBNA Corporation. On December 27, 2000, FTBNA sold $265.8 million of its single relationship credit card accounts and assets to MBNA Corporation. These transactions resulted in divestiture gains of $8.2 million in 2001 and $50.2 million in 2000.

On January 2, 2001, First Tennessee Securities Corporation (FTSC), a wholly owned subsidiary of FTBNA, acquired certain assets of Midwest Research-Maxus Group Limited, a Cleveland-based institutional equity research firm. This transaction was completed for approximately $13.7 million and was immaterial to First Tennessee.

On October 18, 2000, FTBNA sold its corporate and municipal trust business to The Chase Manhattan Bank for $35.1 million, which resulted in a divestiture gain of $33.4 million. An additional divestiture gain of $4.6 million due to an earn-out was recognized in first quarter 2001.

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Note 3 — Earnings Per Share

The following table shows a reconciliation of earnings per share to diluted earnings per share:

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Note 4 — Loans

The composition of the loan portfolio on June 30 is detailed below:

The following table presents information concerning nonperforming loans on June 30:

Nonperforming loans consist of impaired loans, other nonaccrual loans and certain restructured loans. An impaired loan is a loan that management believes the contractual amount due probably will not be collected. Impaired loans are generally carried on a nonaccrual status. Nonaccrual loans are loans on which interest accruals have been discontinued due to the borrower’s financial difficulties. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral is sufficient to recover the principal balance and accrued interest.

Generally, interest payments received on impaired loans are applied to principal. Once all principal has been received, additional payments are recognized as interest income on a cash basis. The following table presents information concerning impaired loans:

An allowance for loan losses is maintained for all impaired loans. Activity in the allowance for loan losses related to non-impaired loans, impaired loans, and for the total allowance for the six months ended June 30, 2002 and 2001, is summarized as follows:

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Note 5 — Business Segment Information

First Tennessee provides traditional retail/commercial banking and other financial services to its customers through various regional and national business lines. Effective January 1, 2002, the business segment information has been adapted to better reflect First Tennessee’s strategic alignment and positioning and to conform to similar changes in internal segment reporting. Prior periods have been restated for comparability. The new segments are FTN Banking Groups, First Horizon, FTN Financial, Transaction Processing, Corporate, and Strategic Initiative Items. FTN Banking Groups includes the Retail/Commercial Bank, Investments, Insurance, Financial Planning, Trust, Credit Card and Cash Management. This segment offers traditional banking financial services and products and also promotes comprehensive financial planning to address customer needs and desires for investments, insurance, estate planning, education funding, cash reserves and retirement goals. First Horizon includes First Horizon Home Loans, First Horizon Equity Lending and First Horizon Money Centers (the last two were previously included in the Retail/Commercial Bank). These business lines were combined to create a common focus and a stronger presence in the national market. FTN Financial added Strategic Alliances and Correspondent Services to the existing business mix that included Capital Markets, Equity Research and Investment Banking. Strategic Alliances is a customer relationship service group recently formed to enhance our portfolio of innovative investment services. Correspondent Services was a part of the Retail/Commercial Bank previously. Transaction Processing continues to offer credit card merchant processing, nationwide bill payment processing, check clearing operations and other products and services. The corporate segment includes certain corporate expenses, SFAS No. 133 gains/(losses), interest expense on trust preferred and REIT preferred stock, and other items not allocated or not specifically assigned to business segments. The Strategic Initiative Items segment isolates items occurring in 2001 that were related to a strategic initiative to enhance growth and business mix.

Total revenue, expense and asset levels reflect those which are specifically identifiable or which are allocated based on an internal allocation method. Because the allocations are based on internally developed assignments and allocations, they are to an extent subjective. This assignment and allocation has been consistently applied for all periods presented. The following table reflects the approximate amounts of consolidated revenue, expense, tax, and assets for the three month and year to date periods ending June 30, 2002 and 2001 and has been adjusted for comparability.

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Note 6 — Contingencies

Contingent liabilities arise in the ordinary course of business, including those related to litigation. Various claims and lawsuits, in addition to those listed below, are pending against First Tennessee and its subsidiaries. Although First Tennessee cannot predict the outcome of these lawsuits, after consulting with counsel, management has been able to form an opinion on the effect all of these lawsuits, except the matter mentioned in the last paragraph, will have on the consolidated financial statements. It is management’s opinion that when resolved, these lawsuits will not have a material adverse effect on the consolidated financial statements of First Tennessee.

In 2001, the Tennessee Supreme Court affirmed a $209,156 award of compensatory damages against FTBNA (as successor by merger to Community Bank of Germantown) as well as a $60,000 award in FTBNA’s favor against the plaintiff. The Supreme Court also vacated a $9,000,000 punitive damage award against FTBNA and remanded the case to the trial court to reassess punitive damages in accordance with the factors outlined in an earlier Tennessee Supreme Court opinion. This case has been settled.

Two certified class actions, alleging that FTBNA and another defendant engaged in unfair and deceptive practices in connection with the financing of satellite dish television systems and involving approximately 8,000 plaintiffs, were combined in Alabama federal court. In May 2002, the settlement of these actions became final. Four additional suits on similar allegations were filed on behalf of multiple individual plaintiffs in Mississippi state court in 2001 and 2002. These cases have been settled also. In addition, two similar satellite systems actions, each filed by one plaintiff, are pending in the Choctaw Tribal Court. Another case, filed by eight plaintiffs and involving similar allegations, is pending in federal court in Mississippi and has been amended to add as plaintiffs 42 of the 54 persons who chose to opt out of the class settlement.

Many mortgage lenders, including a First Tennessee subsidiary, have been sued in putative class actions on the theory that yield spread premiums paid to mortgage brokers are referral fees banned by the Real Estate Settlement Practices Act (“RESPA”). Under that act, liability for an impermissible referral fee is three times the amount of the fee. Accordingly, the potential damages could be substantial. In June 2001, the Eleventh Circuit Court of Appeals upheld certification of a class in a yield spread premium case against a lender unaffiliated with First Tennessee. Although the decision was procedural, certain statements in the decision could be interpreted to suggest a liability standard favorable to plaintiff borrowers. In October 2001, the U.S. Department of Housing and Urban Development published a policy statement disagreeing with the Eleventh Circuit’s decision. In other pending cases involving lenders unaffiliated with First Tennessee, the Eleventh Circuit has ordered briefing on the effect of HUD’s new policy statement. In light of HUD’s 2001 policy statement, the U.S. Court of Appeals for the Eighth Circuit ruled in March 2002 that lawsuits challenging the payment of yield spread premiums under RESPA are not appropriate for class action treatment. In June 2002, the U.S. Court of Appeals for the Ninth Circuit held that the yield spread premium paid by the lender was not an impermissible “referral fee” and that certification of a plaintiff class was inappropriate. Because the suits against First Tennessee’s subsidiary are in an early stage of litigation and the law in this area is not clearly established, First Tennessee cannot at this time evaluate either the likelihood of an unfavorable outcome or the dollar amount of any potential loss exposure. First Tennessee believes its subsidiary’s yield spread premium payments, which are consistent with industry practices, are lawful, and intends to defend vigorously the lawsuits against it.

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Note 7 — Intangible Assets

Following is a summary of intangible assets, net of accumulated amortization, included in the Consolidated Statements of Condition:

The gross carrying amount of other intangible assets subject to amortization is $93.9 million on June 30, 2002, net of $60.7 million of accumulated amortization. Estimated aggregate amortization expense for the remainder of 2002 is expected to be $3.3 million and is expected to be $6.3 million, $5.7 million, $4.1 million and $2.7 million for the twelve-month periods of 2003, 2004, 2005 and 2006, respectively.

On January 1, 2002, First Tennessee adopted the provisions of SFAS No. 142 (see Note 1 – Financial Information). The following table presents on a proforma basis net income and related per share amounts exclusive of amortization expense (net of tax effect) recognized in 2001 related to goodwill no longer being amortized.

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Note 8 — Mortgage Servicing Rights

Following is a summary of changes in capitalized mortgage servicing rights, net of accumulated amortization, included in the Consolidated Statements of Condition:

The mortgage servicing rights on June 30, 2002 and 2001, had estimated market values of approximately $646.6 million and $760.3 million, respectively. These balances represent the rights to service approximately $48.7 billion and $45.0 billion of mortgage loans on June 30, 2002 and 2001. On June 30, 2002, a valuation allowance due to impairment of $24.9 million was required. On June 30, 2001, no valuation allowance was required. Estimated MSR amortization expense for the twelve month periods ending June 30, 2003, 2004, 2005, 2006 and 2007, are $91.2 million, $79.1 million, $68.8 million, $59.2 million, and $50.2 million, respectively. The assumptions underlying these estimates are subject to modification based on changes in market conditions and portfolio behavior (such as prepayment speeds). As a result, these estimates are subject to change in a manner and amount that is not presently determinable by management.

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ITEM 2.
FIRST TENNESSEE NATIONAL CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS
AND FINANCIAL CONDITION

GENERAL INFORMATION

First Tennessee National Corporation (First Tennessee) is headquartered in Memphis, Tennessee, and is a nationwide, diversified financial services institution which provides banking and other financial services to its customers through various regional and national business lines. Effective January 1, 2002, the business segment information has been adapted to better reflect First Tennessee’s strategic alignment and positioning and to conform to similar changes in internal segment reporting. Prior periods have been restated for comparability. The new segments are FTN Banking Groups, First Horizon, FTN Financial, Transaction Processing, Corporate and Strategic Initiative Items. FTN Banking Groups includes the Retail/Commercial Bank, Investments, Insurance, Financial Planning, Trust Services and Asset Management, Credit Card and Cash Management. This segment offers traditional banking financial services and products and also promotes comprehensive financial planning to address customer needs and desires for investments, insurance, estate planning, education funding, cash reserves and retirement goals. First Horizon includes First Horizon Home Loans (previously referred to as mortgage banking), First Horizon Equity Lending and First Horizon Money Centers (both of which were previously included in the Retail/Commercial Bank). These business lines were combined to create a common focus and a stronger presence in the national market. FTN Financial added Strategic Alliances and Correspondent Services to the existing business mix that included Capital Markets, Equity Research and Investment Banking. Strategic Alliances is a customer relationship service group recently formed to enhance our portfolio of innovative investment services. Correspondent Services was a part of the Retail/Commercial Bank previously. Transaction Processing continues to offer credit card merchant processing, nationwide bill payment processing, check clearing operations and other products and services. The Corporate segment includes certain corporate expenses, SFAS No. 133 gains/(losses) (see Other — Accounting for Derivative Instruments and Hedging Activities), interest expense on trust preferred and REIT preferred stock, and other items not allocated or not specifically assigned to business segments. The Strategic Initiative Items segment isolates items occurring in 2001 that were related to a strategic initiative to enhance growth and business mix, as announced by First Tennessee in 2000 (see Business Line Review for additional detail).

Based on management’s best estimates, certain revenue and expenses are allocated and equity is assigned to the various segments to reflect the inherent risk in each business line. These allocations are periodically reviewed and may be revised from time to time to more accurately reflect current business conditions and risks; the previous history has been adjusted to ensure comparability.

For the purpose of this management discussion and analysis (MD&A), noninterest income (also called fee income) and total revenue exclude securities gains and losses. Net interest income has been adjusted to a fully taxable equivalent (FTE) basis for certain tax-exempt loans and investments included in earning assets. Earning assets, including loans, have been expressed as averages, net of unearned income. First Tennessee Bank National Association, the primary bank subsidiary, is also referred to as FTBNA in this discussion.

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The following is a discussion and analysis of the financial condition and results of operations of First Tennessee for the three-month and sixth-month periods ended June 30, 2002, compared to the three-month and sixth-month periods ended June 30, 2001. To assist the reader in obtaining a better understanding of First Tennessee and its performance, this discussion should be read in conjunction with First Tennessee’s unaudited consolidated financial statements and accompanying notes appearing in this report. Additional information including the 2001 financial statements, notes, and management’s discussion and analysis is provided in the 2001 Annual Financial Disclosures included as an appendix to the 2002 Proxy Statement.

FORWARD-LOOKING STATEMENTS

Management’s discussion and analysis may contain forward-looking statements with respect to First Tennessee’s beliefs, plans, goals, expectations, and estimates. These statements are contained in certain sections that follow such as Noninterest Income, Net Interest Income, and Other. Forward-looking statements are statements that are not based on historical information but rather are related to future operations, strategies, financial results or other developments. The words “believe”, “expect”, “anticipate”, “intend”, “estimate”, “should”, “is likely”, “will”, “going forward”, and other expressions that indicate future events and trends identify forward-looking statements. Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond a company’s control, and many of which, with respect to future business decisions and actions (such as acquisitions and divestitures), are subject to change. Examples of uncertainties and contingencies include, among other important factors, general and local economic and business conditions; expectations of and actual timing and amount of interest rate movements (which can have a significant impact on a financial services institution); market and monetary fluctuations; inflation; competition within and outside the financial services industry; possible terrorist activity; technology; and new products and services in the industries in which First Tennessee operates. Other factors are those inherent in originating and servicing loans, including prepayment risks and fluctuation of collateral values and changes in customer profiles. Additionally, the actions of the Securities and Exchange Commission, the Financial Accounting Standards Board, the Office of the Comptroller of the Currency (OCC) and the Board of Governors of the Federal Reserve System, unanticipated regulatory and judicial proceedings, and changes in laws and regulations applicable to First Tennessee and First Tennessee’s success in executing its business plans and strategies and managing the risks involved in the foregoing, could cause actual results to differ. First Tennessee assumes no obligation to update any forward-looking statements that are made from time to time.

CRITICAL ACCOUNTING POLICIES

The consolidated financial statements of First Tennessee are prepared in conformity with generally accepted accounting principles and follow general practices within the industries in which it operates. This preparation requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Management believes the following policies are both important to the portrayal of the company’s financial condition and results and require subjective or complex judgments. Additional information is provided in the 2001 Annual Financial Disclosures.

Subject to the use of estimates, assumptions and judgments is management’s evaluation process used to determine the adequacy of the allowance for loan losses which combines several factors: historical loss experience derived from analytical models, specific analysis of commercial credits over $1 million, current trends and economic conditions, and reasonably foreseeable events. Because current economic conditions can change and future events are inherently difficult to predict, the anticipated amount of estimated loan losses, and therefore the adequacy of the allowance, could change. First Tennessee believes the allowance for loan losses is adequate and properly recorded in the financial statements. See Provision for Loan Losses/Asset Quality. The fair value of First Tennessee’s investment in

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mortgage servicing rights (MSR) is important to the presentation of the consolidated financial statements in that MSR are subject to a fair value based impairment standard and are actively hedged in fair value hedging relationships. MSR do not trade in an active open market with readily observable prices. Rather, sales of MSR tend to occur in principal-to-principal transactions, and although precise terms and conditions of sale are typically not readily available, information regarding the value of transactions is generally obtainable. As such, like other participants in the mortgage banking business, First Tennessee relies on an internal discounted cash flow model to estimate the fair value of its MSR. First Tennessee uses assumptions in the model that it believes are appropriate and comparable to those used by other participants in the mortgage banking business and reviews its values and assumptions with outside advisors on a quarterly basis. While First Tennessee believes that the values produced by its internal model are indicative of the fair value of its MSR portfolio, these values can change significantly depending upon the then current interest rate environment and other economic conditions, and the proceeds that might be received should First Tennessee actually consider a sale of the MSR portfolio could differ from the amounts reported at any point in time. First Tennessee believes MSR are properly recorded in the financial statements.

In various segments of its business, particularly in First Horizon, First Tennessee uses derivative financial instruments to reduce exposure to changes in interest rates and market prices for financial instruments. Substantially all of these derivative financial instruments are designated as hedges for financial reporting purposes. The application of the hedge accounting policy requires judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings and measurement of changes in the fair value of hedged items. First Tennessee believes that its techniques for addressing these judgmental areas are in line with industry practices in assessing hedge effectiveness. However, if in the future the derivative financial instruments used by First Tennessee no longer qualify for hedge accounting treatment and, consequently, the change in fair value of hedged items could not be recognized in earnings, the impact on the consolidated results of operations and reported earnings could be significant. First Tennessee believes hedge effectiveness is evaluated properly in preparation of the financial statements.

Most of the derivative financial instruments used by First Tennessee have active markets and indications of fair value can be readily obtained. Under the existing accounting rules, the commitments to extend mortgage loans at fixed interest rates entered into between First Horizon Home Loans and its customers qualify as derivative financial instruments. In the absence of a ready and observable market for loan commitments, First Tennessee uses an internal model and one of several industry valuation techniques to value its fixed-rate loan commitments. While First Tennessee believes the value produced by its internal model is reasonable, the proceeds that might be received should First Tennessee actually consider a sale of the loan commitments could differ from the amounts reported at any point in time. First Tennessee believes loan commitments are properly recorded in the financial statements.

First Tennessee’s activities as a servicer of mortgage loans subjects it to the risk of loss from foreclosure and other servicing-related activities. The estimation of an adequate foreclosure loss reserve involves the same judgments regarding the predictive power of past foreclosure results and the impact of current trends and operating conditions. While First Tennessee believes that the current analytical model and related assumptions used to determine the foreclosure loss reserve are proper and in line with industry practice and reflective of current trends and conditions, actual foreclosure losses could differ from the estimated amount as properties and collateral are actually disposed. First Tennessee believes the foreclosure loss reserve is adequate and properly recorded in the financial statements.

The assessment of contingent liabilities, including legal contingencies and tax liabilities, involves the use of estimates, assumptions and judgments, and there can be no assurance that future events, such as court decisions or I.R.S. positions, will not differ from management’s current assessment. First Tennessee believes reserves for contingent liabilities are adequate and properly recorded in the financial statements.

Under SFAS No. 142, “Goodwill and Other Intangible Assets”, which became effective on January 1, 2002, goodwill is no longer amortized, but is subject to an impairment test. First Tennessee has not recognized any impairment of the goodwill currently on its books during 2002; however, subsequent developments or information could result in impairment.

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FINANCIAL SUMMARY (Comparison of second quarter 2002 to second quarter 2001)

Earnings for second quarter 2002 were $90.4 million, an increase of 5 percent from last year’s second quarter earnings of $85.8 million. Diluted earnings per common share were $.69 in 2002 compared to $.65 in 2001. Earnings for second quarter 2001 before the effect of debt restructurings were $89.0 million, or $.68 diluted earnings per common share. Return on average shareholders’ equity was 23.7 percent and return on average assets was 1.87 percent for second quarter 2002. Return on average shareholders’ equity was 25.1 percent and return on average assets was 1.79 percent for the same period in 2001. Before the effect of debt restructurings, return on average shareholders’ equity was 26.0 percent and return on average assets was 1.86 percent for second quarter 2001.

On June 30, 2002, First Tennessee was ranked as one of the top 50 bank holding companies nationally in market capitalization ($4.8 billion) and total assets ($19.8 billion). On June 30, 2001, market capitalization was $4.4 billion and total assets were $18.8 billion.

Total revenue grew 2 percent from second quarter 2001, with a 1 percent increase in fee income (noninterest income excluding securities gains and losses) and a 6 percent increase in net interest income.

NONINTEREST INCOME

Fee income provides the majority of First Tennessee’s revenue and contributed 66 percent to total revenue in second quarter 2002 compared to 67 percent for the same period in 2001. Second quarter 2002 fee income increased 1 percent to $338.9 million from $337.0 million in 2001. The December 31, 2001, acquisition of Synaxis Group, Inc. (Synaxis), a commercial insurance broker, impacted the results of second quarter 2002, adding $9.7 million to noninterest income. Divestiture gains of $70.1 million in second quarter 2001 (all of which are included in Strategic Initiative Items — see BUSINESS LINE REVIEW — Strategic Initiative Items below) also impacted the growth rate. Excluding the impact of Synaxis in 2002 and divestiture gains in 2001, total fee income would have increased 23 percent. A more detailed discussion of the major line items follows.

Mortgage Banking

First Horizon Home Loans, a subsidiary of FTBNA and the major component of the First Horizon business segment, originates and services residential mortgage loans. Following origination, the mortgage loans, primarily first-lien, are sold to investors in the secondary market. Various hedging strategies are used to mitigate changes in the market value of the loan during the time period beginning with a price commitment to the customer and ending when the loan is delivered to the investor. Closed loans held during this time period are referred to as the mortgage warehouse. Origination fees and gains or losses from the sale of loans are recognized at the time a mortgage loan is sold into the secondary market. A portion of the gain or loss is recognized at the time an interest rate lock commitment is made to the customer. Secondary marketing activities include gains or losses from mortgage pipeline and warehouse hedging activities, product pricing decisions, and gains or losses from the sale of loans into the secondary market including the capitalized net present value of the MSR. Servicing rights permit the collection of fees for gathering and processing monthly mortgage payments for the owner of the mortgage loans. There were no bulk or flow sales of MSR in second quarter 2002. First Horizon Home Loans employs hedging strategies intended to counter a change in the value of its MSR through changing interest rate environments. MSR hedge gains/(losses) reflect effects of hedging including servicing rights net value changes (see also Other — Accounting for Derivative Instruments and Hedging Activities). Other income includes income from the foreclosure repurchase program and other miscellaneous items. Mortgage trading securities gains/(losses) relate to market value adjustments primarily on interest-only strips and related hedges. Mortgage banking fee income is reported net of amortization impairment and other expenses related to MSR and related hedges.

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Mortgage banking fee income increased 21 percent to $129.9 million from $107.8 million for second quarter 2001 as shown in Table 1.

Table 1 — Mortgage Banking

Origination activity decreased 11 percent to $5.9 billion and loan sales into the secondary market decreased 13 percent to $5.2 billion in second quarter 2002 compared to last year as refinance mortgage activity fell. This drop in refinance activity occurred despite the fact that mortgage rates were generally lower than a year ago, primarily reflecting the impact of the extended period of refinance opportunity that has existed in the market place since early last year. Due to the decrease in origination volume and loans sold into the secondary market and lower servicing values created during the period, fees from the mortgage origination process (loan origination fees, profits from the sale of loans, flow sales of MSR, and other secondary marketing activities) decreased 2 percent to $117.5 million from $120.0 million in second quarter 2001. This decrease was net of increased pipeline hedging gains. Both the reduced servicing values and increased pipeline hedging gains can be attributed to the general decline in mortgage rates experienced throughout the quarter.

MSR amortization was $29.9 million for second quarter 2002 compared with $26.8 million in 2001, and for second quarter 2002 there was a MSR impairment loss of $24.9 million compared to a $25.5 million loss in second quarter 2001. Net MSR hedging gains (MSR net hedge results less time decay of MSR hedges) were $21.0 million (increase in the value of hedges offset by decrease in value of hedged MSR) in second quarter 2002 compared to $2.3 million net gains (increase in the value of hedged MSR offset by decrease in value of hedges) in 2001.

The mortgage-servicing portfolio (which includes servicing for ourselves and others) totaled $48.7 billion on June 30, 2002, compared to $45.0 billion on June 30, 2001. Mortgage servicing fee income increased 14 percent to $43.4 million in 2002 primarily due to the 8 percent increase in the mortgage-servicing portfolio. Servicing fees also benefited from an increase in the mix of higher fee products and a reduction in a negative impact from prepayments.

Going forward, if mortgage interest rates rise from current levels, the origination volume from refinanced mortgages, and therefore revenue from origination fees, profits from the sale of loans and MSR and gains from pipeline and warehouse hedging and other loan sale activities, is expected to decline along with the current expense levels associated with amortization and write-off of existing MSR.

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Home purchase-related mortgage originations should reflect the recent expansion of our sales force, as well as the relative strength or weakness of the economy. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion.

Capital Markets

Capital markets fee income, the major component of revenue in the FTN Financial segment, is primarily generated from the purchase and sale of securities as both principal and agent and from investment banking, portfolio advisory and equity research services. Inventory positions are limited to the procurement of securities solely for distribution to customers by the sales staff. Inventory is effectively hedged to protect against movements in interest rates. For second quarter 2002, capital markets fee income increased 49 percent to $98.2 million from $65.7 million in 2001. This increase reflects continued growth and penetration into the targeted institutional customer base and non-traditional product initiatives. Total securities bought and sold increased 9 percent to $400.3 billion from $367.0 billion in 2001. Total underwritings during second quarter 2002 were $12.3 billion compared to $14.5 billion for the same period in 2001.

Going forward, revenues will be dependent on the expansion of the customer base, the volume of investment banking transactions and the introduction of new products, as well as the strength of loan growth in the U.S. economy and the steepness of the yield curve. Actual results could differ because of several factors, including those presented in the Forward-Looking Statements section of the MD&A discussion.

Other Fee Income

Fee income from deposit transactions and cash management for second quarter 2002 increased 15 percent to $36.4 million from $31.6 million in 2001 primarily due to growth in deposit service charges and cash management fees. Trust services and investment management fees decreased 8 percent to $13.3 million from $14.4 million in 2001 primarily due to declining asset management fees related to a contraction in market valuations and a decision in 2001 to de-emphasize less profitable product lines. Assets under management fell 16 percent to $7.7 billion on June 30, 2002 from $9.2 billion on June 30, 2001. Merchant processing fee income increased 11 percent to $12.6 million in second quarter 2002 from $11.3 million, due to a portfolio acquisition in second quarter 2002. All other income and commissions increased 34 percent to $48.5 million for second quarter 2002 from $36.1 million in 2001 primarily due to the acquisition of Synaxis. For second quarter 2001, gains from divestitures (all included in Strategic Initiative Items) were $70.1 million due to gains from the sale of a portfolio of student loans ($12 million), the sale of Peoples and Union Bank ($13 million) and the sale of First Tennessee’s partnership interest in Check Solutions Company ($45 million). There were no divestiture gains in second quarter 2002.

Going forward, when the equity market begins to recover, fee income, such as asset management and trust fees, should rebound.

NET INTEREST INCOME

Net interest income increased 6 percent to $177.5 million from $167.5 million in second quarter 2001, primarily due to an improving net interest margin (margin), which has benefited from lower funding costs and a steepening yield curve. Earning assets increased 1 percent to $16.3 billion from $16.2 billion in second quarter 2001. The consolidated margin increased to 4.36 percent for second quarter 2002 compared to 4.15 percent for the same period in 2001. As shown in Table 2, the activity levels and related funding for First Tennessee’s mortgage production and servicing and capital markets activities affect the margin. These activities typically produce different margins than traditional banking activities. Mortgage production and servicing activities can affect the overall margin based on a number of factors, including the size of the mortgage warehouse, the time it takes to deliver loans into the secondary market, the amount of custodial balances, and the level of MSR. Capital markets activities tend to compress the margin because of its strategy to reduce market risk by hedging its inventory in the cash markets, which effectively eliminates net interest income on these positions. As a result, First Tennessee’s consolidated margin cannot be readily compared to that of other bank holding companies.

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Table 2 — Net Interest Margin