UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934
For the quarterly period ended:
June 30, 2004
Commission file number: 1-10853
BB&T CORPORATION(Exact name of registrant as specified in its charter)
(336) 733-2000(Registrant's Telephone Number, Including Area 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. Yes [ X ] No [__]
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ X ] No [__]
At July 31, 2004, 554,433,468 shares of the registrant's common stock, $5 par value, were outstanding.
BB&T CORPORATION
INDEX
BB&T Corporation Page 1 Second Quarter 2004 10-Q
Item 1. Financial Statements
BB&T CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(Unaudited)(Dollars in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
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BB&T CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME(Unaudited)(Dollars in thousands, except per share data)
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BB&T CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITYFor the Six Months Ended June 30, 2004 and 2003(Unaudited)(Dollars in thousands)
(1) Other includes unvested restricted stock.
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BB&T CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(Dollars in thousands)
Back to Index
BB&T Corporation Page 5 Second Quarter 2004 10-Q
BB&T CORPORATION AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSJune 30, 2004(Unaudited)
A. Basis of Presentation
In the opinion of management, the accompanying unaudited consolidated balance sheets, the consolidated statements of income, the consolidated statements of changes in shareholders’ equity, and the consolidated statements of cash flows of BB&T Corporation and subsidiaries (referred to herein as “BB&T”, “the Corporation” or “the Company”), present fairly in all material respects BB&T’s financial position at June 30, 2004 and December 31, 2003; BB&T’s results of operations for the three months and six months ended June 30, 2004 and 2003; and BB&T’s cash flows for the six months ended June 30, 2004 and 2003. In the opinion of management, all adjustments necessary to fairly present the consolidated financial position and consolidated results of operations have been made. All such adjustments are of a normal, recurring nature.
The consolidated financial statements and notes thereto are presented in accordance with the instructions for Form 10-Q. The information contained in the footnotes included in BB&T’s 2003 Annual Report on Form 10-K should be referred to in connection with these unaudited interim consolidated financial statements. In certain instances, amounts reported in the 2003 financial statements were reclassified to conform to the 2004 financial statement presentation. Such reclassifications had no material effect on the Company’s reported consolidated financial position or consolidated results of operations.
The consolidated financial statements of BB&T include the accounts of BB&T Corporation and those subsidiaries that are majority-owned by BB&T or over which BB&T otherwise exercises control. In consolidation, all significant intercompany accounts and transactions have been eliminated. The results of operations of companies acquired in transactions accounted for as purchases are included only from the dates of acquisition. All material wholly owned and majority-owned subsidiaries are consolidated unless control does not rest with BB&T or deconsolidation is required by generally accepted accounting principles. The Company has investments in certain entities for which BB&T does not have a controlling interest. BB&T accounts for these investments using the equity method whereby its ownership interest in the entities’ income or loss is recorded in other noninterest income on the Consolidated Statements of Income. The Company periodically evaluates the carrying value of these investments for impairment.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan and lease losses, valuation of mortgage servicing rights, valuation of goodwill, other intangible assets, other purchase accounting related adjustments, benefit plan obligations and expenses, and tax assets and liabilities.
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B. Nature of Operations
BB&T is a financial holding company headquartered in Winston-Salem, North Carolina. BB&T conducts its operations primarily through its subsidiary banks, which have branches in North Carolina, South Carolina, Virginia, Maryland, West Virginia, Kentucky, Tennessee, Georgia, Florida, Alabama, Indiana and Washington, D.C. BB&T’s subsidiary banks provide a wide range of banking services to individuals and businesses and offer a variety of loans to businesses and consumers, including mortgage loans. BB&T’s loans are primarily to individuals residing in the market areas described above or to businesses located in this geographic area. BB&T’s subsidiary banks also market a wide range of deposit services to individuals and businesses. BB&T’s subsidiary banks either directly, or through their subsidiaries, offer lease financing to businesses and municipal governments; discount brokerage services, annuities and mutual funds; life insurance, property and casualty insurance, health insurance and commercial general liability insurance on an agency basis; insurance premium financing; permanent financing arrangements for commercial real estate and loan servicing for third-party investors; direct consumer finance loans to individuals; payroll processing; trust services and asset management. The nonbank subsidiaries of BB&T Corporation provide a variety of financial services including automobile financing, equipment financing, factoring, full-service securities brokerage and capital markets services.
C. Changes in Accounting Principles and Effects of New Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). This Interpretation provides guidance with respect to the identification of variable interest entities and when the assets, liabilities, noncontrolling interests, and results of operations of a variable interest entity need to be included in a company’s consolidated financial statements. The Interpretation requires consolidation by business enterprises of variable interest entities in cases where the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity, or in cases where the equity investors lack one or more of the essential characteristics of a controlling financial interest, which include the ability to make decisions about the entity’s activities through voting rights, the obligations to absorb the expected losses of the entity if they occur, or the right to receive the expected residual returns of the entity if they occur. Due to significant implementation issues, the FASB modified the wording of FIN 46 and issued FIN 46R in December of 2003. FIN 46R deferred the effective date for the provisions of FIN 46 to entities other than Special Purpose Entities (“SPEs”) until financial statements issued for periods ending after March 15, 2004. SPEs were subject to the provisions of either FIN 46 or FIN 46R as of December 15, 2003. Management has evaluated BB&T’s investments in variable interest entities and potential variable interest entities or transactions, particularly in limited liability partnerships involved in low-income housing development (“LIHTC investments”) and trust preferred securities structures because these entities or transactions constitute BB&T’s primary FIN 46 and FIN 46R exposure. Under FIN 46, it was determined that BB&T is not the primary beneficiary of the trusts that issued trust preferred securities; thus BB&T’s trust preferred securities were deconsolidated as of September 30, 2003. As a result, other assets and long-term debt each increased by $8.9 million. As of December 31, 2003, BB&T had adopted FIN 46R. The adoption of FIN 46 and FIN 46R did not have a material effect on BB&T’s consolidated financial position or consolidated results of operations beyond the impact on trust preferred securities because it was determined that BB&T is not the primary beneficiary of the LIHTC investments. BB&T’s involvement with variable interest entities at June 30, 2004, is primarily limited to $26.9 million in outstanding balances in LIHTC investments, with an additional $191.1 million in future funding commitments. BB&T has utilized LIHTC investments to invest in areas serving low to moderate-income communities since 1994. Because these investments generate tax credits which minimize the financial impact of a loss of capital, BB&T has chosen to utilize established syndicators to reduce this risk. Interpretive guidance relating to FIN 46R is continuing to evolve and BB&T’s management will continue to assess various aspects of consolidations and variable interest entity accounting as additional guidance becomes available.
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In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). The Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The Statement was effective for contracts entered into or modified after June 30, 2003, with certain exceptions, and for hedging relationships designated after June 30, 2003. In addition, the provisions of the Statement, with certain exceptions, were required to be applied prospectively. The initial implementation of the Statement did not have a material effect on BB&T’s consolidated financial position or consolidated results of operations and management does not anticipate any such impact in the future.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 applies specifically to a number of financial instruments that companies have historically presented within their financial statements either as equity or between the liabilities section and the equity section, rather than as liabilities. On November 7, 2003, the FASB issued FASB Staff Position (“FSP”) 150-3, “Effective Date and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities.” FSP 150-3 defers the effective date of certain provisions of SFAS No. 150, specifically the provisions that apply to mandatorily redeemable noncontrolling interests. This deferral is expected to remain in effect indefinitely until the accounting for these interests is addressed in later guidance. The remaining provisions of SFAS No. 150 were effective for financial instruments entered into or modified after May 31, 2003, and otherwise were effective and adopted by BB&T on July 1, 2003. The implementation of these portions of the Statement did not have a material effect on BB&T’s consolidated financial position or consolidated results of operations. Management is currently evaluating the potential impact of the deferred portion of the Statement.
In December 2003, the FASB issued SFAS No. 132 (revised 2003),“Employers’ Disclosures about Pensions and Other Postretirement Benefits.” This Statement requires additional annual disclosures about the assets, obligations and cash flows of defined benefit pension and postretirement plans, as well as quarterly and annual disclosures with respect to the expense recorded for such plans. The revised disclosures, which are required to be provided on a quarterly basis, are presented herein.
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In December 2003, the Accounting Standards Executive Committee (“AcSEC”) issued Statement of Position (“SOP”) 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.” The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes loans acquired in business combinations. The SOP does not apply to loans originated by BB&T. BB&T intends to adopt the provisions of SOP 03-3 effective January 1, 2005, and does not expect the initial implementation to have a significant effect on BB&T’s consolidated financial position or consolidated results of operations. Management is currently assessing the long-term effect of the SOP.
On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105,“Application of Accounting Principles to Loan Commitments”(“SAB 105”). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments (“IRLC”), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, “Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133.” Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. BB&T early adopted the provisions of SAB 105 effective January 1, 2004. The initial impact upon adoption was a $2.3 million reduction of mortgage banking income. Since the provisions of SAB 105 affect only the timing of the recognition of mortgage banking income, management does not anticipate that this guidance will have a material adverse effect on either BB&T’s consolidated financial position or consolidated results of operations.
In May 2004, the FASB issued FASB Staff Position (“FSP”) 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (the Act). This Staff Position provides guidance on the accounting for the effects of the Act for employers that sponsor postretirement health care plans that provide prescription drug benefits. Management currently does not anticipate that the implementation of the Staff Position will materially affect BB&T’s consolidated financial position or consolidated results of operations.
In the second quarter of 2004, the Emerging Issues Task Force (“EITF”) released EITF Issue 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” The Issue provided guidance for evaluating whether an investment is other-than-temporarily impaired and requires certain disclosures with respect to these investments. On June 30, 2004, BB&T held certain investments having continuous unrealized loss positions for more than 12 months totaling $224.4 million. Substantially all of these investments were in U.S. Treasuries and U.S. government agency obligations, the cash flows of which are guaranteed by the U.S. government or its agencies and, therefore, it is expected that the securities would not be settled at a price less than their amortized cost. Because the decline in market value was caused by interest rate increases and not credit quality, and because BB&T has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, BB&T has not recognized any other-than-temporary impairment in connection with these investments.
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D. Mergers and Acquisitions
The following table presents summary information with respect to significant mergers and acquisitions of financial institutions and other significant financial services companies completed by BB&T Corporation during 2003 and thus far during 2004:
Summary of Completed Mergers and Acquisitions
(1) Includes cash consideration totaling $50.0 million(2) Includes cash consideration totaling $171.1 million
The intangibles related to transactions completed in 2004 in the above table include $218.4 million of other identifiable intangibles, which are being amortized on an accelerated basis over their estimated useful lives. The table above does not include mergers and acquisitions made by any acquired company.
Insurance and Other Non-Bank Acquisitions
In addition to the financial institutions and other significant financial services companies presented in the table above, BB&T acquired three insurance agencies that were accounted for as purchases during the six months ended June 30, 2004. In conjunction with these transactions, BB&T issued approximately 396 thousand shares of common stock and paid approximately $4.1 million in cash, recording approximately $12.8 million in goodwill and $12.2 million in identifiable intangible assets with an average life of 10 years. BB&T acquired six insurance agencies during 2003 which were accounted for as purchases. In conjunction with these transactions, BB&T issued approximately 1.7 million shares of common stock and paid approximately $1.0 million in cash. Approximately $42.3 million in goodwill and $30.9 million of identifiable intangible assets with an average life of 10 years were recorded in conjunction with these transactions.
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On June 10, 2004, BB&T Asset Management completed its acquisition of privately held investment advisory firm de Garmo & Kelleher of Washington D.C. With more than $630 million in assets under management, de Garmo & Kelleher provides investment counsel to individuals, families, professional corporations and charities in more than 25 states.
On April 30, 2004, BB&T completed its acquisition of Capitol Premium Plan Inc., an insurance premium finance company based in Charlotte, North Carolina, which was combined with BB&T’s wholly owned insurance premium finance subsidiary, Prime Rate Premium Finance Corporation Inc.
The acquisitions described above do not exceed the pro forma disclosure thresholds prescribed by SFAS No. 141, “Business Combinations.”
BB&T typically provides an allocation period for all purchase acquisitions to identify and quantify the fair value of the assets acquired and liabilities assumed; therefore, the purchase accounting information presented herein may subsequently be adjusted to reflect changes in allocations of purchase price.
Merger-Related and Restructuring Charges
In conjunction with the consummation of an acquisition and the completion of other requirements, BB&T typically accrues certain merger-related expenses related to estimated severance costs, costs to terminate lease contracts, costs related to the disposal of duplicate facilities and equipment, costs to terminate data processing contracts and other costs associated with the acquisition. The following table presents an analysis of accrued merger costs. This account includes amounts accrued that were reflected as expenses and amounts recorded through purchase accounting adjustments:
Merger Accrual Activity
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E. Calculation of Earnings per Common Share
BB&T’s basic and diluted earnings per common share amounts were calculated as follows:
BB&T CORPORATION AND SUBSIDIARIESCOMPUTATION OF EARNINGS PER SHAREFor the Periods as Indicated
For the quarters ending June 30, 2004 and 2003, respectively, options to purchase an additional 16.6 million shares and 10.0 million shares of common stock were outstanding, but were not included in the computation of dilutes earnings per share because their inclusion would have had an antidilutive effect. For the first six months of 2004 and 2003, respectively, antidilutive options to purchase 14.4 million shares and 10.1 million shares of common stock were outstanding.
F. Segment Disclosures
BB&T’s operations are divided into seven reportable business segments: the Banking Network, Mortgage Banking, Trust Services, Insurance Services, Specialized Lending, Investment Banking and Brokerage, and Treasury. These operating segments have been identified based primarily on BB&T’s existing organizational structure. The segments require unique technology and marketing strategies and offer different products and services. While BB&T is managed as an integrated organization, individual executive managers are held accountable for the operations of these business segments.
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BB&T emphasizes revenue growth by focusing on client service, sales effectiveness and relationship management. The segment results contained herein are presented based on internal management accounting policies that were designed to support these strategic objectives. Unlike financial accounting, there is no comprehensive authoritative body of guidance for management accounting equivalent to generally accepted accounting principles. Therefore, the performance of the segments is not comparable with BB&T’s consolidated results or with similar information presented by any other financial institution. Additionally, because of the interrelationships of the various segments, the information presented is not indicative of how the segments would perform if they operated as independent entities.
Please refer to BB&T’s Annual Report on Form 10-K for the year ended December 31, 2003, for a description of internal accounting policies and the basis of segmentation, including a description of the segments presented in the accompanying tables.
The following tables disclose selected financial information with respect to BB&T’s reportable business segments for the periods indicated:
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BB&T CorporationReportable SegmentsFor the Three Months Ended June 30, 2004 and 2003
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BB&T CorporationReportable SegmentsFor the Six Months Ended June 30, 2004 and 2003
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The following table presents a reconciliation of segment results to consolidated results:
G. Stock-Based Compensation
BB&T maintains various stock-based compensation plans. These plans provide for the granting of stock options, stock appreciation rights, restricted stock, performance units and performance shares to selected BB&T employees and directors. All of BB&T’s stock-based compensation plans have been presented to and approved by BB&T’s shareholders. BB&T accounts for its stock option plans based on the intrinsic value method set forth in APB Opinion No. 25 and related Interpretations, under which no compensation cost has been recognized for any of the periods presented, except with respect to restricted stock plans as disclosed in the accompanying table. The following table presents BB&T’s net income, basic earnings per share and diluted earnings per share as reported, and pro forma net income and pro forma earnings per share assuming compensation cost for BB&T’s stock option plans had been determined based on the fair value at the grant dates for awards under those plans granted after December 31, 1994, consistent with the method prescribed by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”).
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The fair value of each option grant was estimated as of the date of grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions used for grants in 2004 and 2003, respectively: dividend yield of 3.0% in 2004 and 2003; expected volatility of 27% in 2004 and 2003; risk free interest rates of 3.9% and 3.5% for the second quarter and first six months of 2004; risk free interest rates of 3.0% and 3.1% for the second quarter and first six months of 2003; and expected lives of 6.0 years for both 2004 and 2003.
Because the SFAS No. 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years.
H. Off-Balance Sheet Arrangements and Guarantees
BB&T’s significant off-balance sheet arrangements include certain investments in low-income housing and historic building rehabilitation projects throughout its market area. BB&T enters into such arrangements as a means of supporting local communities, and recognizes tax credits relating to its investments. At June 30, 2004, and December 31, 2003, BB&T’s investments in such projects totaled $26.9 million and $12.7 million, respectively. BB&T typically acts as a limited partner in these investments and does not exert control over the operating or financial policies of the partnerships. BB&T’s subsidiary banks typically provide financing during the construction and development of the properties; however, permanent financing is generally obtained from independent third parties upon completion of a project. Outstanding commitments to fund low-income housing investments totaled $191.1 million and $215.0 million at June 30, 2004 and December 31, 2003, respectively.
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Guarantees
Standby letters of credit, which include performance and financial guarantees, are unconditional commitments issued by BB&T to guarantee the performance of customers to third parties. These guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper issuance, bond financing and similar transactions. The credit risk involved in issuing these guarantees is essentially the same as that involved in extending loans to clients and as such, is collateralized when appropriate. As of June 30, 2004, BB&T had issued a total of $1.2 billion in standby letters of credit, which were entered into subsequent to December 31, 2002. As a result of BB&T’s adoption of FIN 45 at January 1, 2003, BB&T’s estimated liability for such guarantees was $.5 million at June 30, 2004, which was included in other liabilities.
In the ordinary course of business, BB&T indemnifies its officers and directors to the fullest extent permitted by law against liabilities arising from pending or threatened litigation. BB&T also issues standard representations, warranties and indemnifications in underwriting agreements, merger and acquisition agreements, loan sales, brokerage activities and other similar arrangements. Counterparties in many of these indemnifications provide similar indemnifications to BB&T. Although these agreements often do not specify limitations, BB&T has not been required to act on the guarantees and does not believe that any payments pursuant to them would materially change the financial condition or results of operations as presented herein.
Merger and acquisition agreements for businesses other than financial institutions occasionally include additional incentives to the acquired entities to offset the loss of future cash flows previously received through ownership positions. Typically, these incentives are based on the acquired entity’s contribution to BB&T’s earnings compared to agreed-upon amounts. When offered, these incentives are typically issued for terms of three to eight years. In the aggregate, the maximum potential contingent consideration payable under such agreements is $145.9 million over the next five years.
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I. Goodwill and Other Intangibles
The changes in the carrying amount of goodwill attributable to each of BB&T’s operating segments for the six months ended June 30, 2004, and the year ended December 31, 2003, are as follows:
Goodwill Activity by Operating Segment(Dollars in thousands)
(1) Adjustments reflect allocations of purchase price subsequent to the dates of acquisition.
The following table presents the gross carrying amounts and accumulated amortization for BB&T’s identifiable intangible assets subject to amortization at the dates presented:
(1) Other amortizing identifiable intangibles are primarily composed of customer relationship intangibles.
During the six months ended June 30, 2004, and 2003, BB&T recorded $52.7 million and $13.6 million, respectively, in amortization expenses associated with identifiable intangible assets.
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The following table presents estimated amortization expense for each of the next five years:
J. Benefit Plans
BB&T provides various benefit plans to substantially all employees. Employees of acquired entities generally participate in existing BB&T plans soon after consummation of the business combinations. The plans of acquired institutions are typically merged into the BB&T plans upon consummation of the mergers, and, under these circumstances, credit is usually given to these employees for years of service at the acquired institution for vesting and eligibility purposes. Please refer to BB&T’s Annual Report on Form 10-K for the year ended December 31, 2003, for detailed descriptions and disclosures about the various benefit plans offered by BB&T.
The following table summarizes the components of net periodic benefit cost recognized for the three-month and six-month periods ended June 30, 2004, and 2003, respectively:
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BB&T previously disclosed in its Annual Report on Form 10-K for the year ended December 31, 2003, that it did not anticipate making a contribution to the defined benefit pension plans during 2004 and is not required to make any contributions. However, management elected to make a discretionary contribution of $25.0 million in the second quarter of 2004. Management currently has no firm plans to make additional discretionary contributions during the remainder of 2004.
BB&T previously disclosed in its Annual Report on Form 10-K for the year ended December 31, 2003, that it anticipated contributing $8.1 million to the postretirement benefit plan during 2004. Based on projections at June 30, 2004, the expected contributions to the plan total $5.3 million.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This report contains forward-looking statements with respect to the financial condition, results of operations and business of BB&T. These forward-looking statements involve risks and uncertainties and are based on the beliefs and assumptions of the management of BB&T, and on the information available to management at the time that these disclosures were prepared. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) competitive pressures among depository and other financial institutions may increase significantly; (2) changes in the interest rate environment may reduce net interest margins and/or the volumes and values of loans made or held as well as the value of other financial assets held; (3) general economic or business conditions, either nationally or regionally, may be less favorable than expected, resulting in, among other things, a deterioration in credit quality and/or a reduced demand for credit or other services; (4) legislative or regulatory changes, including changes in accounting standards, may adversely affect the businesses in which BB&T is engaged; (5) costs or difficulties related to the integration of the businesses of BB&T and its merger partners may be greater than expected; (6) expected cost savings associated with pending or recently completed mergers may not be fully realized or realized within the expected time frames; (7) deposit attrition, customer loss or revenue loss following pending or recently completed mergers may be greater than expected; (8) competitors of BB&T may have greater financial resources and develop products that enable such competitors to compete more successfully than BB&T; and (9) adverse changes may occur in the securities markets.
Critical Accounting Policies
The accounting and reporting policies of BB&T Corporation and its subsidiaries are in accordance with accounting principles generally accepted in the United States and conform to general practices within the banking industry. BB&T’s financial position and results of operations are affected by management’s application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues and expenses. Different assumptions in the application of these policies could result in material changes in BB&T’s consolidated financial position and/or consolidated results of operations. The more critical accounting and reporting policies include BB&T’s accounting for the allowance for loan and lease losses, valuation of mortgage servicing rights, valuing intangible assets associated with mergers and acquisitions, costs and benefit obligations associated with BB&T’s pension and postretirement benefit plans, and income taxes. Understanding BB&T’s accounting policies is fundamental to understanding BB&T’s consolidated financial position and consolidated results of operations. Accordingly, BB&T’s significant accounting policies are discussed in detail in Note 1 in the “Notes to Consolidated Financial Statements” in BB&T’s 2003 Annual Report on Form 10-K filed with the Securities and Exchange Commission.
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The following is a summary of BB&T’s critical accounting policies that are highly dependent on estimates, assumptions and judgments.
It is the policy of BB&T to maintain an allowance for loan and lease losses that equals management’s best estimate of probable losses that are inherent in the portfolio at the balance sheet date. Estimates of loan and lease losses are determined by analyzing historical loan and lease losses, current trends in delinquencies and charge-offs, plans for problem loan and lease administration, the results of regulatory examinations, and changes in the size, composition and risk assessment of the loan and lease portfolio. Also included in management’s estimates of loan and lease losses are considerations with respect to the impact of economic events, the outcome of which is uncertain. These events may include, but are not limited to, fluctuations in overall interest rates, political conditions, legislation that directly or indirectly affects the banking industry and economic conditions affecting specific geographical areas and industries in which BB&T conducts business.
BB&T has a mortgage loan servicing portfolio and related mortgage servicing rights. Mortgage servicing rights represent the present value of the future net servicing fees from servicing mortgage loans acquired or originated by BB&T. The most critical accounting policy associated with mortgage servicing is the methodology used to determine the fair value of mortgage servicing rights, which requires the development of a number of assumptions, including anticipated loan principal amortization and prepayments of principal. The value of mortgage servicing rights is significantly affected by mortgage interest rates available in the marketplace, which influence the speed of mortgage loan prepayments. In general, during periods of declining interest rates, the value of mortgage servicing assets declines due to increasing prepayments attributable to increased mortgage refinance activity. Conversely, during periods of rising interest rates, the value of servicing assets generally increases due to reduced refinance activity. BB&T amortizes mortgage servicing rights over the estimated period that servicing income is expected to be received based on projections of the amount and timing of future cash flows. The amount and timing of servicing asset amortization is adjusted quarterly based on actual results and updated projections.
BB&T’s growth in business, profitability and market share over the past several years has been enhanced significantly by mergers and acquisitions. For purchase acquisitions, BB&T is required to record the assets acquired, including identified intangible assets and liabilities assumed, at their fair value, which in many instances involves estimates based on third party valuations, such as appraisals or internal valuations based on discounted cash flow analyses or other valuation techniques. The determination of the useful lives of intangible assets is subjective, as is the appropriate amortization period for such intangible assets. These estimates also include the establishment of various accruals and allowances based on planned facilities dispositions and employee severance considerations, among other acquisition-related items. In addition, purchase acquisitions typically result in goodwill, which is subject to ongoing periodic impairment tests based on the fair value of net assets acquired compared to the carrying value of goodwill.
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The calculation of BB&T’s income tax provision is complex and requires the use of estimates and judgments in its determination. As part of the Company’s analysis and implementation of business strategies, consideration is given to the tax laws and regulations that apply to the specific facts and circumstances for any transaction under evaluation. This analysis includes the amount and timing of the realization of income tax liabilities or benefits. Management closely monitors tax developments in order to evaluate the effect they may have on the Company’s overall tax position and the estimates and judgments utilized in determining the income tax provision and records adjustments as necessary.
BB&T offers various pension plans and postretirement benefit plans to employees. The calculation of the obligations and related expenses under these plans requires the use of actuarial valuation methods and assumptions. Actuarial valuations and assumptions used in the determination of future values of plan assets and liabilities are subject to management judgment and may differ significantly if different assumptions are used.
EXECUTIVE SUMMARY
BB&T’s total assets at June 30, 2004, were $97.3 billion, an increase of $6.9 billion, or 7.6%, from December 31, 2003. The asset categories that experienced the largest increases were securities available for sale and loans and leases, including loans held for sale, which grew $1.9 billion, or 12.3%, and $4.7 billion, or 7.6%, respectively, during the first half of 2004.
Total deposits at June 30, 2004 were $66.7 billion, an increase of $7.3 billion, or 12.3%, from December 31, 2003. Short-term borrowed funds decreased $1.1 billion, or 15.0%, and long-term debt decreased $283.1 million, or 2.6%, during the first six months of 2004. Total shareholders’ equity increased $590.0 million, or 5.9%, during the same time frame.
Consolidated net income for the second quarter of 2004 totaled $400.1 million, an increase of 26.5% compared to the $316.2 million earned during the comparable quarter of 2003. On a diluted per share basis, earnings for the three months ended June 30, 2004, were $.72, compared to $.67 for the same period in 2003, an increase of 7.5%. BB&T’s results of operations for the second quarter of 2004 produced an annualized return on average assets of 1.65% and an annualized return on average shareholders’ equity of 15.17% compared to prior year ratios of 1.57% and 16.38%, respectively.
Consolidated net income for the first six months of 2004 totaled $728.6 million, an increase of 13.1% compared to the $644.0 million earned during the same period in 2003. On a diluted per share basis, earnings for the first six months of 2004 and 2003 were $1.32 and $1.36, respectively, which represents a decrease of 2.9%. BB&T’s results of operations for the first six months of 2004 produced an annualized return on average assets of 1.55% and an annualized return on average shareholders’ equity of 14.07% compared to prior year ratios of 1.62% and 17.06%, respectively.
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Results during the second quarter reflect improvements in several key drivers of BB&T's profitability. Among these were stronger loan growth, particularly in comparison with the first quarter of 2004, higher revenues from noninterest income generating businesses, continued improvement in asset quality and improving expense control. Please refer to BB&T’s Annual Report on Form 10-K for the year ended December 31, 2003, for additional information with respect to BB&T’s recent accomplishments and significant challenges. The factors causing the fluctuations in the major balance sheet and income statement categories for the second quarter and first six months of 2004 are further discussed in the following sections.
ANALYSIS OF FINANCIAL CONDITION
Loans and Leases
BB&T emphasizes commercial lending to small and medium-sized businesses, consumer lending and mortgage lending with an overall goal of maximizing the profitability of the loan portfolio while maintaining strong asset quality. For the first six months of 2004, average total loans were $65.0 billion, an increase of $11.0 billion, or 20.3%, compared to the same period in 2003. During the first six months of 2004, average commercial loans, including lease receivables, increased $3.2 billion, or 10.8%, compared to the same period in 2003 and composed 49.6% of the loan portfolio compared to 53.9% for the first six months of 2003. Average consumer loans, which include sales finance, revolving credit and direct retail, totaled $20.1 billion during the second quarter of 2004, an increase of $6.0 billion, or 43.1%, compared to the same period in 2003. During the first half of 2004, consumer loans composed 30.9% of average loans compared to 26.0% for the first six months of 2003. Average mortgage loans totaled $12.7 billion for the first six months of 2004, which represents an increase of $1.8 billion, or 16.5%, from the 2003 average and composed the remaining 19.5% of the loan and lease portfolio compared to 20.1% for the same period of 2003.
For the second quarter of 2004, average total loans were $66.9 billion, an increase of $12.5 billion, or 23.0%, compared to the same period in 2003. Average commercial loans and leases for the second quarter of 2004 totaled $33.1 billion, up $3.9 billion, or 13.2%, compared to the same period in 2003 and composed 49.5% of the loan and lease portfolio compared to 53.8% for the second quarter of 2003. Average consumer loans totaled $20.5 billion for the second quarter of 2004, an increase of $6.4 billion, or 45.4%, compared to the same period in 2003 and composed 30.7% of the loan and lease portfolio compared to 26.0% in 2003. Average mortgage loans totaled $13.2 billion for the current quarter, which represents an increase of $2.2 billion, or 20.1%, from the 2003 average and composed the remaining 19.8% of the loan and lease portfolio compared to 20.2% for the same period of 2003.
The growth rates of the average loans described above were affected by loan portfolios held by companies that were acquired in purchase transactions during the second half of 2003 and first half of 2004. In particular, on July 1, 2003, loans totaling $6.3 billion were acquired through the purchase of First Virginia. On April 14, 2004, loans totaling $1.7 billion were acquired through the purchase of Republic Bancshares, Inc. (“Republic”). Excluding the effect of purchase accounting transactions, the average “internal” loan growth for the three months ended June 30, 2004, was approximately 7.6% compared to the same period in 2003. By category, excluding the effects of purchase accounting transactions, average mortgage loans, including loans held for sale, increased 15.1%, average commercial loans and leases grew 5.0%, and average consumer loans increased 7.4% in the second quarter of 2004 compared to the second quarter of 2003.
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During the second quarter of 2004, BB&T’s average loan portfolio grew 23.2% on an annualized basis compared to the first quarter of 2004 because of a significant increase in loan demand across BB&T’s footprint. Excluding the impact of growth resulting from acquisitions, average loans and leases grew at an annualized growth rate of approximately 12.3% compared to the first quarter of 2004. This increase reflects the strongest internal quarterly growth rate since 2000. The acceleration in loan growth was spread across all major loan categories. Average commercial loans grew at approximately 9.1% on an annualized basis, excluding acquisitions, compared to the first quarter. Average direct retail loans grew approximately 13.5% on an annualized basis, excluding acquisitions. The internal growth rate in average mortgage loans, which was approximately 22.9% compared to the first quarter, was partially affected by the fluctuation in loans held for sale and the retention of mortgage loans in recent quarters. Average revolving credit loans increased at an annualized rate of approximately 5.4% compared to the first quarter, excluding acquisitions, which reflected expected seasonal fluctuations. Finally, average sales finance internal growth significantly improved compared to recent quarters, with average balances increasing at an annualized rate of 5.7% during the second quarter of 2004 compared to the first quarter.
The annualized fully taxable equivalent (“FTE”) yields on commercial, consumer and mortgage loans for the first six months of 2004 were 5.26%, 6.71%, and 5.63%, respectively, resulting in an annualized yield on the total loan portfolio of 5.78%. The FTE yields on commercial, consumer and mortgage loans for the first six months of 2003 were 5.68%, 7.90%, and 6.26%, respectively, resulting in an annualized yield on the total loan portfolio of 6.37%. This reflects a decrease of 59 basis points in the annualized yield on the total loan portfolio during the first six months of 2004 in comparison to 2003. For the second quarter of 2004, the annualized yield on the total loan portfolio was 5.72%, reflecting a decrease of 57 basis points compared to the second quarter of 2003. The decreases in yields for both the six months and the second quarter were partially due to a lower average prime rate, which is used in the pricing of many loans. During the first six months of 2004, the prime rate averaged 4.00% compared to 4.25% during the same period in 2003. In addition to the decline in the prime rate, the runoff of higher-yielding fixed-rate loans and more competition in loan pricing produced the remainder of the decrease in loan yields. The impact on interest income from loans and leases from the decrease in the yield on the portfolio was more than offset by the acquisition of First Virginia and strong internal loan growth thus far during 2004 and, as a result, interest income from loans and leases on an FTE basis increased 11.6% and 9.4% in the second quarter and first six months of 2004, respectively, compared to the same periods of 2003.
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Securities
Securities available for sale totaled $17.5 billion at June 30, 2004, an increase of $1.9 billion, or 12.3%, compared with December 31, 2003. Securities available for sale had net unrealized losses, net of deferred income taxes, of $228.1 million at June 30, 2004, compared to net unrealized gains, net of deferred income taxes, of $11.5 million at December 31, 2003. Average total securities for the first six months of 2004 amounted to $17.8 billion, an increase of 5.0% compared to the average balance during the first six months of 2003. Average total securities for the second quarter of 2004 amounted to $18.4 billion, an increase of 5.4% compared to the average balance for the second quarter of 2003. The increase in securities available for sale was the result of a combination of factors including the reinvestment of sales proceeds from the trading securities portfolio, the investment of funds generated by strong deposit growth and the reinvestment of proceeds from sales, calls and maturities of securities during the first six months of 2004.
Trading securities totaled $389.0 million, down $304.8 million compared to the balance at December 31, 2003. The decrease in trading securities primarily resulted from management’s decision to liquidate the portion of the trading portfolio being used as an economic risk management strategy in connection with BB&T’s mortgage servicing rights.
The annualized FTE yield on the average securities portfolio for the first six months of 2004 was 4.11%, a decrease of 113 basis points from the annualized yield earned in the first six months of 2003. During the second quarter of 2004, the annualized yield on the securities portfolio was 4.04%, a decrease of 98 basis points compared to the second quarter of 2003. These decreases in yield resulted principally from the prolonged low interest rate environment and purchases of lower-yielding securities. As BB&T’s higher yielding securities matured, sold, or were called, the resulting cash flows were reinvested in securities paying lower interest rates.
On June 30, 2004, BB&T held certain investments having continuous unrealized loss positions for more than 12 months totaling $224.4 million. Substantially all of these investments were in U.S. Treasuries and U.S. government agency obligations, the cash flows of which are guaranteed by the U.S. government or its agencies and, therefore, it is expected that the securities would not be settled at a price less than their amortized cost. Because the decline in market value was caused by interest rate increases and not credit quality, and because BB&T has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, BB&T has not recognized any other-than-temporary impairment in connection with these investments.
Other Interest Earning Assets
Federal funds sold and securities purchased under resale agreements or similar arrangements totaled $176.5 million at June 30, 2004, a decrease of $156.3 million, or 47.0%, compared to December 31, 2003. Interest-bearing deposits with banks increased $43.1 million, or 15.9%, compared to year-end 2003. These categories of earning assets are subject to large daily fluctuations based on the availability of these types of funds. The average yield on other interest-earning assets for the first six months of 2004 was 1.47%, unchanged compared to the first six months of 2003. For the second quarter of 2004, the average yield on other interest-earning assets was 1.50%, up from 1.36% in the second quarter last year.
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Goodwill and Other Assets
BB&T’s other noninterest-earning assets, excluding premises and equipment and noninterest-bearing cash and due from banks, increased $926.6 million from December 31, 2003, to June 30, 2004. The increase was due primarily to additional goodwill and other intangibles resulting from the acquisitions of McGriff, Seibels & Williams, Inc. (“McGriff”) and Republic, which totaled $413.2 million and $260.3 million, respectively.
Other noninterest-earning assets also include commercial mortgage servicing rights totaling $14.7 million and residential mortgage servicing rights totaling $356.4 million, net of an allowance for impairment, which totaled $85.1 million at June 30, 2004.
Deposits
Deposits totaled $66.7 billion at June 30, 2004, an increase of $7.3 billion, or 12.3%, from December 31, 2003. Average deposits for the first six months of 2004 increased $11.5 billion, or 22.1%, to $63.8 billion compared to the first six months of 2003. The categories of deposits with the highest average rates of growth were money rate savings accounts, including investor deposit accounts, which increased $4.7 billion, or 28.8%, and noninterest-bearing deposits, which increased $3.2 billion, or 39.9%.
For the second quarter of 2004, average deposits increased $13.1 billion, or 24.8%, compared to the second quarter of 2003. The categories of deposits with the highest average rates of growth were similar to the ones noted above for the six-month periods ending June 30, 2004 and 2003. Average money rate savings accounts, noninterest-bearing deposits, and savings and interest checking accounts increased $5.4 billion, $3.3 billion, and $1.7 billion, respectively, for the second quarter of 2004, which represent increases of 32.9%, 40.1%, and 52.4%, respectively, compared to the second quarter of 2003.
The growth in average deposits during the first half of 2004 compared to the corresponding period of 2003 includes the effect of deposits acquired in purchase accounting transactions completed during 2004 and the second half of 2003. In particular, the purchase of First Virginia at the beginning of the third quarter of 2003 and the purchase of Republic during the second quarter of 2004 added $9.5 billion and $2.5 billion, respectively, in deposits. If the effects of purchase accounting transactions are excluded, average deposits for the six months ended June 30, 2004, increased approximately 3.5% compared to the same time period in 2003. For the second quarter of 2004, total average deposits, excluding the effects of purchase accounting transactions, increased approximately 4.1% compared to the same period last year.
In addition to the positive growth in client deposits over the last two years, there has been a shift in the overall deposit mix from certificate accounts and other time deposits to lower-cost transaction accounts such as noninterest-bearing deposits and money rate savings accounts. This shift reflects the reduced attractiveness of time deposits and client preferences for more liquid investments in a low interest rate environment as well as BB&T’s efforts to emphasize growth in noninterest-bearing accounts.
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The annualized average rate paid on total interest-bearing deposits during the first six months of 2004 was 1.30%, a decrease of 52 basis points compared to 2003. For the second quarter of 2004, the average rate paid on total interest-bearing deposits was 1.28%, a decrease of 45 basis points compared to the second quarter of 2003. These decreases in the average rates paid resulted from the lower interest rate environment that existed during 2004 compared to 2003, which included a 25 basis point decrease in the average federal funds rate, and the shift in deposit mix from certificates of deposit and higher-cost time deposits to lower-cost savings and transaction accounts.
Borrowings
While client deposits remain the primary source for funding loan originations, management uses short-term borrowings as a supplementary funding source for loan growth. At June 30, 2004, short-term borrowed funds totaled $6.2 billion, a decrease of $1.1 billion, or 15.0%, compared to December 31, 2003. The decrease in short-term borrowed funds compared to December 31, 2003, which are mainly composed of federal funds purchased, was primarily a result of healthy deposit growth, which provided sufficient resources for funding loan growth. For the second quarter of 2004, average short-term borrowed funds were $6.7 billion, an increase of $1.9 billion, or 40.8%, from the comparable period of 2003. For the six months ended June 30, 2004, average short-term borrowed funds increased $2.3 billion, or 51.5%, compared to the same period in 2003.
The average annualized rate paid on short-term borrowed funds was 1.07% for the first six months of 2004, a decrease of 25 basis points from the average rate of 1.32% paid in the comparable period of 2003. The average rate paid on short-term borrowed funds was 1.08% in the second quarter of 2004, a decrease of 21 basis points compared to the rate paid in the second quarter of 2003. These decreases in the cost of short-term borrowed funds resulted from the lower interest rate environment that has existed during 2004 compared to 2003, which included a 25 basis point decrease in the average federal funds rate.
Long-term debt consists primarily of Federal Home Loan Bank (“FHLB”) advances to BB&T’s banking subsidiaries and corporate subordinated notes. Long-term debt has been utilized for a variety of funding needs, including the repurchase of common stock. Long-term debt totaled $10.5 billion at June 30, 2004, down $283.1 million, or 2.6%, from the balance at December 31, 2003. For the second quarter of 2004, average long-term debt totaled $10.7 billion, a decrease of $2.5 billion, or 19.0%, compared to the second quarter of 2003. For the six months ended June 30, 2004, average long-term borrowed funds were $10.6 billion, down $2.7 billion, or 20.4%, compared to the first six months of 2003. The average annualized rate paid on long-term borrowed funds was 3.37% for the first six months of 2004, a decrease of 73 basis points from the average rate of 4.10% paid during the first six months of 2003. The average annualized rate paid on long-term debt for the second quarter of 2004 was 3.36%, a decrease of 68 basis points compared to the second quarter of 2003.
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The decrease in the average balance of long-term debt and average annualized interest rate paid compared to the first six months of 2003 were primarily the result of a balance sheet restructuring completed during the second and third quarters of 2003, which was intended to improve net interest income and the net interest margin. As part of the restructuring, BB&T refinanced $3.0 billion of long-term FHLB advances, thus lowering the current annual interest rate paid on these advances during the next five years, after which the FHLB has an option to increase the interest rate paid on such advances depending on market rates then available. In addition, BB&T prepaid $2.9 billion in long-term FHLB advances as part of the restructuring in 2003 and restructured an additional $1.9 billion in the first quarter of 2004 because of the availability of more cost-effective funding sources.
Asset Quality
Nonperforming assets, composed of foreclosed real estate, repossessions, nonaccrual loans and restructured loans, totaled $412.9 million at June 30, 2004, compared to $447.1 million at December 31, 2003. As a percentage of loans and leases plus foreclosed property, nonperforming assets were .62% at June 30, 2004, down from ..72% at December 31, 2003. Loans 90 days or more past due and still accruing interest totaled $95.7 million at June 30, 2004, compared to $116.8 million at year-end 2003.
BB&T’s net charge-offs totaled $57.2 million for the second quarter and amounted to ..34% of average loans and leases, on an annualized basis, compared to $58.2 million, or .43% of average loans and leases, on an annualized basis, in the corresponding period in 2003. For the six months ended June 30, 2004 and 2003, net charge-offs totaled $114.4 million and $120.9 million, respectively, and represented .35% and .45%, respectively, of average loans and leases on an annualized basis.
The allowance for loan and lease losses totaled $816.3 million at June 30, 2004, compared to $784.9 million at December 31, 2003, an increase of 4.0%. The allowance amounted to 1.22% of loans and leases outstanding at June 30, 2004, compared to 1.26% at year-end 2003. Excluding loans held for sale, the allowance for loan and lease losses was 1.23% and 1.27% of loans and leases at June 30, 2004 and December 31, 2003, respectively.
The above levels of nonperforming assets as a percentage of total assets and quarterly net charge-offs as a percentage of average loans are the lowest since 2000. During the last five quarters, BB&T’s credit quality has steadily improved as demonstrated by the successive quarterly declines in the levels of nonperforming assets and quarterly net charge-offs over that time period. These positive trends in asset quality are the primary factor that has resulted in a lower allowance for loan and lease losses as a percentage of total loans. Other factors include management’s decision to retain, rather than sell, $3.6 billion of fixed rate residential mortgage loans, which normally have lower credit risk and, therefore, require a lower relative allowance in comparison to commercial or consumer loans. Also, the acquisition of First Virginia, which had strong credit quality, including lower net charge-offs and lower nonperforming assets than BB&T, further improved the overall risk profile of BB&T’s loan portfolio, producing decreases in the allowance for loan and lease losses as a percentage of total loans and leases.
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The provision for loan and lease losses for the second quarter of 2004 was $64.0 million compared to $61.5 million during the same period in 2003. For the six months ended June 30, 2004, the provision for loan and lease losses totaled $126.5 million compared to $124.5 million in 2003.
Asset quality statistics for the last five calendar quarters are presented in the accompanying tables.
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ASSET QUALITY ANALYSIS(Dollars in thousands)
* Includes loans held for sale and is net of unearned income. Applicable ratios are annualized.** Excludes net charge-offs and average loans from BB&T's specialized lending operations.
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MARKET RISK MANAGEMENT
The effective management of market risk is essential to achieving BB&T’s strategic financial objectives. As a financial institution, BB&T’s most significant market risk exposure is interest rate risk. The primary objective of interest rate risk management is to minimize the effect that changes in interest rates have on net interest income. This is accomplished through active management of asset and liability portfolios with a focus on the strategic pricing of asset and liability accounts and management of appropriate maturity mixes of assets and liabilities. The goal of these activities is the development of appropriate maturity and repricing opportunities in BB&T’s portfolios of assets and liabilities that will produce consistent net interest income during periods of changing interest rates. BB&T’s Asset / Liability Management Committee (“ALCO”) monitors loan, investment and liability portfolios to ensure comprehensive management of interest rate risk. These portfolios are analyzed for proper fixed-rate and variable-rate mixes under various interest rate scenarios.
The asset/liability management process is designed to achieve relatively stable net interest margins and assure liquidity by coordinating the volumes, maturities or repricing opportunities of earning assets, deposits and borrowed funds. It is the responsibility of the ALCO to determine and achieve the most appropriate volume and mix of earning assets and interest-bearing liabilities, as well as to ensure an adequate level of liquidity and capital, within the context of corporate performance goals. The ALCO also sets policy guidelines and establishes long-term strategies with respect to interest rate risk exposure and liquidity. ALCO meets regularly to review BB&T’s interest rate risk and liquidity positions in relation to present and prospective market and business conditions, and adopts funding and balance sheet management strategies that are intended to ensure that the potential impact on earnings and liquidity as a result of fluctuations in interest rates is within acceptable standards.
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The majority of BB&T’s assets and liabilities are monetary in nature, and, therefore, differ greatly from most commercial and industrial companies that have significant investments in fixed assets or inventories. Fluctuations in interest rates and actions of the Board of Governors of the Federal Reserve System (“FRB”) to regulate the availability and cost of credit have a greater effect on a financial institution’s profitability than do the effects of higher costs for goods and services. Through its balance sheet management function, which is monitored by ALCO, BB&T positions itself to respond to changing needs for liquidity, changes in interest rates and inflationary trends.
Management uses Interest Sensitivity Simulation Analysis (“Simulation”) to measure the sensitivity of projected earnings to changes in interest rates. Simulation takes into account the current contractual agreements that BB&T has with its customers on deposits, borrowings, loans, investments and any commitments to enter into those transactions. Management monitors BB&T’s interest sensitivity by means of a computer model that incorporates the current volumes, average rates earned and paid, and scheduled maturities and payments of asset and liability portfolios, together with multiple scenarios of projected prepayments, repricing opportunities and anticipated volume growth. Using this information, the model projects earnings based on projected portfolio balances under multiple interest rate scenarios. This level of detail is needed to simulate the effect that changes in interest rates and portfolio balances may have on the earnings of BB&T. This method is subject to the accuracy of the assumptions that underlie the process, but it provides a better illustration of the sensitivity of earnings to changes in interest rates than other analyses such as static or dynamic gap.
The asset/liability management process requires a number of key assumptions. Management determines the most likely outlook for the economy and interest rates by analyzing external factors, including published economic projections and data, the effects of likely monetary and fiscal policies, as well as any enacted or prospective regulatory changes. BB&T’s current and prospective liquidity position, current balance sheet volumes and projected growth, accessibility of funds for short-term needs and capital maintenance are also considered. This data is combined with various interest rate scenarios to provide management with information necessary to analyze interest sensitivity and to aid in the development of strategies to reach performance goals.
The following table shows the effect that the indicated changes in interest rates would have on net interest income as projected for the next 12 months under the “most likely” interest rate scenario incorporated into the Interest Sensitivity Simulation computer model. Key assumptions in the preparation of the table include prepayment speeds of mortgage-related assets, cash flows and maturities of derivative financial instruments, changes in market conditions, loan volumes and pricing, deposit sensitivity, customer preferences, and capital plans. The resulting change in net interest income reflects the level of sensitivity that net interest income has in relation to changing interest rates.
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Interest Sensitivity Simulation Analysis
(1) BB&T's model did not calculate a 1% decrease in 2004 or a 1.25% decrease in 2003.
Management has established parameters for asset/liability management, which prescribe a maximum impact on net interest income of 3% for a 150 basis point parallel change in interest rates over six months from the most likely interest rate scenario, and a maximum of 6% for a 300 basis point change over 12 months. It is management’s ongoing objective to effectively manage the impact of changes in interest rates and minimize the resulting effect on earnings.
Derivative Financial Instruments
BB&T utilizes a variety of derivative financial instruments to manage various financial risks. These derivatives primarily consist of interest rate swaps, swaptions, caps, floors, collars, financial forward and futures contracts, when-issued securities and options written and purchased. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. BB&T uses derivatives primarily to hedge business loans, federal funds purchased, long-term debt, mortgage servicing rights, mortgage banking operations, and certificates of deposit. BB&T also uses derivatives to facilitate transactions on behalf of its clients.
Derivative contracts are written in amounts referred to as notional amounts. Notional amounts only provide the basis for calculating payments between counterparties. Notional amounts do not represent amounts to be exchanged between parties and are therefore not a measure of financial risk. On June 30, 2004, BB&T had derivative financial instruments outstanding with notional amounts totaling $20.0 billion. The estimated net fair value of open contracts was $23.3 million at June 30, 2004.
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Credit risk related to derivatives arises when amounts receivable from a counterparty exceed those payable. Because the notional amount of the instruments only serves as a basis for calculating amounts receivable or payable, the risk of loss with any counterparty is limited to a small fraction of the notional amount. BB&T deals with national market makers with strong credit ratings in its derivatives activities. BB&T further controls the risk of loss by subjecting counterparties to credit reviews and approvals similar to those used in making loans and other extensions of credit. In addition, counterparties are required to provide cash collateral to BB&T when their unsecured loss positions exceed certain negotiated limits. All of the derivative contracts to which BB&T is a party settle monthly, quarterly or semiannually. Further, BB&T has netting agreements with the dealers with which it does business. Because of these factors, BB&T’s credit risk exposure related to derivative contracts at June 30, 2004, was not material.
The following tables set forth certain information concerning BB&T’s derivative financial instruments at June 30, 2004:
Derivative Classifications and Hedging RelationshipsJune 30, 2004(Dollars in thousands)
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Derivative Financial InstrumentsJune 30, 2004(Dollars in thousands)
N/A - not applicable.
Contractual Obligations, Contingent Liabilities and Other Commitments
BB&T utilizes a variety of financial instruments to meet the financial needs of its clients and to reduce exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, options written, standby letters of credit and financial guarantees, interest rate caps, floors and collars, interest rate swaps, swaptions, when-issued securities, and forward and futures contracts. Please refer to BB&T’s Annual Report on Form 10-K for the year ended December 31, 2003, for discussion with respect to BB&T’s quantitative and qualitative disclosures about its fixed and determinable contractual obligations. Items disclosed in the Annual Report on Form 10-K have not materially changed since that report was filed. A discussion of BB&T’s derivative financial instruments is included in the “Derivative Financial Instruments” section herein.
CAPITAL ADEQUACY AND RESOURCES
The maintenance of appropriate levels of capital is a management priority and is monitored on an ongoing basis. BB&T’s principal goals related to capital are to provide an adequate return to shareholders while retaining a sufficient base from which to support future growth and to comply with all regulatory standards.
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Total shareholders’ equity was $10.5 billion at June 30, 2004, compared to $9.9 billion at December 31, 2003, an increase of 5.9%. BB&T’s book value per common share at June 30, 2004 was $18.95 compared to $18.33 at December 31, 2003. BB&T’s tangible shareholders’ equity was $5.86 billion at June 30, 2004, a slight decrease from $5.92 billion at December 31, 2003. BB&T’s tangible book value per common share at June 30, 2004 was $10.56 compared to $10.92 at December 31, 2003.
Bank holding companies and their subsidiaries are subject to regulatory requirements with respect to risk-based capital adequacy. Capital adequacy is an important indicator of financial stability and performance. Risk-based capital ratios measure capital as a percentage of a combination of risk-weighted balance sheet and off-balance sheet risk. The risk-weighted values of both balance sheet and off-balance sheet items are determined in accordance with risk factors specified by Federal bank regulatory pronouncements.
Tier 1 capital is calculated as common shareholders’ equity excluding unrealized gains or losses on debt securities available for sale, unrealized gains on equity securities available for sale and unrealized gains or losses on cash flow hedges, net of deferred income taxes; plus certain mandatorily redeemable capital securities, less nonqualifying intangible assets, net of applicable deferred income taxes, and certain nonfinancial equity investments. Tier 1 capital is required to be at least 4% of risk-weighted assets, and total capital (the sum of Tier 1 capital, a qualifying portion of the allowance for loan and lease losses and qualifying subordinated debt) must be at least 8% of risk-weighted assets, with one half of the minimum consisting of Tier 1 capital.
In addition to the risk-based capital measures described above, regulators have also established minimum leverage capital requirements for banking organizations. This is the primary measure of capital adequacy used by management and is calculated by dividing period-end Tier 1 capital by average tangible assets for the most recent quarter. The minimum required Tier 1 leverage ratio ranges from 3% to 5% depending upon Federal bank regulatory agency evaluation of an organization’s overall safety and soundness. BB&T’s regulatory capital and ratios are set forth in the following table:
CAPITAL RATIOS
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Share Repurchase Activity
BB&T has periodically repurchased shares of its own common stock. In accordance with North Carolina law, repurchased shares cannot be held as treasury stock, but revert to the status of authorized and unissued shares upon repurchase.
On August 26, 2003, BB&T’s Board of Directors granted authority for the repurchase of up to 50 million shares of BB&T’s common stock as needed for general corporate purposes. The plan remains in effect until all the authorized shares are repurchased unless modified by the Board of Directors.
The following table presents the common stock repurchases made by BB&T during the second quarter of 2004:
(1) Repurchases reflect shares exchanged or surrendered in connection with the exercise of stock options under BB&T's stock option plans.
ANALYSIS OF RESULTS OF OPERATIONS
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The following table sets forth selected financial ratios for the last five calendar quarters:
ANNUALIZEDPROFITABILITY MEASURES
Mergers and acquisitions have played an important role in the development of BB&T’s franchise. BB&T recorded certain merger-related and restructuring costs during both 2004 and 2003. During the second quarter of 2004, BB&T recorded $351 thousand in net after-tax charges primarily associated with the acquisition of Republic. During the second quarter of 2003, BB&T incurred $7.0 million in net after-tax charges primarily associated with the acquisition of First Virginia and the acquisitions and systems conversions of Equitable Bank and Regional Financial Corporation. Merger-related charges and expenses include personnel-related expenses such as staff relocation costs, severance benefits, early retirement packages and contract settlements. They also include furniture, equipment and occupancy costs related to department and branch consolidations as well as costs related to converting the data processing systems of the acquired companies to BB&T’s automation platform. For the six months ended June 30, 2004 and 2003, BB&T incurred $6.5 million and $10.0 million, respectively, in net after-tax charges primarily associated with the same purchase acquisitions that affected the respective second quarters of 2004 and 2003. The above expenses are reflected in BB&T’s Consolidated Statements of Income as a category of noninterest expenses.
The following table presents the components of merger-related and restructuring charges included in noninterest expenses. This table includes increases to previously recorded merger-related accruals and period expenses for merger-related items that must be expensed as incurred. Items that are required to be expensed as incurred include certain expenses associated with systems conversions, data processing, training, travel and other costs.
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Summary of Merger-Related and Restructuring Charges(Dollars in thousands)
Severance and personnel-related costs include severance, employee retention, payments related to change-in-control provisions of employment contracts, outplacement services and other benefits associated with employee termination, which typically occur in corporate support and data processing functions.
Occupancy and equipment charges represent merger-related costs or credits associated with lease terminations, obsolete equipment write-offs, and the sale of duplicate facilities and equipment. Credits may result when obsolete properties or equipment are sold for more than originally estimated. Systems conversions and related charges include expenses necessary to convert and combine the acquired branches and operations of merged companies. Marketing and public relations costs represent direct media advertising related to the acquisitions. The other merger-related charges are comprised of asset and supply inventory write-offs, litigation accruals, costs to conform an acquired institution’s accounting policies to those of BB&T and other similar charges.
In conjunction with the consummation of an acquisition and the completion of other requirements, BB&T typically accrues certain merger-related expenses related to estimated severance costs, costs to terminate lease contracts, costs related to the disposal of duplicate facilities and equipment, costs to terminate data processing contracts and other costs associated with the acquisition. The following tables present a summary of activity with respect to BB&T’s merger and restructuring accruals related to the mergers listed above, with the more significant mergers (F&M National Corporation and First Virginia) presented separately. These tables include costs reflected as expenses, as presented in the table above, and accruals recorded through purchase accounting adjustments.
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Merger-related and restructuring accruals related to First Virginia are generally expected to be utilized during 2004, unless they relate to specific contracts or legal obligations that expire in later years or they relate to the disposal of duplicate facilities and equipment, which may take longer to complete.
The remaining accruals at June 30, 2004, for F&M National Corporation are related primarily to costs to exit certain leases and to dispose of excess facilities and equipment. These liabilities will be utilized in the future upon termination of the various leases and sale of duplicate property. These accruals are expected to be substantially utilized in 2004 unless they relate to specific contracts expiring in later years.
Activity with respect to the merger and restructuring accruals for all other mergers is presented in the accompanying table:
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The liabilities for severance and personnel-related costs relate to severance liabilities that will be paid out based on such factors as expected termination dates, the provisions of employment contracts and the terms of BB&T’s severance plans. The remaining occupancy and equipment accruals relate to costs to exit certain leases and to dispose of excess facilities and equipment. Such liabilities will be utilized upon termination of the various leases and sale of duplicate property. Liabilities associated with systems conversions relate to termination penalties on contracts with information technology service providers. These liabilities will be utilized as the contracts are paid out and expire. The other merger-related liabilities relate to litigation, accruals to conform the accounting policies of acquired institutions to those of BB&T, and other similar charges.
Because BB&T often has multiple merger integrations in process, and due to limited resources must schedule in advance significant events in the merger conversion and integration process, BB&T’s merger process and utilization of merger accruals may cover an extended period of time. In general, a major portion of accrued costs are utilized in conjunction with or immediately following the systems conversion, when most of the duplicate positions are eliminated and the terminated employees begin to receive severance payments. Other accruals are utilized over time based on the sale, closing or disposal of duplicate facilities or equipment or the expiration of lease contracts. Merger accruals are re-evaluated periodically and adjusted as necessary. The remaining accruals at June 30, 2004, are expected to be utilized during 2004, unless they relate to specific contracts that expire in later years.
The accruals utilized during 2004 in the tables above include reversals of $29.5 million of previously recorded merger-related and restructuring accruals principally related to the finalization of estimates for employee terminations, contract cancellations and occupancy costs. The above reversals include $16.6 million of pre-tax adjustments to goodwill that had no effect on BB&T’s consolidated results of operations. The remaining $12.8 million was included as a reduction of merger-related and restructuring charges during 2004 in the Consolidated Statements of Income.
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Net Interest Income and Net Interest Margin
Net interest income on an FTE basis was $860.2 million for the second quarter of 2004 compared to $731.6 million for the same period in 2003, an increase of $128.6 million, or 17.6%. For the three months ended June 30, 2004, average earning assets increased $13.5 billion, or 18.6%, compared to the same period of 2003, while average interest-bearing liabilities increased $9.2 billion, or 14.8%, and the net interest margin decreased from 4.06% in the second quarter of 2003 to 4.02% in the current quarter. The decrease in the net interest margin was caused by a combination of several factors. The reinvestment of proceeds from the sales, maturities and prepayments of securities in lower yielding securities, additional interest expense incurred in connection with BB&T’s stock buy-back program, net loan and deposit premium amortization related to the purchase of First Virginia and Republic all adversely affected the net interest margin in the second quarter of 2004. At the same time, the margin was positively affected by the balance sheet restructuring completed during 2003, which consisted of BB&T refinancing or prepaying approximately $5.9 billion of long-term FHLB advances and retaining an additional $3.6 billion in fixed-rate mortgage loans from originations made during the second half of 2003 and the first quarter of 2004.
For the six months ended June 30, 2004, net interest income on an FTE basis was $1.7 billion compared to $1.5 billion for the same period in 2003, an increase of $234.0 million, or 16.1%. Average earning assets for the first six months of 2004 increased $12.0 billion, or 16.8%, compared to the same period of 2003, while average interest-bearing liabilities increased $7.9 billion, or 12.7%. The net interest margin for the six months ended June 30, 2004 was 4.06%, down from 4.09% for the first six months of 2003. The decrease resulted largely from the same factors that affected the quarterly comparison described above.
The following tables set forth the major components of net interest income and the related annualized yields and rates for the second quarter and first six months of 2004 compared to the same periods in 2003, and the variances between the periods caused by changes in interest rates versus changes in volumes.
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Net Interest Income and Rate / Volume AnalysisFor the Three Months Ended June 30, 2004 and 2003
(1) Yields related to securities, loans and leases exempt from income taxes are stated on a taxable equivalent basis assuming tax rates in effect for the periods presented.(2) Includes Federal funds sold and securities purchased under resale agreements or similar arrangements.(3) Loan fees, which are not material for any of the periods shown, have been included for rate calculation purposes.(4) Nonaccrual loans have been included in the average balances. Only the interest collected on such loans has been included as income.(5) Includes assets which were held for sale or available for sale at amortized cost and trading securities at estimated fair value.(6) Changes in interest income and expense attributable to both changes in interest rates and changes in volumes are allocated proportionately.
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Net Interest Income and Rate / Volume AnalysisFor the Six Months Ended June 30, 2004 and 2003
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Noninterest Income
Noninterest income for the three months ended June 30, 2004, was $573.7 million compared to $461.1 million for the same period in 2003, an increase of $112.6 million, or 24.4%. Excluding the effects of growth resulting from the timing of purchase acquisitions, noninterest income grew approximately 4.4% in the second quarter of 2004 compared to the same period in 2003. Noninterest income increased primarily due to strong revenue growth from BB&T’s insurance operations as well as growth in income from mortgage banking, service charges on deposit accounts and other nondeposit fees and commissions. These increases were partially offset by a decrease in the amount of securities gains recognized in the second quarter of 2004 compared to the second quarter of 2003. The growth also reflects the contributions of acquisitions.
For the six months ended June 30, 2004, noninterest income totaled $1.1 billion, an increase of $145.8 million, or 16.1%, compared to the same period in 2003. Excluding the effects of growth resulting from the timing of purchase acquisitions, noninterest income decreased slightly in the first six months of 2004 compared to the same period in 2003 due to significant gains on securities recognized in the first six months last year.
Service charges on deposits totaled $131.4 million for the second quarter of 2004, up $34.8 million, or 36.0%, compared to the second quarter of 2003. For the first six months of 2004, service charges on deposits totaled $254.2 million, an increase of $60.8 million, or 31.4%, compared to the same period in 2003. The primary reasons for the increases in both the quarter and six months were the purchases of First Virginia and Republic, improved collection of NSF and overdraft charges, and a reduction in the amount of waived customer fees. Excluding the effect of acquisitions, service charges on deposits increased approximately 12.6% and 9.6% for the three-month and six-month periods ended June 30, 2004, respectively, compared to the comparable periods in 2003.
Trust income totaled $31.5 million for the current quarter, an increase of $5.3 million, or 20.1%, compared to the same period a year ago. For the first six months of 2004, trust income totaled $61.5 million, an increase of $9.2 million, or 17.7%, compared to the same period in 2003. The increases in trust income were primarily due to the acquisition of First Virginia and to increases in mutual fund and wealth management fees. In addition, the value of trust assets under management, including custodial accounts, increased from $25.8 billion at June 30, 2003, to $26.6 billion at June 30, 2004. Total trust assets under management at June 30, 2004, include $2.2 billion in trust assets from the acquisition of First Virginia and reflect a reduction compared to last year of $2.4 billion in trust assets from the North Carolina state employees’ 401(k) plan, which transferred to a successor trustee.
Investment banking and brokerage fees and commissions totaled $63.6 million during the second quarter of 2004, an increase of $3.0 million, or 5.0%, compared to the second quarter of 2003. For the first six months of 2004, investment banking and brokerage fees and commissions totaled $140.2 million, an increase of $27.3 million, or 24.2%, compared to the same period in 2003. The increases in this category of revenue for the second quarter and first six months of 2004 resulted primarily from growth in investment banking services fees and commissions and the entry into the high yield market by Scott & Stringfellow, BB&T’s wholly owned investment banking and brokerage subsidiary, which contributed $2.3 million and $24.2 million of the increase for each period, respectively.
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Insurance commissions totaled $164.7 million for the second quarter of 2004, an increase of $63.2 million, or 62.3%, compared to the same three-month period of 2003. For the first six months of 2004, insurance commissions totaled $288.4 million, up $98.3 million, or 51.7%, compared to the same period last year. Solid internal growth combined with the expansion of BB&T’s insurance agency network through insurance agency acquisitions, the largest of which was the purchase of McGriff, Seibels & Williams Inc. (“McGriff”), generated the strong increases in insurance revenues. The acquisition of McGriff contributed approximately $46.8 million in additional insurance revenues in the second quarter of 2004 and $77.1 million for the first six months of 2004. In addition, higher revenues from BB&T’s wholesale insurance brokerage operations contributed $13.8 million and $18.7 million in revenue growth for the current quarter and first six months of 2004 compared to the same periods in 2003. Excluding the effect of acquisitions, insurance commissions increased approximately 8.4% and 9.3% for the second quarter and first six months of 2004, respectively, compared to the same periods in 2003.
Income from commercial and residential mortgage banking activities totaled $67.5 million for the second quarter of 2004, up $100.2 million, compared to a net loss of $32.7 million for the second quarter of 2003. The significant increase in net mortgage banking revenues is primarily a function of interest rate volatility, which affects the value of BB&T’s mortgage servicing rights. During the second quarter of 2004, higher mortgage interest rates, compared to the same period last year, reduced the volume of refinancing activities and resulted in lower prepayment speed assumptions for existing serviced loans which resulted in an increase in the value of BB&T’s mortgage servicing rights. This increase in value resulted in net revenue of $30.4 million, which is included in mortgage banking income in the second quarter of 2004. The $30.4 million in revenue was the net effect of recapturing $91.9 million in the previously established valuation allowance related to mortgage servicing rights and losses from derivatives and other risk management strategies totaling $61.5 million. In comparison, lower mortgage interest rates in the second quarter of 2003 required BB&T to record a $109.3 million increase in the allowance for mortgage servicing rights, which reduced mortgage banking income. Furthermore, the lower prepayment speed assumptions in the second quarter of 2004 caused a reduction in the amount of amortization expense associated with commercial and residential mortgage servicing rights, which totaled $21.8 million for the second quarter of 2004 compared to $49.8 million in the comparable period last year. Total residential mortgage originations for the second quarter of 2004 were $3.2 billion compared to $6.0 billion for the second quarter of 2003. In addition, BB&T undertook a mortgage retention strategy in mid-2003 as part of a balance sheet restructuring, which involved an initiative to retain rather than sell approximately $3.6 billion of fixed-rate mortgage loans. Due to this strategy and the lower residential mortgage originations, loan sales for the second quarter of 2004 were $2.3 billion, down from $4.2 billion sold in the second quarter last year. As a result, residential mortgage production revenue, which includes earnings from the origination and sale of mortgage loans, decreased $64.1 million, or 66.7%, compared to the second quarter of 2003. Residential mortgage servicing fees associated with loans serviced for investors were down from $26.5 million in the second quarter of 2003 to $22.8 million in the current quarter as a result of a slight decline in the average portfolio of loans serviced for investors. Commercial mortgage loan revenues for the second quarter of 2004 totaled $3.7 million, compared to $3.9 million earned in the second quarter of 2003.
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For the first six months of 2004, income from commercial and residential mortgage banking activities totaled $74.6 million, an increase of $47.4 million, compared to $27.3 million for the comparable period in 2003. The increase in net mortgage revenues was primarily caused by the same factors that affected the quarterly growth, which included a $26.2 million net recapture of the valuation allowance for mortgage servicing rights in the first half of 2004, (which was composed of a $48.3 million recapture of the previously established valuation allowance related to mortgage servicing rights and losses from derivatives and other risk management strategies totaling $22.1 million), compared to a $146.2 million increase in the allowance in 2003, and a $43.3 million reduction in the amortization expense associated with commercial and residential mortgage servicing rights. These increases in mortgage banking income were substantially offset by lower residential mortgage production revenue, which decreased $161.9 million, or 78.7%, compared to the first six months of 2003.
Other nondeposit fees and commissions, including bankcard fees and merchant discounts, totaled $79.5 million for the second quarter of 2004, an increase of $18.7 million, or 30.8%, compared to the three months ended June 30, 2003. For the six months ended June 30, 2004, other nondeposit fees and commissions, including bankcard fees and merchant discounts, totaled $151.1 million, an increase of $34.1 million, or 29.1%, compared to the same period in 2003. The principal drivers of the second quarter increase were check card interchange fees, ATM fees, money orders, and bankcard income, which increased $4.6 million, $2.8 million, $1.2 million, and $6.5 million, respectively, compared to the same period in 2003. The 29.1% increase in other nondeposit fees and commissions, including bankcard fees and merchant discounts, for the first six months of 2004 was also primarily driven by check card interchange fees and bankcard income, which increased $8.0 million and $12.6 million, respectively, compared to the same period in 2003. In addition, ATM fees, money orders, and safe deposit box fees increased $5.5 million, $2.8 million, and $2.0 million, respectively, over the same time period. All of these increases include additional fees and commissions as a result of the acquisitions of First Virginia and Republic.
Net securities gains were immaterial during the second quarter of 2004 compared to net gains of $109.5 million realized during the same period last year. For the first six months of 2004, BB&T recorded a net loss from sales and transfers of securities totaling $.5 million compared with net securities gains totaling $143.7 million realized during the same period one year ago. The net securities gains in the second quarter and first half of 2003 from the sale of securities available for sale were taken to economically offset increases in the valuation allowance necessary to reduce the carrying value of BB&T’s mortgage servicing rights as discussed above. No such sales were taken during the same periods in 2004. In recent quarters, BB&T has shifted to a risk management strategy related to mortgage servicing rights and mortgage banking largely dependent on derivatives.
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Other income totaled $35.4 million for the second quarter of 2004, a decrease of $3.2 million, or 8.3%, compared with the same period one year ago. The primary drivers of the decrease were a decline in the value of various financial assets isolated for the purpose of providing post-employment benefits and lower income from miscellaneous investments made by a small business investment company totaling $3.6 million and $3.9 million, respectively. These decreases were partially offset by other miscellaneous income, which increased $2.4 million compared to the second quarter of 2003. For the six months ended June 30, 2004, other income totaled $82.2 million, an increase of $13.0 million, or 18.8%, compared with the same period last year. The primary drivers of this increase were a fair value adjustment related to miscellaneous investments made by a small business investment company and an increase in other miscellaneous income totaling $12.7 million and $4.8 million, respectively. These increases were partially offset by lower income from investments in limited partnerships and other miscellaneous investments, which declined $7.3 million compared to the first six months of 2003.
Noninterest Expense
Noninterest expenses totaled $750.7 million for the second quarter of 2004 compared to $650.9 million for the same period a year ago, an increase of $99.7 million, or 15.3%. For the first six months of 2004, noninterest expenses totaled $1.5 billion, an increase of $233.6 million, or 18.6%, over the same period a year ago. Noninterest expenses for the second quarter and first six months of 2004 include $.8 million and $10.4 million, respectively, of pretax merger-related and restructuring expenses principally associated with the acquisitions of First Virginia and Republic.
Personnel expense, the largest component of noninterest expense, was $433.9 million for the current quarter, compared to $367.5 million for the same period in 2003, an increase of $66.4 million, or 18.1%. This increase was primarily attributable to the acquisitions of First Virginia, McGriff and Republic, which contributed approximately $52.7 million of the increase in personnel expenses. Additionally, during the current quarter, incentive compensation expenses and employee benefit expenses increased $9.6 million and $6.3 million, respectively, compared to the second quarter of 2003. For the six months ended June 30, 2004, personnel expense totaled $856.8 million, up $136.6 million, or 19.0%, compared to 2003. The increase resulted primarily from the same factors that produced the quarterly increase. Excluding the effect of acquisitions, personnel expenses decreased approximately 4.7% and 2.0% for the second quarter and first six months of 2004, respectively, compared to the same periods in 2003, as a result of improving expense control and the realization of efficiencies from recent mergers.
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Occupancy and equipment expense for the three months ended June 30, 2004, totaled $103.4 million compared to $85.6 million for the second quarter of 2003, representing an increase of $17.8 million, or 20.8%. For the first six months of 2004, occupancy and equipment expense totaled $203.6 million, up $30.2 million, or 17.4%, compared to 2003. The increases resulted primarily from the acquisitions of First Virginia, McGriff and Republic, which collectively added approximately $9.9 million and $19.2 million, respectively, in occupancy and equipment expenses during the second quarter and first six months of 2004. In addition, building maintenance and real estate taxes increased $1.4 million and $1.1 million, respectively, during the second quarter of 2004 compared to 2003. For the first six months of 2004, building maintenance and real estate taxes increased $5.0 million and $1.6 million, respectively, compared to 2003.
The amortization of intangible assets totaled $28.7 million for the current quarter, an increase of $21.9 million from the $6.8 million incurred in the second quarter of 2003. For the six months ended June 30, 2004, amortization of intangible assets totaled $52.7 million, an increase of $39.2 million compared to the same period last year. The increases were due to acquisitions completed during the second half of 2003 and the first six months of 2004, the largest of which were the purchases of First Virginia, McGriff, and Republic, which contributed the majority of additional amortization expenses during the above periods in 2004 compared to 2003. See Note D to the Consolidated Financial Statements herein for a summary of completed mergers and acquisitions.
Other noninterest expenses, including professional services, totaled $183.9 million for the second quarter of 2004, an increase of $3.7 million, or 2.0%, compared to the same period of 2003. The principal drivers of the increase were higher professional services expense, miscellaneous processing expense and supplies expense, which increased $1.8 million, $1.9 million and $2.2 million, respectively, compared to the second quarter of 2003. In addition, deposit-related expenses, general insurance expenses, and telephone expenses increased $2.6 million, $2.6 million, and $1.4 million, respectively, over the same time period. For the six months ended June 30, 2004, other noninterest expenses, including professional services, totaled $365.1 million, an increase of $32.7 million, or 9.8%, compared to the same period in 2003. The principal reasons for the increase were similar to the factors that affected the quarterly growth. Other noninterest expenses for the 2004 periods include the impact of the First Virginia, McGriff, and Republic acquisitions.
Provision for Income Taxes
The provision for income taxes totaled $198.6 million for the second quarter of 2004, an increase of $62.7 million, or 46.2%, compared to the second quarter of 2003. For the six months ended June 30, 2004, the provision for income taxes totaled $354.6 million, an increase of $76.5 million, or 27.5%, compared to the same period of 2003. The increased provision for income taxes was the combined result of higher pretax income and an increase in the effective tax rate. BB&T’s effective income tax rates were 33.2% and 30.1% for the three months ended June 30, 2004 and 2003, respectively, and 32.7% and 30.2% for the first six months of 2004 and 2003, respectively.
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BB&T has extended credit to and invested in the obligations of states and municipalities and their agencies. The income generated from these investments together with certain other transactions that have favorable tax treatment have reduced BB&T’s overall effective tax rate from the statutory rate in 2004 and 2003.
BB&T continually monitors and evaluates the potential impact of current events and circumstances on the estimates and assumptions used in the analysis of its income tax positions and, accordingly, BB&T’s effective tax rate may fluctuate in the future. On a periodic basis, BB&T evaluates its income tax positions based on tax laws and regulations and financial reporting considerations, and records adjustments as appropriate. This evaluation takes into consideration the status of current Internal Revenue Service (“IRS”) examinations of BB&T’s tax returns, recent positions taken by the IRS on similar transactions, if any, and the overall tax environment in relation to tax-advantaged transactions.
In the normal course of business, BB&T is subject to examinations from various tax authorities. These examinations may alter the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions. During 2003, the Internal Revenue Service (“IRS”) concluded its examination of BB&T’s federal income tax returns for the years ended December 31, 1996, 1997 and 1998. Following their examination, the IRS issued a Revenue Agent Report assessing taxes and interest in the amount of $59.3 million related to BB&T’s income tax treatment of certain leveraged lease transactions which were entered into during the years under examination. The assessment, which was paid by BB&T during 2003, did not significantly affect BB&T’s consolidated results of operations in 2003 as it related primarily to differences in the timing of recognizing income and deductions for income tax purposes for which deferred taxes had been previously provided. Management continues to believe that BB&T’s treatment of these leveraged leases was appropriate and in compliance with existing tax laws and regulations for the years examined. BB&T filed a refund request for the taxes and interest related to this matter which was denied by the IRS during the second quarter of 2004. Management intends to continue pursuing a refund of the taxes and interest relative to the assessment and is currently evaluating other available options.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Please refer to “Market Risk Management” in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section herein.
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Item 4. Control and Procedures
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, the Company’s Chief Executive Officer and the Chief Financial Officer evaluated the effectiveness of the Company’s disclosure controls and procedures in accordance with Rule 13a-15 under the Exchange Act. Based on their evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures enable the Company to record, process, summarize and report in a timely manner the information that the Company is required to disclose in its Exchange Act reports.
Changes in Internal Control over Financial Reporting
There were no changes in the Company’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 1. Legal Proceedings
The nature of the business of BB&T’s banking subsidiaries ordinarily results in a certain amount of litigation. The subsidiaries of BB&T are involved in various legal proceedings, all of which are considered incidental to the normal conduct of business. Management believes that the liabilities arising from these proceedings will not have a materially adverse effect on the consolidated financial position or consolidated results of operations of BB&T.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
(e) Please refer to “Share Repurchase Activity” in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section herein.
Item 4. Submission of Matters to a Vote of Security Holders
BB&T held its Annual Meeting of Shareholders on April 27, 2004, to consider and vote on the matters listed below. A total of 427,848,085 of the Company’s shares were present or represented by proxy at the meeting. This represented approximately 78% of the Company’s outstanding shares.
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The proposal to approve an amendment to BB&T’s articles of incorporation to cause directors to be elected in accordance with the Bylaws (i.e. to eliminate staggered terms for directors) and to provide that directors can be removed with or without cause was approved, with 411,523,816 shares voting for, 10,722,817 shares voting against, and 5,657,297 shares abstaining.
The proposal to approve certain amendments to BB&T’s bylaws to (i) eliminate staggered terms for directors and make certain other revisions regarding the terms of directors; (ii) provide that directors can be removed with or without cause; (iii) enhance the Board’s ability to fill director vacancies; and (iv) make certain revisions to the bylaw provision governing bylaw amendments was defeated, with 240,160,801 shares voting for, 80,724,028 shares voting against, and 5,844,932 shares abstaining. Under the terms of BB&T’s current articles of incorporation and bylaws, these amendments required the affirmative vote of at least two-thirds of the outstanding shares of common stock entitled to vote at the Annual Meeting.
The individuals named below were re-elected to serve as directors of the Corporation for a three-year term expiring in 2007:
The individual named below was re-elected to a two-year term as a director expiring in 2006:
The individual named below was re-elected to a one-year term as a director expiring in 2005:
The proposal to approve the Corporation's 2004 Stock Incentive Plan was approved, with 277,312,487 shares voting for, 41,594,324 shares voting against, and 7,846,602 shares abstaining.
The proposal to ratify the reappointment of PricewaterhouseCoopers LLP as the Corporation's independent auditors was approved, with 417,104,850 shares voting for, 6,981,292 shares voting against, and 3,819,499 shares abstaining.
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The shareholder proposal regarding executive compensation matters was defeated, with 90,163,737 shares voting for, 223,272,727 shares voting against, and 13,294,666 shares abstaining.
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Item 6. Exhibits and Reports on Form 8-K
(a)
EXHIBIT INDEX
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Current Reports on Form 8-K filed or furnished during and following the quarter ended June 30, 2004.
On April 13, 2004, BB&T furnished a Current Report on Form 8-K under Item 12 to report the results of operations for the first quarter of 2004. On May 3, 2004, BB&T filed a Current Report on Form 8-K under Item 5 to announce changes to BB&T’s Executive Management team. On July 13, 2004, BB&T furnished a Current Report on Form 8-K under Item 12 to report the results of operations for the second quarter of 2004.
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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.
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