UNITED STATESSECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
xQuarterly Report Pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2004
OR
oTransition Report Pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934
Commission File Number 1-9861
M&T BANK CORPORATION
One M & T Plaza Buffalo, New York 14203(Address of principal executive offices)(Zip Code)
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.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Number of shares of the registrant’s Common Stock, $.50 par value, outstanding as of the close of business on October 29, 2004: 116,139,696 shares.
FORM 10-Q
For the Quarterly Period Ended September 30, 2004
2
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements.
M&T BANK CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (Unaudited)
3
CONSOLIDATED STATEMENT OF INCOME (Unaudited)
4
CONSOLIDATED STATEMENT OF CASH FLOWS (Unaudited)
5
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)
CONSOLIDATED SUMMARY OF CHANGES IN ALLOWANCE FOR CREDIT LOSSES (Unaudited)
6
NOTES TO FINANCIAL STATEMENTS
7
NOTES TO FINANCIAL STATEMENTS, CONTINUED
8
9
10
11
12
13
The financial information of the Company’s segments was compiled utilizing the accounting policies described in note 21 to the Company’s consolidated financial statements as of and for the year ended December 31, 2003. The management accounting policies and processes utilized in compiling segment financial information are highly subjective and, unlike financial accounting, are not based on authoritative guidance similar to generally accepted accounting principles. As a result, the financial information of the reported segments is not necessarily comparable with similar information reported by other financial institutions. As also described in note 21 to the Company’s 2003 consolidated financial statements, goodwill and core deposit and other intangible assets (and the amortization charges associated with such assets) resulting from acquisitions of financial institutions have not been allocated to the Company’s reportable segments, but are included in the “All Other” category. The Company has, however, assigned such intangible assets to business units for purposes of testing for impairment. Information about the Company’s segments is presented in the following tables:
14
6. Segment Information, continued
15
16
17
18
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
Net income of M&T Bank Corporation (“M&T”) during the third quarter of 2004 totaled $186 million or $1.56 of diluted earnings per common share, increases of 19% and 22%, respectively, from $156 million or $1.28 of diluted earnings per common share in the corresponding quarter of 2003. During the second quarter of 2004, net income was $184 million or $1.53 of diluted earnings per common share. Basic earnings per common share were $1.59 in the recent quarter, up from $1.31 in the year-earlier quarter and $1.56 in 2004’s second quarter. The after-tax impact of merger-related expenses associated with M&T’s April 1, 2003 acquisition of Allfirst Financial Inc. (“Allfirst”) from Allied Irish Banks, p.l.c., (“AIB”) was $12 million or $.10 each of diluted and basic earnings per share in the third quarter of 2003. There were no merger-related expenses in the second or third quarters of 2004.
M&T’s recent quarter’s results include the following three events. First, M&T reorganized certain of its subsidiaries which altered the taxable status of such subsidiaries in certain jurisdictions thereby decreasing M&T’s effective state income tax rate for the quarter. As a result of the reorganizations, both income tax expense during the third quarter of 2004 and deferred tax liabilities at September 30, 2004 were reduced by $12 million. Nevertheless, M&T’s effective income tax rate in future periods is not expected to be significantly different from what it otherwise would have been had the subsidiary reorganizations not occurred. Second, M&T Bank, a wholly owned subsidiary of M&T and M&T’s principal bank subsidiary, made a tax-deductible $25 million cash contribution to The M&T Charitable Foundation, a tax-exempt private charitable foundation, which increased “other expense” by the amount of the contribution while reducing income tax expense by $10 million, resulting in a net after-tax expense of $15 million. Finally, a $3 million after-tax gain was realized on the sale of a venture capital investment that M&T had obtained in the acquisition of Allfirst. Collectively, these three events were offsetting and did not have a material effect on net income or earnings per share.
For the nine-month period ended September 30, 2004, net income was $530 million or $4.39 per diluted share, up 30% and 22%, respectively, from $407 million or $3.59 per diluted share during the first nine months of 2003. Basic earnings per share were $4.48 for the first three quarters of 2004, compared with $3.68 in the similar 2003 period. The after-tax impact of merger-related expenses associated with the Allfirst acquisition reduced net income during the first nine months of 2003 by approximately $38 million and diluted and basic earnings per share by $.33 and $.34, respectively. There were no merger-related expenses during the corresponding 2004 period.
The annualized rate of return on average total assets for M&T and its consolidated subsidiaries (“the Company”) in the third quarter of 2004 was 1.42%, compared with 1.24% in the year-earlier quarter and 1.45% in the second quarter of 2004. The annualized rate of return on average common stockholders’ equity was 13.02% in the recent quarter, compared with 11.37% in the third quarter of 2003 and 13.12% in 2004’s second quarter. Excluding the impact of merger-related expenses, the annualized returns on average assets and average common equity were 1.34% and 12.27%, respectively, during 2003’s third quarter. During the first three quarters of 2004, the annualized rates of return on average assets and average common stockholders’ equity were 1.39% and 12.44%, respectively, compared with 1.23% and 11.55%, respectively, in the similar 2003 period. Excluding the impact of merger-related expenses, the annualized returns on average assets and average common equity were 1.35% and 12.62%, respectively, during the first nine months of 2003.
19
Merger-related expenses associated with the Allfirst acquisition incurred during the three-month and nine-month periods ended September 30, 2003 totaled $19 million ($12 million after tax effect) and $58 million ($38 million after tax effect), respectively. Such expenses were for professional services and temporary help associated with the conversion of systems and/or integration of operations; initial marketing and promotion expenses designed to introduce M&T Bank to Allfirst’s customers; travel and relocation costs; and printing, supplies and other costs of commencing operations in new markets and offices. There were no unpaid merger-related expenses as of September 30, 2004. In accordance with generally accepted accounting principles (“GAAP”), included in the determination of goodwill associated with the Allfirst merger were charges totaling $29 million, net of applicable income taxes ($48 million before tax effect), for severance costs for former Allfirst employees; investment banking and other professional fees; and termination of Allfirst contracts for various services. As of September 30, 2004, the remaining unpaid portion of such charges totaled $4 million and related largely to severance payments being disbursed to former employees in installments over time.
Supplemental Reporting of Non-GAAP Results of Operations
M&T has accounted for substantially all of its business combinations using the purchase method of accounting. As a result, the Company had recorded intangible assets consisting of goodwill and core deposit and other intangible assets totaling $3.1 billion at each of September 30, 2004 and December 31, 2003, and $3.2 billion at September 30, 2003. Included in such intangible assets at each of those dates was goodwill of $2.9 billion. Amortization of core deposit and other intangible assets, after tax effect, totaled $11 million ($.09 per diluted share) during the third quarter of 2004, compared with $14 million ($.11 per diluted share) in the corresponding quarter of 2003 and $12 million ($.10 per diluted share) in 2004’s second quarter. For the nine month periods ended September 30, 2004 and 2003, amortization of core deposit and other intangible assets, after tax effect, totaled $36 million ($.30 per diluted share) and $35 million ($.31 per diluted share), respectively.
Since 1998, M&T has consistently provided supplemental reporting of its results on a “net operating” or “tangible” basis, from which M&T excludes the after-tax effect of amortization of core deposit and other intangible assets (and the related goodwill, core deposit intangible and other intangible asset balances, net of applicable deferred tax amounts) and expenses associated with merging acquired operations into the Company, since such expenses are considered by management to be “nonoperating” in nature. Although “net operating income” as defined by M&T is not a GAAP measure, M&T’s management believes that this information helps investors understand the effect of acquisition activity in reported results.
Net operating income during the third quarter of 2004 rose 8% to $198 million from $183 million in the corresponding 2003 quarter. Diluted net operating earnings per share for the recent quarter were $1.65, up 11% from $1.49 in the year-earlier quarter. Net operating income and diluted net operating earnings per share were $196 million and $1.63, respectively, in the second quarter of 2004. For the first three quarters of 2004, net operating income and diluted net operating earnings per share were $566 million and $4.69, respectively, compared with $479 million and $4.23 in the similar 2003 period.
Expressed as an annualized rate of return on average tangible assets, net operating income was 1.60% in the recent quarter, compared with 1.55% in the year-earlier quarter and 1.64% in the second quarter of 2004. Net operating income expressed as an annualized return on average tangible common equity was 29.42% in the third quarter of 2004, compared with 30.67% in the third quarter of 2003 and 30.12% in 2004’s second quarter. Including the effect of merger-related expenses, the annualized net operating returns on average tangible assets and average tangible common stockholders’ equity for the third quarter of 2003 were 1.44% and 28.59%, respectively. For the first nine months of 2004, net operating income represented an annualized return on average tangible assets and average tangible common stockholders’ equity of
20
1.58% and 28.45%, respectively, compared with 1.54% and 28.55%, respectively, in the corresponding 2003 period. Including the effect of merger-related expenses, the annualized net operating returns on average tangible assets and average tangible common stockholders’ equity for the nine-month period ended September 30, 2003 were 1.42% and 26.32%, respectively.
Reconciliations of GAAP amounts with corresponding non-GAAP amounts are provided in table 2.
Taxable-equivalent Net Interest Income
Taxable-equivalent net interest income increased 2% to $444 million in the third quarter of 2004 from $435 million in the year-earlier quarter. The improvement reflects a 7% rise in average earning assets to $45.9 billion, partially offset by a decline in the Company’s net interest margin, or taxable-equivalent net interest income expressed as an annualized percentage of average earning assets, from 4.02% in 2003’s third quarter to 3.85% in the recent quarter. Taxable-equivalent net interest income was $438 million in the second quarter of 2004 when average earning assets were $44.9 billion and the Company’s net interest margin was 3.92%. The increase in net interest income from 2004’s second quarter to the recently completed quarter was due largely to a $950 million increase in average earning assets, reflecting a $707 million increase in average loans outstanding and a $252 million increase in the average balance of investment securities.
Average loans and leases rose to $37.6 billion in the recent quarter from $37.0 billion in the year-earlier quarter. That increase was due largely to higher balances of commercial real estate loans and consumer loans. Partially offsetting the commercial real estate and consumer loan growth were lower average consumer real estate loan balances resulting largely from the impact of two fourth quarter 2003 transactions in which M&T converted $1.3 billion of such loans into mortgage-backed securities which are now held in the investment securities portfolio and a decision by the Company during the recent quarter to reclassify loans to developers of residential real estate properties to commercial real estate loans from consumer real estate loans. The average balance of such loans during 2004’s third quarter was $407 million, compared with $188 million in the third quarter of 2003 and $323 million in 2004’s second quarter. The prior period amounts have not been reclassified given that such amounts represented less than 1% of total loans and, accordingly, were not considered significant to the Company’s consolidated balance sheet. Average loans and leases in 2004’s third quarter rose 2% from $36.9 billion in the second quarter of 2004, led by growth in the commercial loan and commercial real estate loan portfolios. The following table summarizes quarterly changes in the major components of the loan and lease portfolio.
AVERAGE LOANS AND LEASES(net of unearned discount)Dollars in Millions
For the first three quarters of 2004, taxable-equivalent net interest income was $1.3 billion, up 10% from $1.2 billion in the similar 2003 period. An increase in average loans and leases of $3.6 billion, largely resulting
21
from the impact of the $10.3 billion of loans obtained in the Allfirst acquisition on April 1, 2003, was the leading factor contributing to that improvement. The loans obtained in the Allfirst transaction included approximately $4.5 billion of commercial loans and leases (including $314 million of leveraged leases and $230 million of loans to foreign borrowers), $2.5 billion of commercial real estate loans, $383 million of residential real estate loans and $2.9 billion of consumer loans and leases. Higher average balances of investment securities also contributed to the year-over-year improvement in taxable-equivalent net interest income. Partially offsetting the impact of growth in earning assets was a lower net interest margin, which declined 23 basis points (hundredths of one percent) to 3.90% during the first nine months of 2004 from 4.13% in the year-earlier period.
Investment securities averaged $8.2 billion in the recent quarter, up from $5.8 billion in the corresponding quarter of 2003 and $7.9 billion in the second quarter of 2004. The higher level of investment securities in 2004’s third quarter as compared with the year-earlier period includes the impact of the fourth quarter 2003 residential real estate loan securitizations already noted and purchases of residential mortgage-backed securities and collateralized mortgage obligations during the second and third quarters of 2004. The investment securities portfolio is largely comprised of residential and commercial mortgage-backed securities and collateralized mortgage obligations, shorter-term U.S. Treasury notes, debt securities issued by municipalities, and debt and preferred equity securities issued by government-sponsored agencies and certain financial institutions. When purchasing investment securities, the Company considers its overall interest-rate risk profile as well as the adequacy of expected returns relative to the risks assumed, including prepayments. In managing the investment securities portfolio, the Company occasionally sells investment securities as a result of changes in interest rates and spreads, actual or anticipated prepayments, credit risk associated with a particular security, or in connection with a business combination. The Company regularly reviews its investment securities for declines in value below amortized cost that might be other than temporary. As of September 30, 2004, the Company concluded that such declines were temporary in nature.
Money-market assets, which are comprised of interest-earning deposits at banks, interest-earning trading account assets, federal funds sold and agreements to resell securities, averaged $68 million in 2004’s third quarter, compared with $95 million in the year-earlier quarter and $76 million in the second quarter of 2004. The size of the Company’s investment securities and money-market assets portfolios are influenced by such factors as demand for loans, which generally yield more than investment securities and money-market assets, ongoing repayments, the levels of deposits, collateral requirements and management of balance sheet size and resulting capital ratios.
As a result of the changes described herein, average earning assets increased $3.0 billion, or 7%, to $45.9 billion in the recent quarter from $42.9 billion in the third quarter of 2003. Average earning assets were $44.9 billion in the second quarter of 2004 and aggregated $44.8 billion and $38.5 billion for the nine-month periods ended September 30, 2004 and 2003, respectively.
Core deposits represent the most significant source of funding for the Company and are comprised of noninterest-bearing deposits, interest-bearing transaction accounts, nonbrokered savings deposits and nonbrokered domestic time deposits under $100,000. The Company’s branch network is its principal source of core deposits, which generally carry lower interest rates than wholesale funds of comparable maturities. Core deposits include certificates of deposit under $100,000 generated on a nationwide basis by M&T Bank, National Association (“M&T Bank, N.A.”), a wholly owned subsidiary of M&T. Core deposits averaged $28.1 billion in the recent quarter, compared with $28.9 billion in the third quarter of 2003 and $28.3 billion in 2004’s second quarter. The following table provides an analysis of quarterly changes in the components of average core deposits. Average time deposits less than $100,000 have declined from prior periods due to the low interest rate environment, as
22
depositors continued to demonstrate reluctance to commit funds to longer-term deposit products. The decline in average NOW account balances from 2003’s third quarter reflects product modifications that resulted in additional customer balances being swept into savings deposit accounts. For the nine-month periods ended September 30, 2004 and 2003, core deposits averaged $28.1 billion and $25.0 billion, respectively. Core deposits assumed on April 1, 2003 in conjunction with the Allfirst acquisition totaled approximately $10.7 billion on that date.
AVERAGE CORE DEPOSITSDollars in Millions
The Company also obtains funding through domestic time deposits of $100,000 or more, deposits originated through the Company’s offshore branch office, and brokered deposits. Domestic time deposits over $100,000, excluding brokered certificates of deposit, averaged $1.3 billion in the third quarters of 2004 and 2003, compared with $1.2 billion in the second quarter of 2004. Offshore branch deposits, primarily comprised of balances of $100,000 or more, averaged $3.3 billion, $1.3 billion and $2.8 billion for the three-month periods ended September 30, 2004, September 30, 2003 and June 30, 2004, respectively. Brokered time deposits averaged $1.8 billion in the third quarter of 2004, compared with $333 million in the year-earlier quarter and $1.3 billion in the second quarter of 2004. At September 30, 2004, brokered time deposits totaled $1.8 billion and had a weighted-average remaining term to maturity of 14 months. Certain of these brokered time deposits have provisions that allow for early redemption. In connection with the Company’s management of interest rate risk, interest rate swap agreements have been entered into under which the Company receives a fixed rate of interest and pays a variable rate and that have notional amounts and terms substantially similar to the amounts and terms of $130 million of brokered time deposits. The Company also had brokered money-market deposit accounts which averaged $57 million during the third quarter of 2004, compared with $60 million and $56 million during the third quarter of 2003 and second quarter of 2004, respectively. Offshore branch deposits and brokered deposits have been used by the Company as an alternative to short-term borrowings. Additional amounts of offshore branch deposits or brokered deposits may be solicited in the future depending on market conditions, including demand by customers and other investors for those deposits, and the cost of funds available from alternative sources at the time.
The Company also uses borrowings from banks, securities dealers, the Federal Home Loan Banks of New York, Pittsburgh and Atlanta (together, the “FHLB”), and others as sources of funding. Short-term borrowings averaged $5.3 billion in the recent quarter, compared with $4.9 billion in the year-earlier quarter and $5.1 billion in the second quarter of 2004. Amounts borrowed from the FHLB and included in short-term borrowings averaged $598 million in the third quarter of 2003, while there were no such short-term borrowings in 2004’s two most recent quarters. Also included in short-term borrowings is a $500 million revolving asset-backed structured borrowing secured by automobile loans that were transferred to M&T Auto Receivables I, LLC, a special purpose subsidiary of M&T Bank formed in November 2002. The subsidiary, the loans and the borrowings are included in the consolidated financial statements of the Company. The remaining short–term borrowings were predominantly comprised of unsecured federal funds borrowings which generally mature daily. Federal funds borrowings averaged $4.5 billion in the third quarter of 2004, compared with $3.4 billion in the year-earlier quarter and $4.3 billion in the second quarter of 2004.
23
Long-term borrowings averaged $5.8 billion in the recent quarter, compared with $6.6 billion and $5.9 billion in the third quarter of 2003 and the second quarter of 2004, respectively. Included in average long-term borrowings were amounts borrowed from the FHLB totaling $3.2 billion in the second and third quarters of 2004 and $4.0 billion in the third quarter of 2003, and subordinated capital notes of $1.3 billion in each of those quarters. Average long-term borrowings for the third quarter of 2003 also included $198 million of floating rate notes payable to AIB that were assumed in the acquisition of Allfirst and that were subsequently repaid. As described in note 5 of Notes to Financial Statements, as of December 31, 2003 the Company applied new accounting provisions promulgated by the Financial Accounting Standards Board (“FASB”) and removed from its consolidated balance sheet the trusts that had issued trust preferred securities. That change had no economic impact on the Company and no material or substantive impact on the Company’s financial statements. Trust preferred securities included in average long-term borrowings totaled $685 million in the third quarter of 2003. Junior subordinated debentures associated with trust preferred securities that were included in average long-term borrowings in the two most recent quarters were approximately $710 million. Information regarding trust preferred securities and the related junior subordinated debentures is provided in note 5 of Notes to Financial Statements. As described later, interest rate swap agreements have been entered into by the Company as part of its management of interest rate risk related to certain long-term borrowings.
In addition to changes in the composition of the Company’s earning assets and interest-bearing liabilities, changes in interest rates and spreads can impact net interest income. Net interest spread, or the difference between the taxable-equivalent yield on earning assets and the rate paid on interest-bearing liabilities, was 3.57% in the third quarter of 2004 and 3.75% in the year-earlier quarter. The yield on earning assets during the recent quarter was 5.10%, down 16 basis points from 5.26% in the third quarter of 2003, while the rate paid on interest-bearing liabilities increased 2 basis points to 1.53% from 1.51%. The decline in interest rates earned from 2003’s third quarter reflect lower yields on loans and investment securities. In the second quarter of 2004, the net interest spread was 3.67%, the yield on earning assets was 5.06% and the rate paid on interest-bearing liabilities was 1.39%. The yield on earning assets in 2004’s second quarter reflects a 5 basis point benefit resulting from $6 million of interest collected on several large nonperforming loans during that quarter. On June 30, 2004, the Federal Reserve raised its benchmark overnight federal funds target rate by 25 basis points. During the recent quarter, two more 25-basis point increases to such target rate were initiated by the Federal Reserve. As a result, both yields on earning assets and rates paid on interest-bearing liabilities of the Company increased from the second quarter to the third quarter of 2004. For the first nine months of 2004, the net interest spread was 3.63%, a decrease of 23 basis points from the corresponding 2003 period. The yield on earning assets and the rate paid on interest-bearing liabilities were 5.08% and 1.45%, respectively, in the first three quarters of 2004, compared with 5.52% and 1.66%, respectively, in the year-earlier period. Lower market interest rates and lower yielding portfolios of loans and investment securities obtained in the acquisition of Allfirst contributed to the reduced yields on earning assets in the nine-month period ended September 30, 2004 as compared with the similar 2003 period.
Net interest-free funds consist largely of noninterest-bearing demand deposits and stockholders’ equity, partially offset by bank owned life insurance and non-earning assets, including goodwill and core deposit and other intangible assets. Average net interest-free funds totaled $8.4 billion in the third quarter of 2004, up from $7.8 billion a year earlier and $8.2 billion in the second quarter of 2004. The increase in net interest-free funds in the recent quarter as compared with the third quarter of 2003 was due, in part, to a reduction in average non-earning asset balances, largely cash and due from banks and other assets. During the first three quarters of 2004 and 2003, average net interest-free funds were $8.1 billion and $6.4 billion, respectively. The increase in average net interest-free funds in the first nine months of 2004 as compared with the year-earlier period was due, in
24
part, to the impact of the April 1, 2004 Allfirst acquisition. Goodwill and core deposit and other intangible assets averaged $3.1 billion during the second and third quarters of 2004, and $3.2 billion during the third quarter of 2003. The cash surrender value of bank owned life insurance averaged $980 million and $932 million in the third quarter of 2004 and 2003, respectively, and $967 million in the second quarter of 2004. Tax-exempt income earned from increases in the cash surrender value of bank owned life insurance is not included in interest income, but rather is recorded in “other revenues from operations.”
The contribution of net interest-free funds to net interest margin was .28% in the recent quarter, compared with .27% in the third quarter of 2003 and .25% in 2004’s second quarter. For the first nine months of both 2004 and 2003, the contribution of net interest-free funds to net interest margin was .27%.
Reflecting the changes described herein, the Company’s net interest margin was 3.85% in 2004’s third quarter, 17 basis points lower than 4.02% in the third quarter of 2003 and down 7 basis points from 3.92% in the second 2004 quarter. During the first nine months of 2004 and 2003, the net interest margin was 3.90% and 4.13%, respectively.
In managing interest rate risk, the Company utilizes interest rate swap agreements to modify the repricing characteristics of certain portions of its portfolios of earning assets and interest-bearing liabilities. Periodic settlement amounts arising from these agreements are generally reflected in either the yields earned on assets or, as appropriate, the rates paid on interest-bearing liabilities. The notional amount of interest rate swap agreements entered into for interest rate risk management purposes as of September 30, 2004 and 2003 was $705 million and $675 million, respectively, and $685 million as of June 30, 2004. In general, under the terms of these agreements, the Company receives payments based on the outstanding notional amount of the swap agreements at fixed rates of interest and makes payments at variable rates.
All of the Company’s interest rate swap agreements entered into for risk management purposes as of September 30, 2004 had been designated as fair value hedges. In a fair value hedge, changes in the fair value of the derivative (the interest rate swap agreement) and in the fair value of the hedged item are recorded in the Company’s consolidated balance sheet with the corresponding gain or loss recognized in current earnings. The difference between changes in the fair value of the interest rate swap agreements and the hedged items represents hedge ineffectiveness and is recorded in “other revenues from operations” in the Company’s consolidated statement of income. In a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in “other revenues from operations” immediately. The amounts of hedge ineffectiveness recognized during the quarters ended September 30, 2004 and 2003 and the quarter ended June 30, 2004 were not material to the Company’s results of operations. The estimated fair values of interest rate swap agreements designated as fair value hedges were a gain of approximately $1 million at September 30, 2004, compared with a gain of $11 million at September 30, 2003 and losses of $1 million at December 31, 2003 and $16 million at June 30, 2004. The fair values of such swap agreements were substantially offset by unrealized gains or losses on the hedged items. The changes in the fair values of the interest rate swap agreements and the hedged items resulted from the effects of changing interest rates.
The weighted average rates to be received and paid under interest rate swap agreements currently in effect were 6.83% and 4.40%, respectively, at September 30, 2004. The average notional amounts of interest rate swap agreements and the related effect on net interest income and margin, and weighted-average interest rates paid or received on those swap agreements, are presented in the accompanying table.
25
INTEREST RATE SWAP AGREEMENTSDollars in Thousands
As a financial intermediary, the Company is exposed to various risks, including liquidity and market risk. Liquidity risk refers to the Company’s ability to ensure that sufficient cash flow and liquid assets are available to satisfy demands for loans and deposit withdrawals, operating costs, and other corporate purposes. Liquidity risk arises whenever the maturities of financial instruments included in assets and liabilities differ. Deposits and borrowings, maturities of money-market assets and investment securities, repayments of loans and investment securities, and cash generated from operations, such as fees collected for services, provide the Company with sources of liquidity. M&T’s banking subsidiaries have access to additional funding sources through FHLB borrowings, lines of credit with the Federal Reserve Bank of New York, and other available borrowing facilities. M&T Bank has also obtained funding through issuances of subordinated capital notes and through the $500 million revolving asset-backed borrowing discussed earlier. Informal and sometimes reciprocal sources of funding are also available to M&T Bank through various arrangements for unsecured short-term borrowings from a wide group of banks and other financial institutions. Short-term federal funds borrowings aggregated $4.7 billion, $3.5 billion and $3.9 billion at September 30, 2004, December 31, 2003 and September 30, 2003, respectively. In general, these borrowings were unsecured and matured on the following business day.
Should the Company experience a substantial deterioration in its financial condition or its debt ratings, or should the availability of short-term funding become restricted due to a disruption in the financial markets, the Company’s ability to obtain funding from these or other sources could be negatively impacted. The Company attempts to quantify such credit-event risk by modeling scenarios that estimate the liquidity impact resulting from a short-term ratings downgrade over various grading levels. The Company estimates such impact by attempting to measure the effect on available unsecured lines of credit, available capacity from secured borrowing sources and securitizable assets.
26
The Company serves in the capacity of remarketing agent for variable rate demand bonds (“VRDBs”) in a line of business largely obtained in the Allfirst acquisition. The VRDBs are enhanced by a direct-pay letter of credit provided by M&T Bank. Holders of the VRDBs generally have the right to sell the bonds to the remarketing agent with seven days notice, which could result in M&T Bank owning the VRDBs for some period of time until such instruments are remarketed. When this occurs, the VRDBs are classified as trading assets in the Company’s consolidated balance sheet. The value of VRDBs in the Company’s trading account totaled $7 million and $45 million at September 30, 2004 and 2003, respectively, and $22 million at December 31, 2003. As of September 30, 2004 and December 31, 2003, the total amount of VRDBs outstanding backed by an M&T Bank letter of credit was $1.6 billion and $1.7 billion, respectively, compared with $1.5 billion at September 30, 2003. M&T Bank also serves as remarketing agent for most of those bonds.
The Company enters into contractual obligations in the normal course of business which require future cash payments. Off-balance sheet commitments to customers may impact liquidity, including commitments to extend credit, standby letters of credit, commercial letters of credit, financial guarantees and indemnification contracts, and commitments to sell real estate loans. Since many of these commitments or contracts expire without being funded in whole or in part, the contract amounts are not necessarily indicative of future cash flows. Further discussion of these commitments is provided in note 7 of Notes to Financial Statements.
M&T’s primary source of funds to pay for operating expenses, shareholder dividends and treasury stock repurchases is the receipt of dividends from its banking subsidiaries, which are subject to various regulatory limitations. Dividends from any banking subsidiary to M&T are limited by the amount of earnings of the banking subsidiary in the current year and the two preceding years. For purposes of this test, at September 30, 2004 approximately $560 million was available for payment of dividends to M&T from banking subsidiaries without prior regulatory approval. These historic sources of cash flow have been augmented in the past by the issuance of trust preferred securities. Information regarding trust preferred securities and the related junior subordinated debentures is included in note 5 of Notes to Financial Statements. M&T also maintains a $30 million line of credit with an unaffiliated commercial bank, of which there were no borrowings outstanding at September 30, 2004 or at December 31, 2003.
On an ongoing basis, management closely monitors the Company’s liquidity position for compliance with internal policies and believes that available sources of liquidity are adequate to meet funding needs anticipated in the normal course of business. Management does not currently anticipate engaging in any activities, either currently or in the long-term, for which adequate funding would not be available and that would cause a significant strain on liquidity at either M&T or its subsidiary banks.
Market risk is the risk of loss from adverse changes in market prices and/or interest rates of the Company’s financial instruments. The primary market risk the Company is exposed to is interest rate risk. The Company is exposed to interest rate risk in its core banking activities of lending and deposit-taking, since assets and liabilities reprice at different times and by different amounts as interest rates change. As a result, net interest income earned by the Company is subject to the effects of changing interest rates. The Company measures interest rate risk by calculating the variability of net interest income in future periods under various interest rate scenarios using projected balances for earning assets, interest-bearing liabilities and derivatives used to hedge interest rate risk. Management’s philosophy toward interest rate risk management is to limit the variability of net interest income. The balances of financial instruments used in the projections are based on expected growth from forecasted business opportunities, anticipated prepayments of loans and investment securities, and expected maturities of investment securities, loans and deposits. Management uses a “value of equity” model to supplement the modeling technique described above. Those supplemental analyses are based on discounted cash flows associated with on- and off-
27
balance sheet financial instruments. Such analyses are modeled to reflect changes in interest rates and shifts in the maturity curve of interest rates and provide management with a long-term interest rate risk metric.
The Company’s Risk Forum Committee, which includes members of senior management, monitors the sensitivity of the Company’s net interest income to changes in interest rates with the aid of a computer model that forecasts net interest income under different interest rate scenarios. In utilizing the model, market implied forward interest rates over the subsequent twelve months are generally used to determine a base interest rate scenario for the net interest income simulation. That calculated base net interest income is then compared to the income calculated under interest rate scenarios assuming incremental 100 and 200 basis point changes to the aforementioned base scenario. The model considers the impact of ongoing lending and deposit gathering activities, as well as interrelationships in the magnitude and timing of the repricing of financial instruments, including the effect of changing interest rates on expected prepayments and maturities. When deemed prudent, management has taken actions, and intends to do so in the future, to mitigate exposure to interest rate risk through the use of on- or off-balance sheet financial instruments. Possible actions include, but are not limited to, changes in the pricing of loan and deposit products, modifying the composition of earning assets and interest-bearing liabilities, and modifying or terminating existing interest rate swap agreements or other financial instruments used for interest rate risk management purposes.
The accompanying table as of September 30, 2004 and December 31, 2003 displays the estimated impact on net interest income from non-trading financial instruments in the base scenario described above resulting from parallel changes in interest rates across repricing categories during the first modeling year.
SENSITIVITY OF NET INTEREST INCOMETO CHANGES IN INTEREST RATESDollars in thousands
The Company utilized many assumptions to calculate the impact that changes in interest rates may have on net interest income. The more significant assumptions related to interest rates in future periods, the rate of prepayments of mortgage-related assets, cash flows from derivative and other financial instruments held for non-trading purposes, loan and deposit volumes and pricing, and deposit maturities. As noted above, the Company also assumed gradual changes in rates during a twelve-month period, including incremental 100 and 200 basis point rate changes, as compared with the assumed base scenario. In the event that a 100 or 200 basis point rate change cannot be achieved, the applicable rate changes are limited to lesser amounts such that interest rates cannot be less than zero. These assumptions are inherently uncertain and, as a result, the Company cannot precisely predict the impact of changes in interest rates on net interest income. Actual results may differ significantly due to the timing, magnitude and frequency of interest rate changes and changes in market conditions and interest rate differentials (spreads) between maturity/repricing categories, as well as any actions, such as those previously described, which management may take to counter such changes. In light of the uncertainties and assumptions associated with the process, the amounts presented in the table and changes in such amounts are not considered significant to the Company’s past or projected net interest income.
The Company has historically engaged in trading activities to meet the financial needs of customers, to fund the Company’s obligations under certain deferred compensation plans and, to a limited extent, to profit from perceived
28
market opportunities. Financial instruments utilized in trading activities have included forward and futures contracts related to foreign currencies and mortgage-backed securities, U.S. Treasury and other government securities, mortgage-backed securities, mutual funds and interest rate contracts, such as swap agreements. The Company generally mitigates the foreign currency and interest rate risk associated with trading activities by entering into offsetting trading positions. The amounts of gross and net trading positions, as well as the type of trading activities conducted by the Company, are subject to a well-defined series of potential loss exposure limits established by the Risk Forum Committee. However, as with any non-government guaranteed financial instrument, the Company is exposed to credit risk associated with counterparties to the Company’s trading activities.
The notional amounts of interest rate contracts entered into for trading purposes totaled $5.4 billion at September 30, 2004 and 2003, and $5.3 billion at December 31, 2003. The notional amounts of foreign currency and other option and futures contracts entered into for trading purposes were $667 million, $541 million and $548 million at September 30, 2004, September 30, 2003 and December 31, 2003, respectively. The notional amounts of these trading contracts are not recorded in the consolidated balance sheet. However, the fair values of all financial instruments used for trading activities are recorded in the consolidated balance sheet. The fair values of all trading account assets and liabilities were $159 million and $100 million, respectively, at September 30, 2004, $254 million and $157 million, respectively, at September 30, 2003, and $215 million and $139 million, respectively, at December 31, 2003. Included in other liabilities in the consolidated balance sheet at September 30, 2004 and December 31, 2003 were $49 million of liabilities related to deferred compensation plans, while at September 30, 2003 $47 million of such liabilities were included in other liabilities. Changes in the balances of deferred compensation-related liabilities due to the valuation of allocated investment options to which the liabilities are indexed are recorded in “other costs of operations” in the consolidated statement of income. Given the Company’s policies, limits and positions, management believes that the potential loss exposure to the Company resulting from market risk associated with trading activities was not material.
Provision for Credit Losses
The Company maintains an allowance for credit losses that in management’s judgment is adequate to absorb losses inherent in the loan and lease portfolio. A provision for credit losses is recorded to adjust the level of the allowance as deemed necessary by management. The provision for credit losses in the third quarter of 2004 was $17 million, compared with $34 million in the year-earlier quarter and $30 million in the second quarter of 2004. Net loan charge-offs were $15 million and $16 million in the third quarter of 2004 and 2003, respectively, and $21 million in 2004’s second quarter. Net charge-offs as an annualized percentage of average loans and leases were .16% in the recent quarter, compared with .17% in the third quarter of 2003 and .23% in the second quarter of 2004. For the nine months ended September 30, 2004 and 2003, the provision for credit losses was $67 million and $103 million, respectively. Through September 30, net charge-offs were $54 million in 2004
29
and $64 million in 2003, representing an annualized .20% and .26%, respectively, of average loans and leases. Net charge-offs of loans acquired from Allfirst have not been significant. A summary of net charge–offs by loan type follows.
NET CHARGE-OFFSBY LOAN/LEASE TYPEIn Thousands
Loans classified as nonperforming, which consist of nonaccrual and restructured loans, aggregated $181 million or .48% of total loans and leases outstanding at September 30, 2004, down from $285 million or .77% at September 30, 2003, $240 million or .67% at December 31, 2003, and $190 million or .51% at June 30, 2004. Included in nonperforming loans on those respective dates were $26 million, $82 million, $67 million and $31 million of nonperforming loans obtained in the Allfirst acquisition. The significant decrease in nonperforming loan levels since September 30, 2003 was the result of several commercial loans that were either paid off, sold or charged off since that date.
Accruing loans past due 90 days or more were $140 million or .37% of total loans and leases at September 30, 2004, compared with $174 million or .47% a year earlier, $155 million or .43% at December 31, 2003 and $135 million or .36% at June 30, 2004. Accruing loans past due 90 days or more include one-to-four family residential mortgage loans serviced by the Company and repurchased from the Government National Mortgage Association (“GNMA”). The repurchased loans totaled $97 million at September 30, 2004, $117 million a year earlier, $100 million at June 30, 2004 and $118 million at December 31, 2003. The outstanding principal balances of the repurchased loans are fully guaranteed by government agencies. The loans were repurchased to reduce servicing costs associated with them, including a requirement to advance principal and interest payments that had not been received from individual mortgagors.
Commercial loans and leases classified as nonperforming totaled $40 million at September 30, 2004, $140 million at September 30, 2003, $105 million at December 31, 2003 and $47 million at June 30, 2004. As noted earlier, the significant decrease in such loans at the two most recent quarter-ends when compared with the 2003 dates was due largely to the ultimate resolution of several large commercial credits through a combination of payoffs, sales and charge-offs.
Nonperforming commercial real estate loans aggregated $57 million at September 30, 2004, $60 million a year earlier, $48 million at December 31, 2003 and $62 million at June 30, 2004.
30
Nonperforming residential real estate loans totaled $43 million and $52 million at September 30, 2004 and 2003, respectively, $51 million at December 31, 2003, and $44 million at June 30, 2004. Residential real estate loans past due 90 days or more and accruing interest totaled $118 million at September 30, 2004, compared with $138 million at September 30, 2003, and $141 million and $119 million at December 31, 2003 and June 30, 2004, respectively. As previously discussed, a substantial portion of such loans related to loans repurchased from GNMA that are fully guaranteed by government agencies.
Nonperforming consumer loans and leases totaled $41 million at the recent quarter-end, compared with $33 million at September 30, 2003, $36 million at December 31, 2003, and $37 million at June 30, 2004. As a percentage of consumer loan balances outstanding, nonperforming consumer loans and leases were .36% at September 30, 2004, .30% a year earlier, and .33% at December 31, 2003 and June 30, 2004.
Assets acquired in settlement of defaulted loans were $16 million at September 30, 2004, $20 million at September 30 and December 31, 2003, and $19 million at June 30, 2004.
A comparative summary of nonperforming assets and certain past due loan data and credit quality ratios as of the end of the periods indicated is presented in the accompanying table.
NONPERFORMING ASSET AND PAST DUE LOAN DATADollars in thousands
Management regularly assesses the adequacy of the allowance for credit losses by performing ongoing evaluations of the loan and lease portfolio, including such factors as the differing economic risks associated with each loan category, the current financial condition of specific borrowers, the economic environment in which borrowers operate, the level of delinquent loans, the value of any collateral and, where applicable, the existence of any guarantees or indemnifications. Management evaluated the impact of changes in
31
interest rates and overall economic conditions on the ability of borrowers to meet repayment obligations when quantifying the Company’s exposure to credit losses and assessing the adequacy of the Company’s allowance for such losses at each reporting date. Factors also considered by management when performing its assessment, in addition to general economic conditions and the other factors described above, included, but were not limited to: (i) the concentration of commercial real estate loans in the Company’s loan portfolio, particularly the large concentration of loans secured by properties in New York State, in general, and in the New York City metropolitan area, in particular; (ii) the amount of commercial and industrial loans to businesses in areas of New York State outside of the New York City metropolitan area and in central Pennsylvania that have historically experienced less economic growth and vitality than the vast majority of other regions of the country; (iii) significant growth in loans to individual consumers, which historically have experienced higher net charge-offs as a percentage of loans outstanding than other loan types; and (iv) the large portfolios of loans obtained in the acquisition of Allfirst which management continues to evaluate in accordance with the Company’s policies and procedures for credit underwriting, loan classification, and measurement of exposure to loss. The level of the allowance is adjusted based on the results of management’s analysis.
Despite recent signs indicating the possible beginning of a general economic upturn, management cautiously and conservatively evaluated the allowance for credit losses as of September 30, 2004 in light of mixed regional economic indicators and, given the relative size of the acquired Allfirst loan portfolios, the status of management’s ongoing detailed credit reviews of such portfolios. Although there are indications that the national economy has improved and optimism about its future outlook is growing, concerns remain about the rate of job growth, which could cause consumer spending to slow; higher interest rates, which, among other things, could adversely impact the housing market and affect consumer confidence levels; and continued stagnant population growth in the upstate New York and central Pennsylvania regions. Management believes that the allowance for credit losses at September 30, 2004 was adequate to absorb credit losses inherent in the portfolio as of that date. The allowance for credit losses was $626 million, or 1.65% of total loans and leases at September 30, 2004, compared with $621 million or 1.67% a year earlier, $614 million or 1.72% at December 31, 2003, and $625 million or 1.66% at June 30, 2004. The ratio of the allowance for credit losses to nonperforming loans was 346% at the most recent quarter-end, compared with 218% a year earlier, 256% at December 31, 2003 and 328% at June 30, 2004. The level of the allowance is adjusted based on the results of management’s evaluation of the loan and lease portfolio as of each respective date.
Other Income
Other income totaled $245 million in the third quarter of 2004, up from $232 million in both the corresponding quarter of 2003 and the second 2004 quarter.
Mortgage banking revenues totaled $32 million in the recent quarter, down from $39 million in the third quarter of 2003, but higher than the $30 million recorded in the second quarter of 2004. Mortgage banking revenues are comprised of both residential and commercial mortgage banking activities. The Company’s involvement in commercial mortgage banking activities is largely comprised of the origination, sales and servicing of loans in conjunction with the Federal National Mortgage Association (“FNMA”) Delegated Underwriting and Servicing (“DUS”) program, which was a business line acquired in the Allfirst transaction.
Residential mortgage banking revenues, which include gains from sales of residential mortgage loans and loan servicing rights, residential mortgage loan servicing fees, and other residential mortgage loan-related fees and income, decreased to $25 million in the recent quarter from $32 million in the
32
year-earlier period, but were up from $23 million in the second quarter of 2004. The significant decrease in such revenues in the recent quarter as compared with the corresponding 2003 quarter was largely due to lower levels of loan originations. Higher origination activity in the 2003 quarter reflected the impact of historically low levels of interest rates that produced an extremely favorable environment for loan origination and refinancing activities by consumers. Residential mortgage loans originated for sale to other investors were approximately $1.1 billion during the third quarter of 2004, compared with $1.6 billion in 2003’s third quarter and $1.3 billion in the second quarter of 2004. Realized gains from sales of residential mortgage loans and loan servicing rights and recognized net unrealized gains attributable to residential mortgage loans held for sale, commitments to originate loans for sale and commitments to sell loans aggregated $8 million in the third quarter of 2004, compared with $17 million in the year-earlier quarter and $7 million in the second 2004 quarter.
As further explained in “Recent Accounting Developments” included herein, in March 2004 the Securities and Exchange Commission (“SEC”) issued SEC Staff Accounting Bulletin (“SAB”) No. 105, “Application of Accounting Principles to Loan Commitments,” which provides guidance regarding the accounting for loans held for sale and loan commitments accounted for as derivative instruments. In accordance with SAB No. 105, effective April 1, 2004 value ascribable to loan cash flows that will ultimately be realized in connection with mortgage servicing activities should not be included in the determination of fair value of loans held for sale or commitments to originate loans for sale, but rather should only be recognized at the time the underlying mortgage loans are sold. The Company adopted the SEC guidance effective April 1, 2004 resulting in a deferral of mortgage banking revenues of approximately $6 million. Neither the amount or timing of receipt of such cash flows nor the economic value of the loans and commitments have changed as a result of this accounting guidance.
Revenues from servicing residential mortgage loans for others were $15 million in the quarter ended September 30, 2004, compared with $13 million and $14 million in the third quarter of 2003 and the second quarter of 2004, respectively. Included in each quarter’s servicing revenues were amounts related to purchased servicing rights associated with small balance commercial mortgage loans, which totaled $2 million in the third quarter of 2004 and $1 million in the year-earlier quarter and in 2004’s second quarter. Residential mortgage loans serviced for others were $14.2 billion at September 30, 2004, $12.0 billion a year earlier, and $13.6 billion at December 31, 2003, including the small balance commercial mortgage loans noted above of approximately $1.3 billion and $800 million at September 30, 2004 and 2003, respectively, and $1.0 billion at December 31, 2003. Capitalized residential mortgage servicing assets, net of a valuation allowance for impairment, were $131 million at September 30, 2004, compared with $106 million at September 30, 2003 and $129 million at December 31, 2003. Included in capitalized residential mortgage servicing assets were $11 million at September 30, 2004, $7 million a year earlier and $8 million at December 31, 2003 of purchased servicing rights associated with the small balance commercial mortgage loans noted above. Residential mortgage loans held for sale were $706 million and $880 million at September 30, 2004 and 2003, respectively, and $723 million at December 31, 2003. Commitments to sell residential mortgage loans and commitments to originate residential mortgage loans for sale at pre-determined rates were $851 million and $550 million, respectively, at September 30, 2004, $1.1 billion and $687 million, respectively, at September 30, 2003 and $824 million and $459 million, respectively, at December 31, 2003. Net unrealized gains on residential mortgage loans held for sale, commitments to sell loans, and commitments to originate loans for sale were $2 million at September 30, 2004 and $7 million at December 31, 2003. Changes in net unrealized gains are recorded in mortgage banking revenues and resulted in a net decrease in revenues of $7 million in the second quarter of 2004 (including $6 million attributable to the implementation of SAB No. 105), an increase in such revenues of $.4 million during 2004’s third quarter, and a decrease of $10 million during 2003’s third quarter.
33
Commercial mortgage banking revenues in each of the second and third quarters of 2004 were $7 million, compared with $6 million in 2003’s third quarter. Revenues from commercial mortgage loan origination and sales activities were $3 million in the third and second quarters of 2004 and $4 million in the quarter ended September 30, 2003. Commercial mortgage loan servicing revenues were $3 million in the two most recent quarters, compared with $2 million in the third quarter of 2003. Capitalized commercial mortgage servicing assets totaled $22 million at September 30, 2004 and 2003, and at December 31, 2003. Commercial mortgage loans held for sale at September 30, 2004 and 2003 were $68 million and $2 million, respectively, and at June 30, 2004 and December 31, 2003 were $34 million and $1 million, respectively.
Service charges on deposit accounts rose to $94 million in the third quarter of 2004 from $91 million in each of the year-earlier quarter and the second quarter of 2004. Trust income totaled $34 million in the recent quarter, compared with $32 million in last year’s third quarter and $35 million in this year’s second quarter. Brokerage services income, which includes revenues from the sale of mutual funds and annuities and securities brokerage fees, totaled $13 million in each of the third quarter of 2004, the year-earlier quarter and the second quarter of 2004. Trading account and foreign exchange activity resulted in gains of $3 million during the third quarter of 2004, $5 million in 2003’s third quarter and $4 million in the second quarter of 2004. Other revenues from operations aggregated $69 million in the third quarter of 2004, compared with $52 million in the third quarter of 2003 and $59 million in 2004’s second quarter. Other revenues from operations included letter of credit and other credit-related fees of $21 million and $15 million in the third quarters of 2004 and 2003, respectively, and $18 million in the second quarter of 2004. Also contributing to the increase in other revenues from operations in the recent quarter as compared with the prior quarters were gains recognized on the sales of equipment as commercial leases expired and from the sale of a venture capital investment largely obtained in the Allfirst acquisition. Other revenues from operations also include tax-exempt income from bank owned life insurance, which includes increases in the cash surrender value of life insurance policies and benefits received. Income from bank owned life insurance totaled $12 million in the recent quarter, compared with $13 million in each of the quarters ended September 30, 2003 and June 30, 2004.
Other income totaled $705 million in the first nine months of 2004, up 18% from $597 million in the corresponding 2003 period. The increase in such income was due to operations associated with Allfirst, specifically the inclusion of nine months of Allfirst-related income in the 2004 period compared with six months of similar income in 2003.
For the first three quarters of 2004, mortgage banking revenues totaled $90 million, down from $117 million in the year-earlier period. Residential mortgage banking revenues decreased to $73 million in the nine-month period ended September 30, 2004 from $104 million in the similar 2003 period. A lower level of loan originations, largely due to the historically low interest rate environment during 2003, was the most significant factor causing the decline in revenues. Also contributing to the decrease was the previously noted adoption of SAB No. 105 which resulted in a deferral of mortgage banking revenues of approximately $6 million. Residential mortgage loans originated for sale to other investors were $3.4 billion in the first nine months of 2004, compared with $4.9 billion in the similar 2003 period. Realized gains from sales of residential mortgage loans and loan servicing rights and recognized unrealized gains on residential mortgage loans held for sale, commitments to originate loans for sale and commitments to sell loans aggregated $23 million and $56 million during the nine-month periods ended September 30, 2004 and 2003, respectively. Revenues from servicing residential mortgage loans for others were $43 million and $40 million for the first three quarters of 2004 and 2003, respectively. Included in such amounts were revenues related to purchased servicing rights associated with the previously noted small balance commercial mortgage loans of $5 million and $3 million for the first nine months of 2004 and 2003, respectively. Commercial mortgage banking revenues totaled $18 million during the first nine months of 2004, up from $13 million in the comparable 2003 period, which included only two quarters of Allfirst-related activity.
34
Due largely to the impact of the Allfirst transaction, service charges on deposit accounts grew to $273 million during the first nine months of 2004 from $220 million in the comparable 2003 period and trust income rose to $102 million from $80 million a year earlier. Brokerage services income increased 7% to $40 million during the first nine months of 2004 from $38 million in the similar 2003 period. Trading account and foreign exchange activity resulted in gains of $12 million and $11 million for the nine-month periods ended September 30, 2004 and 2003, respectively. Reflecting Allfirst-related revenues, other revenues from operations increased to $185 million in the first nine months of 2004 from $131 million in the comparable 2003 period. Included in other revenues from operations during the nine-month periods ended September 30, 2004 and 2003 were letter of credit and other credit-related fees of $57 million and $38 million, respectively, and income from bank owned life insurance of $37 million and $33 million, respectively.
Other Expense
Other expense totaled $407 million in the third quarter of 2004, 3% higher than $396 million in the year-earlier period, and 14% above the $357 million in 2004’s second quarter. Included in the amounts noted above are expenses considered to be “nonoperating” in nature consisting of amortization of core deposit and other intangible assets of $19 million in each of the second and third quarters of 2004, and $23 million in the third 2003 quarter, and merger-related expenses of $19 million for the quarter ended September 30, 2003. There were no merger-related expenses in the second or third quarters of 2004. Exclusive of these nonoperating expenses, noninterest operating expenses aggregated $388 million in the third quarter of 2004, compared with $355 million in the third quarter of 2003 and $338 million in the second quarter of 2004. A significant contributor to the higher operating expenses in 2004’s third quarter as compared with the year-earlier quarter and the second quarter of 2004 was the $25 million charitable contribution noted earlier.
Other expense for the first nine months of 2004 aggregated $1.2 billion, up 8% from $1.1 billion in the similar 2003 period. Included in these amounts are expenses considered to be “nonoperating” in nature consisting of amortization of core deposit and other intangible assets of $59 million in 2004 and $57 million in 2003 and merger-related expenses of $58 million in 2003. There were no merger-related expenses during 2004. Exclusive of these nonoperating expenses, noninterest operating expenses through the first nine months of 2004 increased to $1.1 billion from $955 million in the comparable 2003 period. A significant portion of the increase in such expenses was due to operations associated with Allfirst, specifically, the inclusion of nine months of Allfirst-related operating expenses in the 2004 period compared with six months of similar expenses in 2003. Also contributing to the higher expense level in 2004 was the $25 million charitable contribution already discussed.
Table 2 provides a reconciliation of other expense to noninterest operating expense, as well as a summary of merger-related expenses.
Salaries and employee benefits expense totaled $205 million in the third quarter of 2004, compared with $214 million in the year-earlier quarter and $203 million in the second quarter of 2004. For the first nine months of 2004, salaries and employee benefits expense increased to $608 million from $544 million in the corresponding 2003 period. Salaries and benefits related to the acquired operations of Allfirst were the primary contributor to the rise in salaries in the nine-month period ended September 30, 2004 from the like-2003 period when only two quarters of Allfirst-related operating expenses were incurred.
Excluding the nonoperating expense items previously noted, nonpersonnel expense totaled $183 million in the third quarter of 2004, compared with $145 million in the third quarter of 2003 and $135 million in the second quarter of 2004. Nonpersonnel expenses in the recent quarter include the previously noted
35
$25 million charitable contribution. Also contributing to the higher expense level in 2004’s third quarter was a $7 million increase to the valuation allowance for the impairment of capitalized residential mortgage servicing rights. The addition to the allowance reflects the decrease in the value of capitalized mortgage servicing rights resulting from lower residential mortgage interest rates at September 30, 2004 as compared with June 30, 2004. The lower interest rates resulted in increases in the expected rate of residential mortgage loan prepayments used in calculating the estimated fair value of capitalized servicing rights. In contrast, during the third quarter of 2003 and the second quarter of 2004, the Company recognized partial reversals of the valuation allowance for impairment of capitalized residential mortgage servicing rights of $12 million and $22 million, respectively. The partial reductions of the valuation allowance reflect the increases in value of capitalized mortgage servicing rights resulting from higher residential mortgage loan interest rates at the end of those quarters as compared with such rates at the immediately preceding quarter-end.
Nonpersonnel operating expenses were $487 million during the first nine months of 2004 and $420 million during the corresponding 2003 period. The impact of the Allfirst acquisition was a significant contributor to the higher expense levels during the first three quarters of 2004 as compared with the corresponding 2003 period when only two quarters of Allfirst-related operating expenses were incurred. Also contributing to the increase in expenses in 2004 was the $25 million charitable contribution, partially offset by a net reduction of the valuation allowance for the impairment of capitalized residential mortgage servicing rights of $3 million during 2004’s first nine months, compared with a net addition to such valuation allowance of $6 million in the similar 2003 period.
The efficiency ratio, or noninterest operating expenses (as defined above) divided by the sum of taxable-equivalent net interest income and noninterest income (exclusive of gains and losses from sales of bank investment securities), measures the relationship of noninterest operating expenses to revenues. The Company’s efficiency ratio was 56.4% during the recent quarter, compared with 53.2% during the third quarter of 2003 and 50.4% in 2004’s second quarter. If the $25 million charitable contribution and the $5 million venture capital gain were excluded from the computation, the Company’s efficiency ratio during 2004’s third quarter would have been 53.1%. The efficiency ratios for the nine-month periods ended September 30, 2004 and 2003 were 54.5% and 53.5%, respectively. Noninterest operating expenses used in calculating the efficiency ratio do not include the merger-related expenses or amortization of core deposit and other intangible assets noted earlier. If charges for amortization of core deposit and other intangible assets were included, the ratio for the three-month periods ended September 30, 2004, September 30, 2003 and June 30, 2004 would have been 59.1%, 56.6% and 53.3%, respectively, and for the nine-month periods ended September 30, 2004 and 2003 would have been 57.5% and 56.6%, respectively.
Merger-related expenses consisted largely of expenses for professional services and temporary help associated with the conversion of systems and/or integration of operations; initial marketing and promotion expenses designed to introduce M&T Bank to Allfirst’s customers; travel and relocation costs; and printing, supplies and other costs of commencing operations in new markets and offices.
Capital
Stockholders’ equity at September 30, 2004 was $5.7 billion and represented 10.80% of total assets, compared with $5.6 billion or 11.09% of total assets a year earlier and $5.7 billion or 11.47% at December 31, 2003. On a per share basis, stockholders’ equity was $49.11 at September 30, 2004, up from $46.49 and $47.55 at September 30 and December 31, 2003, respectively. Tangible equity per common share was $23.17 at September 30, 2004, compared with $20.71 at September 30, 2003 and $21.97 at December 31, 2003.
36
During the first quarter of 2004, M&T resumed repurchasing its common stock under authorized repurchase programs. In February 2004, M&T announced that it completed the stock repurchase program authorized in November 2001 and that it had been authorized by its Board of Directors to purchase up to an additional 5,000,000 shares of its common stock. As of September 30, 2004, M&T had repurchased a total of 3,684,700 shares of common stock pursuant to the February 2004 program at an average cost of $90.42 per share. During the third quarter and first nine months of 2004, M&T repurchased 1,435,800 shares and 5,052,600 shares, respectively, of common stock pursuant to the two authorized programs at an average cost per share of $94.20 and $90.77, respectively.
Reflected in stockholders’ equity was accumulated other comprehensive income which reflects the net after-tax impact of unrealized gains or losses on investment securities classified as available for sale; unrealized fair value gains or losses associated with interest rate swap agreements designated as cash flow hedges; and minimum pension liability adjustments. Net unrealized gains on available for sale investment securities were $13 million, or $.11 per common share, at September 30, 2004, compared with unrealized gains of $41 million, or $.34 per share, at September 30, 2003 and $38 million, or $.32 per share, at December 31, 2003. Such unrealized gains are generally due to changes in interest rates and represent the difference, net of applicable income tax effect, between the estimated fair value and amortized cost of investment securities classified as available for sale. The accounting treatment required for investment securities classified as available for sale highlights the inconsistency in GAAP relative to accounting for financial instruments. While changes in fair value for investment securities classified as available for sale impact stockholders’ equity, changes in the fair value of many other financial instruments, such as investment securities classified as held to maturity, loans held for investment, deposits and borrowings generally are not recognized, unless they are subject to the hedge accounting requirements of GAAP. The fair value of deposits and borrowings generally increases during periods of rising interest rates, offsetting general decreases in the fair values of financial assets. Recognition of certain fair value changes while excluding others could therefore produce distorted results. There were no outstanding interest rate swap agreements designated as cash flow hedges at September 30, 2004, September 30, 2003 or December 31, 2003. The minimum pension liability adjustment, net of applicable tax effect, reduced accumulated other comprehensive income by $12 million at September 30, 2004 and December 31, 2003, representing $.11 per share and $.10 per share at each respective date. There was no similar adjustment at September 30, 2003.
Federal regulators generally require banking institutions to maintain “core capital” and “total capital” ratios of at least 4% and 8%, respectively, of risk-adjusted total assets. In addition to the risk-based measures, Federal bank regulators have also implemented a minimum “leverage” ratio guideline of 3% of the quarterly average of total assets. Core capital includes $686 million of the trust preferred securities described in note 5 of Notes to Financial Statements. As of September 30, 2004, total capital also included $1.1 billion of subordinated capital notes.
The Company generates significant amounts of regulatory capital. The rate of regulatory core capital generation, or net operating income (as previously defined) less the sum of dividends paid and the after-tax effect of merger-related expenses expressed as an annualized percentage of regulatory “core capital” at the beginning of each period was 18.61% during the third quarter of 2004, compared with 20.33% in the third quarter of 2003 and 18.65% in the second quarter of 2004.
37
The regulatory capital ratios of the Company, M&T Bank and M&T Bank, N.A., as of September 30, 2004 are presented in the accompanying table.
REGULATORY CAPITAL RATIOSSeptember 30, 2004
Segment Information
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures About Segments of an Enterprise and Related Information,” the Company’s reportable segments have been determined based upon its internal profitability reporting system, which is organized by strategic business unit. Financial information about the Company’s segments is presented in note 6 of Notes to Financial Statements.
Net income earned by the Commercial Banking segment increased to $59 million in the third quarter of 2004 from $52 million in the year-earlier quarter and $57 million in the second quarter of 2004. The improvement from the third quarter of 2003 was attributable to higher letter of credit and other credit-related fees and gains recognized on the sales of equipment as commercial leases expired. Partially offsetting these favorable factors were higher operating expenses of $4 million. Contributing to the increase in the recent quarter’s net income as compared with the second quarter of 2004 were higher letter of credit and other credit-related fees of $7 million and a $3 million decrease in the provision for credit losses, due primarily to lower net charge-offs. A $6 million decline in net interest income, due mainly to a 30 basis point decrease in the net interest margin on loans, partially offset those favorable factors. For the nine months ended September 30, 2004, this segment contributed $169 million to net income, 34% higher than the $127 million earned in the corresponding period of 2003. The favorable performance as compared with the previous year was largely attributable to the Allfirst acquisition, and included higher net interest income of $41 million, service charges on deposit accounts of $11 million, and letters of credit and other credit-related fees of $31 million. A $12 million decline in net charge-offs also contributed to the higher net income in 2004. Partially offsetting these positive factors were higher salaries, benefits, and other operating expenses totaling $24 million, also largely attributable to Allfirst.
The Commercial Real Estate segment contributed $34 million to the Company’s net income during the third quarter of 2004, slightly higher than 2004’s second quarter and up 6% from $32 million in last year’s third quarter. The increase from the third quarter of 2003 was primarily the result of higher net interest income of $3 million, due predominantly to a $560 million, or 8%, increase in loan balances outstanding. For the first three quarters of 2004, net income for the Commercial Real Estate segment rose 10% to $98 million from $90 million during the similar 2003 period. That rise in net income was largely the result of higher net interest income of $15 million, primarily due to higher average loan balances outstanding of $591 million, or 8%, the result of growth in the markets already served by the Company and the impact of balances obtained in the April 1, 2003 Allfirst acquisition. Also contributing to the improved performance were higher commercial mortgage banking revenues of $5 million, largely from the origination, sales and servicing of loans related to the Company’s participation in the FNMA DUS program. The higher revenues were offset, in part, by a $12 million increase in operating expenses, due primarily to salaries, benefits, and other operating expenses related to the business obtained from Allfirst.
38
The Discretionary Portfolio segment earned $28 million during the recent quarter, up only slightly from the year-earlier quarter, but down 12% from $32 million in the second quarter of 2004. That decline was largely the result of a $2 million current quarter addition to the valuation allowance for impairment of capitalized mortgage servicing rights attributable to securitized residential mortgage loans held by this segment, while during 2004’s second quarter there was a $5 million partial reversal of such allowance. Net contribution for this segment increased 34% to $85 million for the first nine months of 2004 from $64 million in the similar 2003 period, primarily the result of a $29 million increase in net interest income from earning assets, including investment securities acquired in the Allfirst transaction.
Reflecting lower revenues from loan origination and sales activities and an increase in the capitalized mortgage servicing rights valuation allowance, net income for the Residential Mortgage Banking segment in the third quarter of 2004 declined to $4 million from $27 million in the third quarter of 2003 and $17 million in the second quarter of 2004. The recent quarter’s results reflect a $6 million impairment charge for capitalized mortgage servicing rights, while partial reversals of previous impairment charges of $11 million and $17 million were recognized during 2003’s third quarter and the second quarter of 2004, respectively. Revenues during the recent quarter from origination and sales activities, including sales of loans to the Company’s Discretionary Portfolio segment, were down $22 million from the year-earlier quarter. Through the first nine months of 2004, the segment’s net income was $21 million, down 60% from $54 million for the similar period in 2003. That unfavorable variance was due primarily to a $59 million decrease in revenues from origination and sales activities, reflecting the generally higher interest rate environment, and the unfavorable impact of the adoption of SAB No. 105 as discussed in “Other Income” included herein. Partially offsetting the decline in those revenues was a $2 million partial reversal in the current year of the valuation allowance for impairment of capitalized mortgage servicing rights, while there was a $6 million addition to such allowance in the 2003 period.
The Retail Banking segment contributed net income for the third quarter of 2004 of $62 million, up 22% from $50 million in the corresponding 2003 quarter and 12% higher than the $55 million earned in the second quarter of 2004. The favorable variance from the third quarter of 2003 was the result of a $10 million decrease in operating expenses, a $4 million decline in the provision for credit losses, due to slower growth in indirect automobile loan balances, and a $5 million increase in revenues, largely from higher service charges on deposit accounts and other fee income. The improvement in this segment’s net income from 2004’s second quarter was due to a $7 million increase in net interest income attributable to deposit accounts, the result of a 16 basis point increase in the net interest margin, and a $2 million decrease in the provision for credit losses due to slower loan growth and lower net charge-offs. For the first three quarters of 2004, the Retail Banking segment’s earnings rose 13% to $166 million from $146 million during the year-earlier period. That favorable performance was due mainly to increases in net interest income of $48 million and service charges on deposit accounts and other fee income of $52 million, offset, in part, by higher operating expenses of $76 million, all substantially related to the acquired Allfirst franchise. An $8 million decline in the provision for credit losses, predominately due to slower loan growth, also contributed to the year-over-year improvement. During the fourth quarter of 2003, certain Allfirst franchise-related indirect expenses incurred by centralized support areas were allocated to the Retail Banking segment, retroactive to the third quarter of 2003. As a result, previously reported noninterest expenses for the three-month and nine-month periods ended September 30, 2003 were increased in the Retail Banking segment and decreased in the “All Other” category by $9 million and, as a result, net income was decreased in the Retail Banking segment and increased in the “All Other” category by $5 million.
The “All Other” category reflects other activities of the Company that are not directly attributable to the reported segments as determined in accordance with SFAS No. 131, such as the M&T Investment Group, which includes
39
the Company’s trust, brokerage and insurance businesses. Also reflected in this category are the amortization of core deposit and other intangible assets, the net impact of the Company’s allocation methodologies for internal funds transfer pricing and the provision for credit losses, and, in 2003, merger-related expenses resulting from the Allfirst acquisition. The previously mentioned $25 million charitable contribution made by M&T Bank to The M&T Charitable Foundation and the $12 million reduction in income tax expense resulting from the reorganization of certain M&T subsidiaries are also reflected in the “All Other” category’s results for the third quarter of 2004.
Recent Accounting Developments
As already noted herein and in note 7 of Notes to Financial Statements, in March 2004 the SEC issued SAB No. 105 which summarizes the views of the SEC’s staff regarding the application of GAAP to loans held for sale and to loan commitments accounted for as derivative instruments. Those views are that, in general, when valuing mortgage loans held for sale and commitments to originate mortgage loans to be sold under the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, value ascribable to loan cash flows that will ultimately be realized in connection with mortgage servicing activities should only be recognized at the time the underlying mortgage loans are sold and should not be considered when determining the fair value of loans held for sale or commitments to originate loans for sale. The SEC expects registrants to apply the accounting described in SAB No. 105 for loan commitments accounted for as derivatives and entered into subsequent to March 31, 2004. In accordance with the new guidance, the Company adopted the provisions of SAB No. 105 effective April 1, 2004 and although such adoption had no economic impact on the Company, it resulted in a $6 million accounting deferral of mortgage banking revenues that will be recognized when the underlying mortgage loans are sold.
On December 8, 2003, the President of the United States signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”). The Act provides for prescription drug benefits under a new Medicare Part D program and federal subsidies to sponsors of retiree health care benefit plans that provide a prescription drug benefit that is at least actuarially equivalent to Medicare Part D. On May 19, 2004, the Financial Accounting Standards Board issued Staff Position No. FAS 106-2 (“FAS 106-2”) providing formal guidance on the accounting for the effects of the Act. FAS 106-2 requires that effects of the Act be included in the measurement of the accumulated postretirement benefit obligation and net periodic postretirement benefit cost when an employer initially adopts its provisions. FAS 106-2 is effective for the first interim or annual period beginning after June 15, 2004. The Company’s postretirement benefit plan does provide prescription drug benefits. The Company has analyzed the provisions of the Act in the context of the prescription drug benefits that it currently provides under its postretirement benefit plan and determined that the impact of the expected federal subsidy is not significant to the Company’s consolidated financial position or its results of operations.
Forward-Looking Statements
Management’s Discussion and Analysis of Financial Condition and Results of Operations and other sections of this quarterly report contain forward-looking statements that are based on current expectations, estimates and projections about the Company’s business, management’s beliefs and assumptions made by management. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions (“Future Factors”) which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements.
Future Factors include changes in interest rates, spreads on earning assets and interest-bearing liabilities, and interest rate sensitivity; credit losses; sources of liquidity; common shares outstanding; common stock price
40
volatility; fair value of and number of stock options to be issued in future periods; legislation affecting the financial services industry as a whole, and/or M&T and its subsidiaries individually or collectively; regulatory supervision and oversight, including required capital levels; increasing price and product/service competition by competitors, including new entrants; rapid technological developments and changes; the ability to continue to introduce competitive new products and services on a timely, cost-effective basis; the mix of products/services; containing costs and expenses; governmental and public policy changes, including environmental regulations; protection and validity of intellectual property rights; reliance on large customers; technological, implementation and cost/financial risks in large, multi-year contracts; the outcome of pending and future litigation and governmental proceedings; continued availability of financing; financial resources in the amounts, at the times and on the terms required to support the Company’s future businesses; and material differences in the actual financial results of merger and acquisition activities compared to the Company’s expectations, including the full realization of anticipated cost savings and revenue enhancements.
These are representative of the Future Factors that could affect the outcome of the forward-looking statements. In addition, such statements could be affected by general industry and market conditions and growth rates, general economic and political conditions, including interest rate and currency exchange rate fluctuations, and other Future Factors.
41
42
Table 2
RECONCILIATION OF QUARTERLY GAAP TO NON-GAAP MEASURES
(1) After any related tax effect.
43
Table 3
AVERAGE BALANCE SHEETS AND ANNUALIZED TAXABLE-EQUIVALENT RATES
44
AVERAGE BALANCE SHEETS AND ANNUALIZED TAXABLE-EQUIVALENT RATES (continued)
45
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk.
Incorporated by reference to the discussion contained under the caption “Taxable-equivalent Net Interest Income” in Part I, Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
ITEM 4. Controls and Procedures.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
M&T and its subsidiaries are subject in the normal course of business to various pending and threatened legal proceedings in which claims for monetary damages are asserted. Management, after consultation with legal counsel, does not anticipate that the aggregate ultimate liability arising out of litigation pending against M&T or its subsidiaries will be material to M&T’s consolidated financial position, but at the present time is not in a position to determine whether such litigation will have a material adverse effect on M&T’s consolidated results of operations in any future reporting period.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
(a) – (b) Not applicable
(c)
46
Item 3. Defaults Upon Senior Securities.
(Not applicable.)
Item 4. Submission of Matters to a Vote of Security Holders.
(None)
Item 5. Other Information.
Item 6. Exhibits.
The following exhibits are filed as part of this report.
47
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
EXHIBIT INDEX
48