Washington Trust Bancorp - 10-Q quarterly report FY

(Mark One)

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

Washington Trust Bancorp, Inc. (the “Bancorp”) is a publicly-owned registered bank holding company and financial holding company.  The Bancorp owns all of the outstanding common stock of The Washington Trust Company (the “Bank”), a Rhode Island chartered commercial bank founded in 1800.  Through its subsidiaries, the Bancorp offers a complete product line of financial services to individuals and businesses including commercial, residential and consumer lending, retail and commercial deposit products, and wealth management services through its offices in Rhode Island, Massachusetts and southeastern Connecticut, ATMs, and its Internet web site (www.washtrust.com).

The consolidated financial statements include the accounts of the Bancorp and its subsidiaries (collectively, the “Corporation” or “Washington Trust”).  All significant intercompany transactions have been eliminated.  Certain prior period amounts have been reclassified to conform to the current period’s classification.  Such reclassifications have no effect on previously reported net income or shareholders’ equity.

The accounting and reporting policies of the Corporation conform to accounting principles generally accepted in the United States of America (“GAAP”) and to general practices of the banking industry.  In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period.  Actual results could differ from those estimates.  Material estimates that are particularly susceptible to near-term change are the determination of the allowance for loan losses and the review of goodwill, other intangible assets and investments for impairment.

In the opinion of management, the accompanying consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) and disclosures necessary to present fairly the Corporation’s financial position as of June 30, 2008 and December 31, 2007, respectively, and the results of operations and cash flows for the interim periods presented.  Interim results are not necessarily reflective of the results of the entire year.  The unaudited consolidated financial statements of the Corporation presented herein have been prepared pursuant to the rules of the Securities and Exchange Commission (“SEC”) for quarterly reports on Form 10-Q and do not include all of the information and note disclosures required by GAAP.  The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in Washington Trust Bancorp, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2007.

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value and expands disclosures of fair value measurements.  SFAS No. 157 applies to the accounting principles that currently use fair value measurement and does not require any new fair value measurements.  The expanded disclosures focus on the inputs used to measure fair value as well as the effect of the fair value measurements on earnings. SFAS No. 157 is effective as of the beginning of the first fiscal year beginning after November 15, 2007 and interim periods within that fiscal year.  The adoption of SFAS No. 157 for financial assets and liabilities did not have a material impact on the Corporation’s financial position or results of operations.  The required disclosures about fair value measurements for financial assets and liabilities have been included in Note 10.  In accordance with FASB Staff Position No. 157-2, “Effective Date of FASB Statement No. 157,” the effective date of SFAS No. 157 as it applies to nonfinancial assets, such as goodwill, and nonfinancial liabilities has been delayed to January 1, 2009.  The Corporation is currently evaluating the impact that the adoption of SFAS No. 157 for nonfinancial assets and liabilities will have on the Corporation’s financial position and results of operations.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Post Retirement Plans (an amendment of FASB Statements No. 87, 88, 106 and 132R)” (“SFAS No. 158”).  The requirement to measure the plan’s assets and obligations as of the employer’s fiscal year end was adopted effective January 1, 2008.  The adoption of the measurement date provision of SFAS No. 158 did not have a material impact on the Corporation’s financial position or results of operations.  See further discussion in Note 11.

The SEC released SAB No. 110 in December 2007.  SAB No. 110 provides guidance on the use of a "simplified" method, as discussed in SAB No. 107, in developing an estimate of expected term of "plain vanilla" share options in accordance with SFAS No. 123 (revised 2004), “Share-Based Payment”.  SAB No. 107 did not expect a company to use the simplified method for share option grants after December 31, 2007.  At the time SAB No. 107 was issued, the SEC believed that more detailed external information about employee exercise behavior (e.g., employee exercise patterns by industry and/or other categories of companies) would, over time, become readily available to companies.  The SEC understands that such detailed information about employee exercise behavior may not be widely available by December 31, 2007. Accordingly, the SEC will continue to accept, under certain circumstances, the use of the simplified method beyond December 31, 2007.  The adoption of SAB No. 110 did not have a material impact on the Corporation’s financial position or results of operations.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS No. 161”).  SFAS No. 161 changes the disclosure requirements for derivative instruments and hedging activities.  Entities are required to provide enhanced disclosures about (1) how and why an entity uses derivative instruments, (2) how derivative instruments and related hedge items are accounted for under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and its related interpretations, and (3) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows.  SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early adoption encouraged.  SFAS No. 161 encourages but does not require comparative disclosures for earlier periods at initial adoption.  The Corporation will provide the additional disclosures necessary upon the adoption of SFAS No. 161.

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS No. 162”).  SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP.  The current GAAP hierarchy is set forth in the American Institute of Certified Public Accountants Statement on Auditing Standards No. 69, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles.”  The FASB has concluded that the GAAP hierarchy should reside in the accounting literature established by the FASB and is issuing SFAS No. 162 to achieve that result.  SFAS No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to Interim Auditing Standards AU Section 411, “The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles”.  The FASB does not expect that SFAS No. 162 will result in a change in current practice.

Securities are summarized as follows:

Securities available for sale with a fair value of $691.1 million and $592.7 million were pledged in compliance with state regulations concerning trust powers and to secure Treasury Tax and Loan deposits, borrowings, and certain public deposits at June 30, 2008 and December 31, 2007, respectively.  In addition, securities available for sale with a fair value of $8.4 million were collateralized for the discount window at the Federal Reserve Bank at June 30, 2008 and December 31, 2007.  There were no borrowings with the Federal Reserve Bank at either date.  Securities available for sale with a fair value of $8.9 million and $1.9 million were designated in a rabbi trust for a nonqualified retirement plan at June 30, 2008 and December 31, 2007, respectively.  As of June 30, 2008 and December 31, 2007, securities available for sale with a fair value of $525 thousand and $532 thousand, respectively, were pledged as collateral to secure certain interest rate swap agreements.

During the six months ended June 30, 2008, impairment charges of $2.0 million were recognized on four equity security perpetual preferred stock holdings, including FHLMC, FNMA and two other corporate issuers, deemed to be other-than-temporarily impaired based on an analysis of the financial condition and operating outlook of the issuers.  These charges were included in net losses on securities in the Consolidated Statements of Income for the six months ended June 30, 2008.  Also included in net losses on securities in the six months ended June 30, 2008 were realized gains of $232 thousand on the sale of commercial debt securities and realized gains of $1.7 million on the sale of other equity securities.

The following table summarizes temporarily impaired securities as of June 30, 2008, segregated by length of time the securities have been in a continuous unrealized loss position.

The following table summarizes temporarily impaired securities as of December 31, 2007, segregated by length of time the securities have been in a continuous unrealized loss position.

Unrealized losses on debt securities generally occur as a result of increases in interest rates since the time of purchase, a structural change in an investment or from deterioration in credit quality of the issuer.  Management evaluates impairments in value whether caused by adverse interest rates or credit movements to determine if they are other-than-temporary.

In accordance with applicable accounting literature, Washington Trust must demonstrate an ability and intent to hold temporarily impaired securities until full recovery of their cost basis to classify such losses as temporary.  Management uses both internal and external information sources to arrive at the most informed decision.  This quantitative and qualitative assessment begins with a review of general market conditions and changes to market conditions, credit, investment performance and structure since the prior review period.  The ability to hold temporarily impaired securities will involve a number of factors, including: forecasted recovery period based on average life and Washington Trust’s capital, earnings and cash flow positions, among other things. Washington Trust currently intends to hold all temporarily impaired securities to full recovery of the cost basis, which may be until maturity.

Management assesses a variety of factors in determining if an impairment is other than temporary, including but not limited to, the likelihood of and probable time horizon for recovery of the cost basis, including analyst forecasts, earnings assumptions and other company specific or sector financial performance metrics.

Debt securities in an unrealized loss position at June 30, 2008 consisted of 195 debt security holdings.  The majority of the loss for debt securities reported in an unrealized loss position at June 30, 2008 was concentrated in variable rate trust preferred securities issued by financial services companies and in U.S. agency or government-sponsored agency mortgage-backed securities.

Included in debt securities in an unrealized loss position at June 30, 2008 are 13 trust preferred security holdings.  These holdings represent seven individual name issuers in the financial industry, including, where applicable, the impact of mergers and acquisitions of issuers subsequent to original purchase, and two pooled trust preferred securities in the form of collateralized debt obligations (“CDO”).  The aggregate unrealized loss position of the 13 trust preferred holdings was $7.6 million, or 20.1% of amortized cost, as of June 30, 2008.  The largest unrealized loss dollar amount of any single issuer was $2.1 million, or 21% of its amortized cost, at June 30, 2008.  Management believes the June 30, 2008 temporary impairment on trust preferred securities, including the trust preferred CDOs, was not a function of underlying credit issues associated with the issuers of the debt obligations and primarily reflected increased investor concerns beginning in the latter part of 2007 and continuing into 2008 about recent losses in the financial services industry related to sub-prime lending and sub-prime exposure.  These concerns resulted in a substantial decrease in market liquidity and increased risk premiums for securities in this sector.  Credit spreads for issuers in this sector widened substantially during recent months, causing prices for these securities holdings to decline.  As recently as September 30, 2007, the aggregate unrealized loss position of the 13 trust preferred holdings was 6.3% of amortized cost and the aggregate unrealized loss position at December 31, 2007 was 9.3% of amortized cost for these holdings.  As of June 30, 2008, the amortized cost and fair value of the two trust preferred CDO holdings was $7.5 million and $5.7 million, respectively.  The CDO holdings consist of trust preferred obligations of banking industry companies and, to a lesser extent, insurance industry companies.  Valuations of the trust preferred CDO holdings are also dependent in part on cash flows from underlying issuers.  Unexpected cash flow disruptions could have an adverse impact on the fair value and performance of these CDOs.  For both of its trust preferred CDO holdings, Washington Trust’s investment is senior to one or more subordinated tranches which have first loss exposure.  The Corporation does not believe it is likely to experience any loss of principal on these CDO investments given the protection that the subordinated classes provide and therefore considers these securities to be temporarily impaired.  All trust preferred debt securities in our portfolio continue to accrue and make payments as expected, and all have credit ratings at or above investment grade minimums.  Washington Trust has the ability and intent to hold these securities to full recovery of the cost basis and management does not consider these investments to be other-than-temporarily impaired.

The unrealized losses on U.S. agency or government-sponsored agency mortgage-backed securities was concentrated in securities purchased during 2003 and 2004, during which time interest rates were at or near historical lows.  The fair value for these and the state and municipal holdings included in this analysis have declined due to the relative increase in short and medium term interest rates since the time of purchase.  The largest unrealized loss percentage amount on any holding in these categories was 5.5% of its amortized cost at June 30, 2008.  Management believes that the nature and duration of impairment on these debt security holdings are a function of changes in investment spreads and interest rate movements.  Washington Trust has the ability and intent to hold these securities to full recovery of the cost basis and management does not consider these investments to be other-than-temporarily impaired.

The equity securities in an unrealized loss position at June 30, 2008 consisted of 11 holdings of financial and commercial entities with unrealized losses of $782 thousand, or 10% of their aggregate cost.  During the six months ended June 30, 2008, Washington Trust recorded $2.0 million in impairment charges on four perpetual preferred stock holdings, including FHLMC, FNMA and two other corporate issuers, based on an analysis of the financial condition and operating outlook of the issuers.  As of June 30, 2008, the Corporation had two perpetual preferred stock holdings of FHLMC and FNMA with a total fair value of $1.0 million and unrealized losses of $34 thousand and seven perpetual preferred stock holdings of financial and utility companies with a total fair value of $4.6 million and unrealized losses of $478 thousand.  Causes of conditions whereby the fair value of equity securities is less than cost include the timing of purchases and changes in valuation specific to individual industries or issuers.  The relationship between the level of market interest rates and the dividend rates paid on individual equity securities may also be a

contributing factor.  Management believes that a portion of the June 30, 2008 temporary impairment on its equity securities holdings was not a function of the financial condition and operating outlook of the issuers and reflected increased investor concerns beginning in the latter part of 2007 and continuing into 2008 about recent losses in the financial services industry related to sub-prime lending and sub-prime exposure.  These concerns resulted in greater volatility in market prices for both common and preferred stocks in this market sector.  Washington Trust has the ability and intent to hold these investments to full recovery of the cost basis and considers the unrealized losses on these equity securities to be temporary.

Should current market conditions continue and should these unrealized losses on these securities continue, they may, in the future, be deemed to be other than temporarily impaired.

The following is a summary of loans:

The balance of loans on nonaccrual status as of June 30, 2008 was $6.2 million, compared to $4.3 million at December 31, 2007.  The $1.9 million increase in nonaccrual loans was largely due to certain commercial loan relationships moving into the non-accruing loan classification.

The following is an analysis of the allowance for loan losses:

The changes in the carrying value of goodwill and other intangible assets for the three and six months ended June 30, 2008 are as follows:

Amortization of intangible assets for the six months ended June 30, 2008 totaled $652 thousand.  Estimated annual amortization expense of current intangible assets with finite useful lives, absent any impairment or change in estimated useful lives, is summarized below.

Advances payable to the Federal Home Loan Bank (“FHLB”) are summarized as follows:

In addition to outstanding advances, the Corporation also has access to an unused line of credit amounting to $8.0 million at June 30, 2008.  Under an agreement with the FHLB, the Corporation is required to maintain qualified collateral, free and clear of liens, pledges, or encumbrances that, based on certain percentages of book and market values, has a value equal to the aggregate amount of the line of credit and outstanding advances (“FHLB borrowings”).  The FHLB maintains a security interest in various assets of the Corporation including, but not limited to, residential mortgages loans, U.S. government or agency securities, U.S. government-sponsored agency securities, and amounts maintained on deposit at the FHLB.  The Corporation maintained qualified collateral in excess of the amount required to collateralize the line of credit and outstanding advances at June 30, 2008.  Included in the collateral were securities available for sale with a fair value of $565.7 million and $476.8 million that were specifically pledged to secure FHLB borrowings at June 30, 2008 and December 31, 2007, respectively.  Unless there is an event of default under the agreement with the FHLB, the Corporation may use, encumber or dispose of any portion of the collateral in excess of the amount required to secure FHLB borrowings, except for that collateral that has been specifically pledged.

Junior subordinated debentures are summarized as follows:

In April 2008, the Bancorp sponsored the creation of Washington Preferred Capital Trust (“Washington Preferred”).  Washington Preferred is a Delaware statutory trust created for the sole purpose of issuing trust preferred securities and investing the proceeds in junior subordinated debentures of the Bancorp.  The Bancorp is the owner of all of the common securities of Washington Preferred.  In accordance with FASB Interpretation 46-R, “Consolidation of Variable Interest Entities—Revised”, Washington Preferred will be treated as an unconsolidated subsidiary.  The common stock investment in the statutory trust will be included in “Other Assets” in the Consolidated Balance Sheet.

corporate purposes.  Like the Capital Securities, the Washington Preferred Debentures bear interest at a rate of 6.2275% until June 15, 2008, and resets quarterly thereafter at a rate equal to the three-month LIBOR rate plus 3.50%.  The Washington Preferred Debentures mature on June 15, 2038, but may be redeemed at par at the Bancorp’s option, subject to the approval of the applicable banking regulator to the extent required under applicable guidelines or policies, at any time on or after June 15, 2013, or upon the occurrence of certain special qualifying events.

Also in April 2008, the Bancorp entered into a five-year interest rate swap contract with a notional amount of $10 million.  Under the terms of this contract, Washington Trust will pay a fixed rate of 6.97% and receive a rate equal to three-month LIBOR plus 3.50%.  See additional discussion on interest rate risk management agreements in Note 9.

The following is a summary of other borrowings:

The Stock Purchase Agreement for the August 2005 acquisition of Weston Financial Group, Inc. (“Weston Financial”) provides for the payment of contingent purchase price amounts based on operating results in each of the years in the three-year earn-out period ending December 31, 2008.  Contingent payments are added to goodwill and recorded as deferred acquisition liabilities at the time the payments are determinable beyond a reasonable doubt.  Deferred acquisition obligations amounted to $1.9 million and $9.9 million at June 30, 2008 and December 31, 2007, respectively.  In the first quarter of 2008 the Corporation paid approximately $8.1 million pursuant to the Stock Purchase Agreement, which represented the 2007 earn-out payment.

The Corporation’s 2006 Stock Repurchase Plan authorizes the repurchase of up to 400,000 shares of the Corporation’s common stock in open market transactions.  There were no shares repurchased under the Corporation’s 2006 Stock Repurchase Plan during the six months ended June 30, 2008.  As of June 30, 2008, a cumulative total of 185,400 shares have been repurchased at a total cost of $4.8 million.

Pursuant to the Amended and Restated Nonqualified Deferred Compensation Plan (“Deferred Compensation Plan”), 3,423 shares were acquired during the six months ended June 30, 2008.

The following table presents the Corporation’s and the Bank’s actual capital amounts and ratios at June 30, 2008 and December 31, 2007, as well as the corresponding minimum and well capitalized regulatory amounts and ratios:

As of June 30, 2008, Bancorp has sponsored the creation of three statutory trusts for the sole purpose of issuing trust preferred securities and investing the proceeds in junior subordinated debentures of the Bancorp.  In accordance with FASB Interpretation 46-R, “Consolidation of Variable Interest Entities – Revised” (“FIN 46-R”), these statutory trusts created by Bancorp are not consolidated into the Corporation’s financial statements; however, the Corporation reflects the amounts of junior subordinated debentures payable to the preferred shareholders of statutory trusts as debt in its financial statements.  The trust preferred securities qualify as Tier 1 capital.

The Corporation’s capital ratios at June 30, 2008 place the Corporation in the “well-capitalized” category according to regulatory standards.  On March 1, 2005, the Federal Reserve Board issued a final rule that would retain trust preferred securities in Tier 1 capital of bank holding companies, but with stricter quantitative limits and clearer standards.  Under the proposal, after a five-year transition period that would end on March 31, 2009, the aggregate amount of trust preferred securities would be limited to 25% of Tier 1 capital elements, net of goodwill.  The Corporation has evaluated the potential impact of such a change on its Tier 1 capital ratio and has concluded that the regulatory capital treatment of the trust preferred securities in the Corporation’s total capital ratio would be unchanged.

The Corporation is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to manage the Corporation’s exposure to fluctuations in interest rates.  These financial instruments include commitments to extend credit, standby letters of credit, financial guarantees, interest rate swap agreements and commitments to originate and commitments to sell fixed rate mortgage loans.  These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the Corporation’s Consolidated Balance Sheets.  The contract or notional amounts of these instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments.  The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.  The contractual and notional amounts of financial instruments with off-balance sheet risk are as follows:

Commitments to extend credit are agreements to lend to a customer as long as there are no violations of any conditions established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Each borrower’s creditworthiness is evaluated on a case-by-case basis.  The amount of collateral obtained is based on management’s credit evaluation of the borrower.

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.  Under the standby letters of credit, the Corporation is required to make payments to the beneficiary of the letters of credit upon request by the beneficiary contingent upon the customer’s failure to perform under the terms of the underlying contract with the beneficiary.  Standby letters of credit extend up to five years.  At June 30, 2008 and December 31, 2007, the maximum potential amount of undiscounted future payments, not reduced by amounts that may be recovered, totaled $8.1 million and $8.0 million, respectively.  At June 30, 2008 and December 31, 2007, there was no liability to beneficiaries resulting from standby letters of credit.  Fee income on standby letters of credit for the six months ended June 30, 2008 and 2007 was insignificant.

At June 30, 2008, a substantial portion of the standby letters of credit were supported by pledged collateral.  The collateral obtained is determined based on management’s credit evaluation of the customer.  Should the Corporation be required to make payments to the beneficiary, repayment from the customer to the Corporation is required.

Interest rate swaps are used from time to time as part of the Corporation’s interest rate risk management strategy.  Swaps are agreements in which the Corporation and another party agree to exchange interest payments (e.g., fixed-rate for variable-rate payments) computed on a notional principal amount.  The credit risk associated with swap transactions is the risk of default by the counterparty.  To minimize this risk, the Corporation enters into interest rate agreements only with highly rated counterparties that management believes to be creditworthy.  The notional amounts of these agreements do not represent amounts exchanged by the parties and thus, are not a measure of the potential loss exposure.

In April 2008, the Bancorp entered into an interest rate swap contract with a notional amount of $10 million to hedge the interest rate risk associated with $10 million of the variable rate junior subordinated debentures.  See additional disclosure in Note 7.  The interest rate swap contract matures in 2013.  The swap effectively converts the debt from variable rate to fixed rate and qualifies for cash flow hedge accounting under SFAS No. 133.  The fair value of this interest rate swap contract amounted to $319 thousand at June 30, 2008 and was reported in other assets on the

The Corporation has entered into interest rate swap contracts to help commercial loan borrowers manage their interest rate risk.  The interest rate swap contracts with commercial loan borrowers allow them to convert floating rate loan payments to fixed rate loan payments.  When we enter into an interest rate swap contract with a commercial loan borrower, we simultaneously enter into a “mirror” swap contract with a third party.  The third party exchanges the client’s fixed rate loan payments for floating rate loan payments.  We retain the risk that is associated with the potential failure of counterparties and inherent in making loans.

At June 30, 2008 and December 31, 2007, Washington Trust had interest rate swap contracts with commercial loan borrowers with notional amounts of $14.1 million and $3.850 million, respectively, and equal amounts of “mirror” swap contracts with third-party financial institutions.  These interest rate swap contracts are carried at fair value with changes recorded as a component of other noninterest income.  The fair values of the interest rate swap contracts with commercial loan borrowers amounted to $21 thousand as of June 30, 2008 and $60 thousand as of December 31, 2007.  The fair values of the “mirror” swap contracts with third-party financial institutions totaled $3 thousand as of June 30, 2008 and $60 thousand as of December 31, 2007.  For the six months ended June 30, 2008, other noninterest income included net gains on customer related interest rate swap contracts of $145 thousand.  Washington Trust did not engage in such interest rate swap contracts during the six months ended June 30, 2007.

Interest rate lock commitments are extended to borrowers that relate to the origination of readily marketable mortgage loans held for sale.  To mitigate the interest rate risk inherent in these rate locks, as well as closed mortgage loans held for sale, best efforts forward commitments are established to sell individual mortgage loans.  Commitments to originate and commitments to sell fixed rate mortgage loans are derivative financial instruments.  Accordingly, the fair value of these commitments is recognized in other assets on the consolidated balance sheet and the changes in fair value of such commitments are recorded in current earnings in the consolidated income statement.  The carrying value of such commitments as of June 30, 2008 and December 31, 2007 and the respective changes in fair values for the six months ended June 30, 2008 and 2007 were insignificant.

Effective January 1, 2008, the Corporation adopted SFAS No. 157 for financial assets and liabilities.  The effective date of SFAS No. 157, as it applies to nonfinancial assets and liabilities, has been delayed to January 1, 2009.  SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosure requirements about fair value measurements.  SFAS No. 157, among other things, emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and states that a fair value measurement should be determined based on the assumptions the market participants would use in pricing the asset or liability.  In addition, SFAS No. 157 specifies a hierarchy of valuation techniques based on whether the types of valuation information (“inputs”) are observable or unobservable.  Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Corporation’s market assumptions.  These two types of inputs have created the following fair value hierarchy:

The Corporation uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures.  Securities available for sale and derivatives are recorded at fair value on a recurring basis.  Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as loans held for sale, collateral dependent impaired loans and mortgage servicing rights.  These nonrecurring fair

Under SFAS No. 157, fair values are based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  When available, the Corporation uses quoted market prices to determine fair value.  If quoted prices are not available, fair value is based upon valuation techniques such as matrix pricing or other models that use, where possible, current market-based or independently sourced market parameters, such as interest rates.  If observable market-based inputs are not available, the Corporation uses unobservable inputs to determine appropriate valuation adjustments using methodologies applied consistently over time.

The following is a description of valuation methodologies for assets and liabilities recorded at fair value, including the general classification of such assets and liabilities pursuant to the valuation hierarchy.

Securities available for sale are recorded at fair value on a recurring basis.  When available, the Corporation uses quoted market prices to determine the fair value of securities; such items are classified as Level 1.  This category includes exchange-traded equity securities and U.S. Treasury obligations.

Level 2 securities include debt securities with quoted prices, which are traded less frequently than exchange-traded instruments, whose value is determined using matrix pricing with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.  This category generally includes obligations of U.S. government-sponsored agencies, mortgage-backed securities issued by U.S. government and government-sponsored agencies, municipal bonds, trust preferred securities, corporate bonds and certain preferred equity securities.

In certain cases where there is limited activity or less transparency around inputs to the valuation, securities may be classified as Level 3.  As of June 30, 2008, Level 3 securities were comprised of two trust preferred CDO holdings, which were not actively traded.  To determine their fair value, Washington Trust utilized third party pricing models and discounted cash flow methodologies.  Their fair values were reviewed against similar securities that were more actively traded in order to assess the reasonableness of the fair values.  Our fair values assumed liquidation in an orderly market and not under distressed circumstances.  Due to the continued market illiquidity and credit risk for securities in the financial sector, the fair value of these securities is highly sensitive to assumption changes and market volatility.

Mortgage loans held for sale are carried on an aggregate basis at the lower of cost or market value.  The fair value of loans held for sale is based on what secondary markets are currently offering for loans with similar characteristics.  As such, we classify loans subjected to nonrecurring fair value adjustments as Level 2.

Substantially all of our derivatives are traded in over-the-counter markets where quoted market prices are not readily available.  Fair value measurements are determined using independent pricing models that utilize primarily market observable inputs, such as swap rates of different maturities and LIBOR rates, and, accordingly, are classified as Level 2.  Examples include interest rate swap contracts.  Any derivative for which we measure fair value using significant assumptions that are unobservable are classified as Level 3.  Level 3 derivatives include interest rate lock commitments written for our residential mortgage loans that we intend to sell.

Collateral dependent loans that are deemed to be impaired in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan,” are valued based upon the fair value of the underlying collateral.  The inputs used in the appraisals of the collateral are observable, and, therefore, the loans are categorized as Level 2.

Mortgage servicing rights do not trade in an active market with readily observable prices.  Accordingly, we determine the fair value of mortgage servicing rights using a valuation model that calculates the present value of the estimated future net servicing income.  The model incorporates assumptions used in estimating future net servicing income, including estimates of prepayment speeds, discount rate, cost to service and contractual servicing fee income.  Mortgage servicing rights are subject to fair value measurements on a nonrecurring basis.  Fair value measurements of our mortgage servicing rights use significant unobservable inputs and, accordingly, are classified as Level 3.

The table below presents the balances of assets and liabilities reported at fair value on a recurring basis.

As of June 30, 2008, two trust preferred CDO securities were transferred from Level 2 to Level 3 classification due to the lack of current observable market activity.  These securities were valued using third party pricing models and discounted cash flow methodologies.

The changes in Level 3 derivative liabilities measured at fair value on a recurring basis in the six month period ended June 30, 2008 were immaterial.

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP.  These adjustments to fair value usually result from the application of lower of cost or market accounting or write-downs of individual assets.  The valuation methodologies used to measure these fair value adjustments are described above.  The following table presents the carrying value of certain assets measured at fair value on a nonrecurring basis during the six months ended June 30, 2008.

The total nonrecurring fair value adjustments included in the Consolidated Statement of Income for the six months ended June 30, 2008 were immaterial.

Effective January 1, 2008, the Corporation adopted the measurement date provisions of SFAS No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS No. 158”).  As a result, the Corporation recognized the following adjustments in individual line items of its Consolidated Balance Sheet as of January 1, 2008:

The adoption of the measurement date provisions of SFAS No. 158 had no effect on the Corporation’s Consolidated Statements of Income or Cash Flows for the six months ended June 30, 2008.

The following table sets forth the plans’ benefit obligations, fair value of plan assets and funded status as of June 30, 2008 and 2007.

The Corporation previously disclosed in its financial statements for the year ended December 31, 2007 that it expected to contribute $2.0 million to its qualified pension plan and $421 thousand in benefit payments to its non-qualified retirement plans in 2008.  During the six months ended June 30, 2008, $2.0 million of contributions have been made to the qualified pension plan and $168 thousand in benefit payments have been made to the non-qualified retirement

Washington Trust has three share-based compensation plans, Bancorp’s 2003 Stock Incentive Plan, as amended (the “2003 Plan”), Bancorp’s 1997 Equity Incentive Plan, as amended (the “1997 Plan”) and the Amended and Restated 1988 Stock Option Plan (the “1988 Plan”), collectively the plans.

Amounts recognized in the consolidated financial statements with respect to these plans are as follows:

During the quarter ended June 30, 2008, the Corporation granted 87,500 non-qualified share options to certain key employees.  The share options awarded were granted with three-year cliff vesting and also provide for accelerated vesting if there is a change in control, death or retirement (as defined in the plans).

The fair value of the share option award granted in the second quarter of 2008 was estimated on the date of grant using the Black-Scholes Option-Pricing Model based on assumptions noted in the following table.  Washington Trust uses historical data to estimate share option exercise and employee departure behavior used in the option-pricing model; groups of employees that have similar historical behavior are considered separately for valuation purposes.  The expected term of options granted was derived from the output of the option valuation model and represents the period of time that options granted are expected to be outstanding.  Expected volatility was based on historical volatility of Washington Trust shares.  The risk-free rate for periods within the contractual life of the share option was based on the U.S. Treasury yield curve in effect at the date of grant.

The weighted average grant-date fair value of the share options awarded during the second quarter of 2008 was $8.09.  There were no share options awarded during the six months ended June 30, 2007.

A summary of share option activity under the Plans as of June 30, 2008, and changes during the six months ended June 30, 2008, is presented below: