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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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 – 174,002,000 shares outstanding as of April 30, 2008.

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-month period ended March 31, 2008 are not necessarily indicative of the results that may be expected for the year ending December 31, 2008.

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 5.2 million and 2.2 million anti-dilutive options for the three months ended March 31, 2008 and 2007, respectively.

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

The following table presents the components of other comprehensive income (loss):

In accordance with Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN 48), the Corporation maintains a reserve for unrecognized income tax positions as a component of other liabilities. Upon adoption of FIN 48 on January 1, 2007, the Corporation recorded a $220,000 decrease in existing reserves for unrecognized income tax positions, with a cumulative effect adjustment for the same amount recorded to retained earnings.

As of March 31, 2008 and 2007 the Corporation had total reserves for unrecognized income tax positions of $3.1 million and $4.1 million, respectively, all of which, if recognized, would impact the effective tax rate. Also as of March 31, 2008 and 2007, the Corporation had $1.0 million and $1.4 million, respectively, in accrued interest payable related to such unrecognized positions. The Corporation recognizes interest accrued related to unrecognized income tax positions as a component of income tax expense. Penalties, if incurred, would also be recognized in income tax expense.

During the three months ended March 31, 2008, the Corporation reversed $2.0 million of its reserves for unrecognized income tax positions, resulting in a reduction of income tax expense. The Corporation had not fully recognized in the consolidated financial statements the positions it had taken on its tax returns for disallowed interest expense on certain tax-exempt municipal securities. In the fourth quarter of 2007, a court ruled in favor of a taxpayer who had taken a similar position on its tax returns. In the first quarter of 2008, the Internal Revenue Service indicated that it would not pursue an appeal of this ruling. As a result, the criteria for remeasurement of this tax position were reached.

The Corporation, or one of its subsidiaries, files income tax returns in the U.S. Federal jurisdiction, and various states. In many cases, unrecognized income 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 2004.

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 benefits for equity awards recognized on 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 1st 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 March 31, 2008, the Option Plans had 14.0 million shares reserved for future grants through 2013.

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.

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 second quarter of 2007. The curtailment loss resulted from a $13.8 million gain from adjusting the funded status of the Pension Plan and an offsetting $13.9 million write-off of unamortized pension costs and related deferred tax assets.

The Corporation currently provides medical and life insurance benefits under a postretirement benefits plan (Postretirement Plan) to certain retired full-time employees who were employees of the Corporation prior to January 1, 1998. Certain 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.

As required by Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Postretirement Plans” (Statement 158), the Corporation recognizes the funded status of its Pension Plan and Postretirement Plan on the consolidated balance sheets and recognizes the changes in that funded status through other comprehensive income.

Effective January 1, 2008, as required by Statement 158, the Corporation changed the actuarial measurement date for its Pension Plan from a fiscal year-end of September 30th to December 31st. The impact of this change in the actuarial measurement date resulted in a $66,000 increase to the Corporation’s prepaid pension asset and a cumulative effect adjustment, net of tax, of $43,000 recorded as an increase to retained earnings.

The net periodic benefit (income) cost for the Pension Plan and Postretirement Plan, as determined by consulting actuaries, consisted of the following components for the three months ended March 31:

In September 2006, the FASB ratified Emerging Issues Task Force (EITF) Issue 06-4, “Accounting for Deferred Compensation and Postretirement 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 postretirement periods. EITF 06-4 requires that the postretirement benefit aspects of an endorsement-type split-dollar life insurance arrangement be recognized as a liability by the employer if that obligation has not been settled through the related insurance arrangement. 

The Corporation adopted the provisions of EITF 06-4 on January 1, 2008 and recorded a $677,000 liability, with a cumulative effect adjustment for the same amount recorded as a reduction to retained earnings. The amount represents the actuarial cost of maintaining endorsement split-dollar life insurance policies for certain employees which have not been effectively settled through their related insurance arrangements.

As of March 31, 2008, interest rate swaps with a notional amount of $98.0 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 and the certificates of deposit are recorded at fair value, with changes in the fair values during the period recorded to other expense. For the three months ended March 31, 2008, net gains of $33,000 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 $96,000 for the three months ended March 31, 2007.

In February 2007, the FASB issued Statement of Financial Accounting Standards 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. Statement 159 became effective on January 1, 2008 and the Corporation adopted the provisions of Statement 159 for the interest rate swaps and the related certificates of deposit.

Prior to the adoption of Statement 159, the Corporation accounted for these interest rate swaps and the related certificates of deposit under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (Statement 133). Under Statement 133, the

Corporation performed tests for each swap to prove they were highly effective. The adoption of Statement 159 for these instruments did not result in a change in the reported values of the interest rate swaps or certificates of deposits on the Corporation’s consolidated balance sheets. However, the administrative burden of completing these periodic effectiveness tests was removed, as such tests are not required under Statement 159.

The Corporation did not adopt the provisions of Statement 159 for any other financial assets or liabilities on its consolidated balance sheets.

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 total amount recorded in accumulated other comprehensive income upon settlement of this derivative 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.

The Corporation entered into a forward-starting interest rate swap with a notional amount of $100.0 million in February 2007 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 total amount recorded in accumulated other comprehensive income upon settlement of this derivative 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 on 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:

As of March 31, 2008, the Corporation recorded a $3.8 million reserve for unfunded lending commitments, included in other liabilities, which represented management’s estimates of losses inherent in commitments to extend credit. Prior to December 31, 2007, the reserve for unfunded lending commitments was included as a component of the allowance for loan losses. As of December 31, 2007,

the Corporation reclassified the reserve for unfunded lending commitments to other liabilities. Prior periods were not reclassified.

Residential Lending ContingenciesBeginning in 2008, residential mortgages are originated and sold by the Corporation through Fulton Mortgage Company (Fulton Mortgage), which is a division of each of the Corporation’s subsidiary banks, and The Columbia Bank, which maintains its own mortgage lending operations. The loans originated and sold through these channels are predominately “prime” loans that conform to published standards of government-sponsored agencies.

During 2007, the Corporation recorded $25.1 million of charges related to actual and potential repurchases of residential loans and home equity loans which were originated and sold to secondary market investors by the former Resource Bank’s mortgage division, Resource Mortgage. Resource Mortgage operated a national wholesale mortgage lending operation through early 2007. Loans were originated and sold under various investor programs, including some that allowed for reduced documentation and/or no verification of certain borrower qualifications, such as income or assets.

The Corporation has managed its residential mortgage lending risk by exiting from the national wholesale mortgage business at Resource Mortgage, where the majority of the repurchased loans were generated. In addition, the Corporation merged Resource Bank, including Resource Mortgage, into Fulton Bank in the first quarter of 2008. During the first quarter of 2008, the Corporation recorded $800,000 of additional charges related to actual and potential repurchases of residential mortgage and home equity loans, and continued to work through the loans repurchased from investors from the prior year.

The following table presents a summary of the approximate principal balances and related reserves/write-downs recognized on the Corporation’s consolidated balance sheet, by general category:

The following presents the change in the reserve/write-down balances:

Management believes that the reserves recorded as of March 31, 2008 are adequate for the known potential repurchases. However, continued declines in collateral values or the identification of additional loans to be repurchased could necessitate additional reserves in the future.

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.

On January 1, 2008, the Corporation adopted the provisions of Statement 157 for all financial assets and liabilities and all nonfinancial assets and liabilities required to be measured at fair value on a recurring basis. Although the adoption of Statement 157 did not impact the values of assets and liabilities on the Corporation’s consolidated balance sheet, the adoption resulted in expanded disclosure requirements for assets and liabilities recorded at fair value.

Statement 157 establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into the following three categories (from highest to lowest priority):

Companies are required to categorize all financial assets and liabilities and all nonfinancial assets and liabilities required to be measured at fair value on a recurring basis into the above three levels.

The Corporation’s assets and liabilities measured at fair value and reported on the Corporation’s consolidated balance sheet that are subject to Statement 157 as of March 31, 2008 were as follows:

The valuation techniques used to measure fair value for the items in the table above are as follows:

In February 2008, the FASB issued FASB Staff Position No. 157-2, “Effective Date of FASB Statement No. 157” (FSP 157-2). FSP 157-2 delayed the effective date of Statement 157 for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis, until fiscal years beginning after November 15, 2008, or January 1, 2009 for the Corporation.

In accordance with FSP 157-2, the Corporation did not apply the provisions of Statement 157 for the following nonfinancial assets and liabilities, which are not measured at fair value on a recurring basis: loans, deposits and borrowings acquired in prior years’ business combinations, other intangible assets initially measured at fair value upon acquisition and reporting units tested annually for goodwill impairment under Financial Accounting Standard No. 142, “Goodwill and Other Intangible Assets”.

The application of FSP 157-2 for these nonfinancial assets and liabilities is not expected to have an impact on their reported values, but will result in additional disclosure related to the inputs associated with their fair value measurements.

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (Statement 161). Statement 161 establishes the disclosure requirements for derivative instruments and for hedging activities, including disclosure of information that should enable users of financial information to understand how and why a company uses derivative instruments, how derivative instruments and related hedged items are accounted for, and how derivative instruments and related hedged items affect a company’s financial position, financial performance, and cash flows. The standard is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, or the Corporation’s March 31, 2009 quarterly report on Form 10-Q. The adoption of Statement 161 is not expected to have a material impact on the Corporation’s consolidated financial statements.

In April 2008, the Corporation entered into a definitive agreement with U.S. Bank National Association ND, d/b/a Elan Financial Services (Elan), to sell its approximately $85.0 million credit card portfolio to Elan. The Corporation estimates that the transaction will result in a gain in the second quarter of 2008 of approximately $10.0 million, which is dependent on the balance of the portfolio on the sale date, among other factors.

Under a separate agreement with Elan, the Corporation will provide ongoing marketing services on behalf of Elan and will receive a fee for each new account originated and a percentage of the revenue earned on both new accounts and accounts sold.

Certain amounts in the 2007 consolidated financial statements and notes have been reclassified to conform to the 2008 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, market risk, changes or adverse developments in economic, political, or regulatory conditions, a continuation or worsening of the current disruption in credit and other markets, including the lack of or reduced access to, and the abnormal functioning of markets for mortgages and other asset-backed securities and for commercial paper and other short-term borrowings, the effect of competition and interest rates on net interest margin and net interest income, investment strategy and income growth, investment securities gains, impairment of securities, changes in rates of deposit and loan growth, asset quality and the impact on assets from adverse changes in the economy and in credit or other markets and resulting effects on credit risk and asset values, balances of risk-sensitive assets to risk-sensitive liabilities, salaries and employee benefits and other expenses, amortization of intangible assets, goodwill impairment, capital and liquidity strategies and other financial and business matters for future periods. 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, actual results could differ materially from forward-looking statements. The Corporation undertakes no obligations to update or revise any forward-looking statements.

The Corporation generates the majority of its revenue through net interest income, or the difference between interest earned on loans and investments and interest paid on deposits and borrowings. Growth in net interest income is dependent upon balance sheet growth and/or maintaining or increasing the net interest margin, which is net interest income (fully taxable-equivalent) 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, 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 first quarter of 2008 increased $368,000, or 0.9%, from the same period in 2007 due to an increase in net interest income of $4.1 million, or 3.4%, a decrease in other expenses of $4.2 million, or 4.2%, and a $3.6 million, or 20.4%, decrease in income tax expense, offset by a $10.3 million increase in the provision for loan losses and a $1.4 million, or 3.5%, decrease in other income.

The following summarizes some of the more significant factors that influenced the Corporation’s results for the three months ended March 31, 2008.

Net Interest Margin and Net Interest Income – In recent years, the interest rate environment has presented challenges to banks in maintaining and growing their net interest margin. 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 securities over various maturity terms. Typically, the shape of the yield curve is upward sloping, with longer-term rates exceeding shorter-term rates. Over the past several years, however, there had been little difference between short and long-term rates and, at times, short-term rates exceeded long-term rates. For banks that depend on shorter-term funding to invest longer term in investment securities and loans, this situation has not been favorable.

During the fourth quarter of 2007 and continuing throughout the first quarter of 2008, the yield curve began to return to a more normal, upward-sloping shape. Since the first quarter of 2007, the Federal Reserve Board (FRB) lowered the overnight Federal funds rate six times, for a total decrease of 250 basis points (from 4.75% to 2.25%), with a total decrease of 200 basis points occuring during the first quarter of 2008.

The following graph shows the U. S. treasury yield curve at March 31, 2008, in comparison to March 31, 2007 and each of the two most recent year-ends. This graph illustrates the recent trend toward a more normal-shaped yield curve:

The majority of the Corporation’s interest-earning assets and interest-bearing liabilities have durations of seven years or less. The reduction in short-term rates during the first quarter of 2008 resulted in an upward slope to the yield curve for these durations that had not been seen for some time. During the first quarter there was a slight improvement in net interest income and net interest margin in comparison to the fourth quarter of 2007, as short-term borrowings and many deposit balances repriced to lower rates more quickly than assets. In the longer term, however, this benefit may be mitigated by the continued repricing of assets and the inability to move deposit rates lower in similar increments.

In comparison to the first quarter of 2007, the Corporation experienced a 53 basis point, or 13.8%, decrease in the cost of average interest-bearing liabilities (from 3.85% in 2007 to 3.32% in 2008) as compared to a 56 basis point, or 8.0%, decrease in the yield on average interest-earning assets (from 6.99% in 2007 to 6.43% in 2008). During the first quarter of 2007, interest recoveries totaling $3.7 million added approximately 13 basis points to net interest margin. As a result these two factors, the net interest margin decreased 16 basis points compared to the first quarter of 2007.

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 loan payments will result in charge-offs of account balances, which, in turn, result in provisions for loan losses recorded on the consolidated statements of income. By its nature, risk in lending cannot be completely eliminated, but it can be controlled and managed through proper underwriting policies, effective collection procedures and risk management activities. External factors, such as economic conditions, which cannot be controlled by the Corporation, will always have some effect on asset quality, regardless of the strength of an organization’s control policies and procedures.

The Corporation’s non-performing assets increased significantly, from $58.0 million, or 0.40% of total assets, at March 31, 2007 to $144.7 million, or 0.90% of total assets, at March 31, 2008. The increase was primarily due to worsening general economic conditions, which have negatively impacted consumer confidence and residential real estate values, and partially due to the repurchase of residential mortgages

previously sold by the Corporation’s former Resource Bank affiliate, as discussed below. This increase in non-performing assets contributed to a $10.3 million increase in the provision for loan losses as compared to the first quarter of 2007.

Management believes that its policies and procedures for managing asset quality are sound. However, there can be no assurance about maintaining strong asset quality in the future. Continuing decreases in the values of underlying collateral or negative trends in general economic conditions could have a detrimental impact on borrowers’ ability to repay their loans.

Residential Lending – During the first quarter of 2008, the Corporation continued to work through the loans repurchased from investors by the former Resource Bank. As disclosed in prior periods, certain residential mortgage and home equity loans that were originated under “non-prime” programs were repurchased due to “early payment defaults” or misrepresentations of borrower information. Upon repurchase, the majority of these loans were placed on non-accrual status or were foreclosed and transferred to other real estate owned. These loans accounted for approximately $31 million of the Corporation’s non-performing assets as of March 31, 2008.

The Corporation has managed its residential lending risk by exiting the national wholesale residential mortgage business at Resource Mortgage, where the majority of the repurchased loans were generated and by merging Resource Bank (and Resource Mortgage) into Fulton Bank in the first quarter of 2008.

See Note G, “Commitments and Contingencies” in the Notes to Consolidated Financial Statements for additional details.

Equity Markets – The Corporation has a significant portfolio of equity investments in financial institutions stocks, with a carrying value of $67.0 million at March 31, 2008. Historically, gains on sales of these securities have been a recurring component of the Corporation’s earnings. However, general economic conditions and uncertainty surrounding the financial institution sector as a whole has impacted the value of these securities, as shown by the portfolio’s $21.2 million of net unrealized losses, recorded within “Investment securities gains” on the consolidated statements of income, as of March 31, 2008. During the first quarter of 2008, the Corporation recorded $3.6 million of losses on stocks that were considered to be other than temporarily impaired. Further declines in bank stock values may impact the Corporation’s ability to realize gains in the future and may also result in additional other than temporary impairment charges.

Visa, Inc. Initial Public Offering – In March 2008, Visa, Inc. (Visa) completed its initial public offering and, as a result, member banks of Visa, who had previously received “Class USA” shares in a restructuring completed in 2007, had these shares converted to “Class B” shares, a portion of which were redeemed by Visa in connection with the initial public offering. Redemption proceeds totaling $3.6 million were recognized as “Investment securities gains” on the consolidated statements of income during the first quarter of 2008. The Corporation retained approximately 133,000 Class B shares, which can be converted to Class A shares at the later of 3 years following the initial public offering or the date on which certain litigation, as defined in Visa’s public filings, has been resolved. The shares will be converted based on a factor that considers the member banks’ relative share of the litigation liability. Since the value of the Class B shares cannot be determined, they have not been recognized on the consolidated balance sheets. Upon conversion to Class A shares, these equity securities will be accounted for in accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities”.

The Corporation had previously recorded a litigation reserve through a charge to earnings in the fourth quarter of 2007, totaling $1.5 million. This reserve represented the estimated fair value of the Corporation’s share of the member banks’ indemnification liability with Visa related to the previously disclosed litigation. As a result of the initial public offering, a litigation escrow was established by Visa, which eliminated the majority of the member banks’ exposure to this litigation. As a result, in the first

quarter of 2008, the Corporation reversed $1.4 million of this reserve through a reduction in other expenses.

FASB Interpretation No. 48 (FIN 48) – Under FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (FIN 48), income tax positions taken on returns that do not meet the recognition and measurement criteria, as defined, may not be recognized for financial statement purposes. The Corporation had not fully recognized on the consolidated financial statements the positions it had taken on its tax returns for the disallowed interest expense on certain tax-exempt municipal securities. In the fourth quarter of 2007, a court ruled in favor of a taxpayer who had taken a similar position on its tax returns. In the first quarter of 2008, the Internal Revenue Service indicated that it would not pursue an appeal of this ruling. As a result, the criteria for remeasurement of this tax position were reached, and the Corporation reversed $2.0 million of reserves it had recorded, resulting in a reduction of income tax expense.

Net Interest IncomeNet interest income increased $4.1 million, or 3.4%, to $125.9 million in 2008 from $121.8 million in 2007 due to an increase in average interest-earning assets, offset by a decline in the net interest margin.

The following table provides a comparative average balance sheet and net interest income analysis for the first quarter of 2008 as compared to the same period in 2007. Interest income and yields are presented on an FTE basis, using a 35% Federal tax rate and statutory interest expense disallowances. 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 decreased $895,000, or 0.4%, due to a decrease of $18.9 million caused by a 56 basis point decrease in rates, offset by an $18.0 million increase in interest income realized from a $1.0 billion, or 7.6%, increase in average balances.

The increase in average interest-earning assets was due mainly to loan growth, which is summarized in the following table:

Loan growth was particularly strong in the commercial loan and commercial mortgage loan categories, which together increased $749.5 million, or 12.0%. The growth in commercial loans was across all commercial loan types, while growth in commercial mortgages was primarily in adjustable rate categories. Additional growth came from residential mortgage loans, which increased $159.1 million, or 22.7%, primarily in traditional adjustable rate products, and an increase in home equity loans of $84.7 million, or 5.9%, which was primarily due to the introduction of a new blended fixed/floating rate product in late 2007. Offsetting these increases were decreases in construction loans of $67.8 million, or

4.9%, due to a slowdown in the residential housing market in most of the Corporation’s geographical areas and a $43.1 million, or 8.3%, decrease in consumer loans, primarily in the indirect automobile portfolio.

The average yield on loans decreased 80 basis points, or 10.5%, from 7.65% in 2007 to 6.85% in 2008. The decrease in yield reflected a lower interest rate environment, as illustrated by a lower average prime rate during the first quarter of 2008 (6.27%) as compared to the same period in 2007 (8.25%).

Average investment securities increased $274.6 million, or 9.6%. In late 2007, the Corporation “pre-purchased” investments, based on the expected cash flows to be generated from maturing U.S. government sponsored agency securities over an approximate six-month period. This strategy allowed the Corporation to immediately obtain rates more favorable than those that may have been available had cash flows been re-invested as they occurred.

The average yield on investment securities increased 33 basis points, or 7.2%, from 4.61% in 2007 to 4.94% in 2008. The increase in yield was partially due to the pre-purchase strategy and partially due to the systematic reinvestment of normal portfolio cash flows, primarily from shorter duration, significantly lower yielding balloon mortgaged-backed securities, into a combination of higher yielding mortgage-backed pass-through securities, conservative U.S. government issued collateralized mortgage obligations and longer term municipal securities. In addition, despite decreases in short-term rates as a result of recent actions by the FRB, yields on securities backed by residential mortgages have not decreased, due primarily to economic factors surrounding the residential housing market.

Average loans held for sale decreased $109.2 million, or 52.5%, as a result of a $278.9 million, or 63.0%, decrease in the volume of loans originated for sale in the first quarter of 2008 as compared to the same period in 2007. The decrease was mainly due to the Corporation’s exit from the national wholesale mortgage business as well as a general slowdown in housing markets.

The $895,000 decrease in interest income (FTE) was exceeded by a decrease in interest expense of $5.6 million, or 5.1%, to $103.3 million in the first quarter of 2008 from $108.9 million in the first quarter of 2007. Interest expense decreased $17.6 million as a result of a 53 basis point, or 13.8%, decrease in the average cost of interest-bearing liabilities. The decrease was offset by a $12.0 million increase in interest expense caused by a $1.1 billion, or 9.4%, increase in average interest-bearing liabilities.

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

The Corporation experienced a net decrease in noninterest-bearing and interest-bearing demand and savings accounts of $235.1 million, or 4.1%, caused by decreases in both business and personal accounts. This decrease was partially offset by a slight increase in time deposits.

As average deposits decreased, borrowings were used to provide the additional funding needed to support the growth in average loans and investments. The following table summarizes the changes in average borrowings, by type:

The increase in short-term borrowings was mainly due to an increase in Federal funds purchased, which increased $269.1 million, and overnight FHLB advances, included within other short-term borrowings, which increased $449.6 million. The increase in long-term debt was due to an increase in FHLB advances as longer-term rates were locked and durations were extended to manage interest rate risk.

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

Approximately $4.9 billion, or 43.2%, of the Corporation’s loan portfolio was in commercial mortgage and construction loans at March 31, 2008, compared to 44.4% at March 31, 2007. While the Corporation does not have a concentration of credit risk with any single borrower, industry or geographical location, economic conditions in general and the performance of real estate markets in particular could impact borrowers’ ability to repay loans in these portfolios. Potential decreases in real estate values could also adversely impact the performance of these loans. The Corporation has maintained stringent underwriting policies and procedures to manage its asset credit quality and credit risk.

The following table presents the activity in the Corporation’s allowance for credit losses: