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, 2006
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 [Ö] NO [__]
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):
Large accelerated filer [ Ö ] Accelerated filer [__] Non-accelerated filer [__]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES [ ] NO [Ö]
At July 31, 2006, 537,040,937 shares of the registrant's common stock, $5 par value, were outstanding.
BB&T CORPORATION
INDEX
BB&T Corporation Page 1 Second Quarter 2006 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.
BB&T Corporation Page 2 Second Quarter 2006 10-Q
BB&T CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME(Unaudited)(Dollars in thousands, except per share data)
BB&T Corporation Page 3 Second Quarter 2006 10-Q
BB&T CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITYFor the Six Months Ended June 30, 2006 and 2005(Unaudited)(Dollars in thousands, except per share data)
BB&T Corporation Page 4 Second Quarter 2006 10-Q
BB&T CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(Dollars in thousands)
Back to Index
BB&T Corporation Page 5 Second Quarter 2006 10-Q
BB&T CORPORATION AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTSJune 30, 2006(Unaudited)
NOTE 1. Basis of Presentation
General
In the opinion of management, the accompanying unaudited consolidated balance sheets, consolidated statements of income, consolidated statements of changes in shareholders’ equity, and 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, 2006 and December 31, 2005; BB&T’s results of operations for the three months and six months ended June 30, 2006 and 2005; and BB&T’s cash flows for the six months ended June 30, 2006 and 2005. In the opinion of management, all adjustments necessary to fairly present the consolidated financial position and consolidated results of operations have been made. All adjustments during the first six months of 2006 were of a normal recurring nature.
These consolidated financial statements and notes are presented in accordance with the instructions for Form 10-Q. The information contained in the footnotes included in BB&T’s 2005 Annual Report on Form 10-K should be referred to in connection with these unaudited interim consolidated financial statements.
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, Georgia, West Virginia, Tennessee, Kentucky, Florida, Alabama, Indiana and Washington, D.C. BB&T’s subsidiary banks provide a wide range of banking services to individuals and businesses. BB&T’s subsidiary banks offer a variety of loans to businesses and consumers. Such loans are made primarily to individuals residing in the market areas described above or to businesses located within BB&T’s geographic footprint. BB&T’s subsidiary banks also market a wide range of deposit services to individuals and businesses. BB&T’s subsidiary banks offer, either directly, or through their subsidiaries, lease financing to businesses and municipal governments; factoring; discount brokerage services, annuities and mutual funds; life insurance, property and casualty insurance, health insurance and commercial general liability insurance on an agency basis and through a wholesale insurance brokerage operation; insurance premium financing; permanent financing arrangements for commercial real estate; loan servicing for third-party investors; direct consumer finance loans to individuals; and trust services. The direct nonbank subsidiaries of BB&T provide a variety of financial services including automobile lending, equipment financing, full-service securities brokerage, payroll processing, asset management and capital markets services.
BB&T Corporation Page 6 Second Quarter 2006 10-Q
Principles of Consolidation
The consolidated financial statements of BB&T include the accounts of BB&T Corporation and those subsidiaries that are majority-owned by BB&T and over which BB&T exercises control. In consolidation, all significant intercompany accounts and transactions are eliminated. The results of operations of companies acquired are included only from the dates of acquisition. All material wholly owned and majority-owned subsidiaries are consolidated unless accounting principles generally accepted in the United States of America require otherwise.
BB&T evaluates variable interests in entities for which voting interests are not an effective means of identifying controlling financial interests. Variable interests are those in which the value of the interest changes with the fair value of the net assets of the entity exclusive of variable interests. If the results of the evaluation indicate the existence of a primary beneficiary and the entity does not effectively disperse risks among the parties involved, that primary beneficiary is required to consolidate the entity. Likewise, if the evaluation indicates that the requirements for consolidation are not met and the entity has previously been consolidated, then the entity would be deconsolidated.
BB&T has variable interests in certain entities that were not required to be consolidated, including affordable housing partnership interests, historic tax credit partnerships, other partnership interests and trusts that have issued capital securities.
BB&T accounts for unconsolidated partnership investments using the equity method of accounting. In addition to affordable housing partnerships, which represent the majority of unconsolidated investments in variable interest entities, BB&T also has investments and future funding commitments to venture capital and other entities. The maximum potential exposure to losses relative to investments in variable interest entities is generally limited to the sum of the outstanding balance, future funding commitments and any related loans to the entity. Loans to these entities are underwritten in substantially the same manner as are other loans and are generally secured.
BB&T has investments in certain entities for which BB&T does not have controlling interest. For these investments, the Company records its interest using the equity method with its portion of income or loss being recorded in other noninterest income on the Consolidated Statements of Income. BB&T periodically evaluates these investments for impairment.
Reclassifications
In certain instances, amounts reported in prior periods’ consolidated financial statements have been reclassified to conform to the current presentation. Such reclassifications had no effect on previously reported shareholders’ equity or net income.
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 of America 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 and the reserve for unfunded lending commitments, valuation of mortgage servicing rights, valuation of goodwill, intangible assets and other purchase accounting related adjustments, benefit plan obligations and expenses, and tax assets, liabilities and expense.
BB&T Corporation Page 7 Second Quarter 2006 10-Q
Equity-Based Compensation
BB&T maintains various equity-based compensation plans. These plans provide for the granting of stock options (incentive and nonqualified), stock appreciation rights, restricted stock, restricted stock units, performance units and performance shares to selected BB&T employees and directors. BB&T adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), on January 1, 2006, using the modified-prospective method, which requires the recognition of compensation costs beginning with the effective date based on (a) the requirements of SFAS No. 123(R) for all share-based awards granted after the effective date and (b) the requirements of SFAS No. 123 , “Accounting for Stock-Based Compensation” (“SFAS No. 123”), for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date. The adoption of SFAS No. 123(R) had the following effect on BB&T’s income before income taxes, net income, basic earnings per share and diluted earnings per share for the three and six month periods ended June 30, 2006.
The adoption of SFAS No. 123(R) also required that excess tax benefits from the exercise of equity-based awards be recorded as a financing cash flow, rather than an operating cash flow. This requirement reduced cash provided by operating activities and increased cash provided by financing activities for the six months ended June 30, 2006 by $4.4 million. Additional disclosures required by SFAS No. 123(R) are included in Note 11 to the consolidated financial statements herein.
As permitted by SFAS No. 123, BB&T accounted for share-based awards granted to employees prior to January 1, 2006 using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees,” and related interpretations. Since the option price equaled the market price on the date of the grant for options awarded by BB&T, compensation cost was not recognized for any of the periods presented, except with respect to restricted stock awards and awards that were modified.
BB&T Corporation Page 8 Second Quarter 2006 10-Q
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 for periods ended prior to January 1, 2006, 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. BB&T’s equity-based awards generally contain a provision that accelerates vesting of awards for holders who retire and have met all retirement eligibility requirements. Prior to the adoption of SFAS No. 123(R), BB&T reported the expense in the pro forma disclosure based on the vesting cycle in the grant agreement and reported an acceleration of the expense for the unrecognized compensation cost in the period that the accelerated vesting occurred. BB&T will continue to account for awards granted prior to the adoption of SFAS No. 123(R) in this manner, with the exception that the unrecognized compensation cost on the date of adoption will be recognized as personnel expense in future periods. For awards granted after January 1, 2006, BB&T has recognized compensation expense based on retirement eligibility dates for all equity-based compensation awards. Therefore, the information presented in the following table is not comparable to the amounts recognized by BB&T during 2006.
Changes in Accounting Principles and Effects of New Accounting Pronouncements
In February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,” (“SFAS No. 155”), which permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. This Statement amends FASB Statements No. 133, “Accounting for Derivative Instruments and Hedging Activities” and FASB No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities”. This Statement is effective for financial instruments acquired or issued after the beginning of the first fiscal year that begins after September 15, 2006. BB&T adopted the provisions of SFAS No. 155 on January 1, 2006. The adoption did not have an impact on BB&T’s consolidated financial position, results of operations or cash flows.
BB&T Corporation Page 9 Second Quarter 2006 10-Q
In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets,” (“SFAS No. 156”), which was issued to simplify the accounting for servicing rights and reduce the volatility resulting from the use of different measurement attributes for servicing rights and the related financial instruments used to economically hedge risks associated with those servicing rights. SFAS No. 156 requires separately recognized servicing rights to be initially measured at fair value, and provides the irrevocable option to subsequently account for those servicing rights (by class) at either fair value or under the amortization method previously required under FASB Statement No. 140. BB&T adopted the provisions of SFAS No. 156 effective January 1, 2006. The initial application of the provisions of SFAS No. 156 was immaterial to BB&T’s consolidated financial position, results of operations and cash flows. The disclosures required by SFAS No. 156 are included in Note 12 to the consolidated financial statements herein.
In July 2006, the FASB issued FASB Staff Position (“FSP”) FAS 13-2 “Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction”, (“FSP FAS 13-2”), which amends SFAS No. 13, “Accounting for Leases.” FSP FAS 13-2 requires an entity to recalculate the allocation of income for a leveraged lease transaction from the inception of the lease if, during the lease term, the projected timing of the income tax cash flows generated by the transaction is revised, even if the total amount of income tax cash flows is not affected. The provisions of FSP FAS 13-2 are effective for fiscal years beginning after December 15, 2006. BB&T has entered into leveraged lease transactions in prior years that may require recalculations because the Internal Revenue Service (“IRS”) has issued a Notice of Proposed Adjustments relating to BB&T’s treatment of certain leveraged lease transactions. Management continues to believe that BB&T’s income tax treatment of these leveraged leases was appropriate and in compliance with the tax laws and regulations in effect at the time that the deductions were taken. BB&T is currently involved in litigation with the IRS concerning the income tax treatment of certain leveraged lease transactions. While management cannot currently predict with certainty whether there will be any changes to the projected income tax cash flows relating to BB&T’s leveraged lease transactions, BB&T may have to record a one-time non-cash after-tax charge to retained earnings which is not expected to exceed approximately $300 million as a cumulative effect of a change in accounting principle on January 1, 2007. The amount of the charge, if any, would then be recognized as net income over the remaining lives of the respective leases.
In July 2006, the FASB issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” (“FIN 48”), an interpretation of SFAS No. 109 “Accounting for Income Taxes.” FIN 48 provides guidance for the financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. FIN 48 also requires additional disclosures related to an entity’s accounting for uncertain tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006. BB&T has taken certain tax positions which are uncertain in nature, primarily related to leveraged lease transactions, and may be required to record a one-time non-cash charge to retained earnings which is not expected to exceed approximately $150 million as a cumulative effect of a change in accounting principle on January 1, 2007. This charge primarily relates to the accrual of penalties and interest and is subject to the outcome of current litigation with the IRS.
BB&T Corporation Page 10 Second Quarter 2006 10-Q
NOTE 2. Business Combinations
Financial Institution Acquisition
On June 1, 2006, BB&T completed the acquisition of Main Street Banks Inc. (“Main Street”), a $2.3 billion bank holding company headquartered in Atlanta, Georgia. The merger enabled the Company to enhance its ongoing commitment to organic growth by adding strategically located financial centers in some of the nation’s fastest growing communities. In conjunction with this transaction, BB&T issued approximately 14.3 million shares and 636 thousand stock options valued at $621.2 million and recorded $423.9 million in goodwill and $45.2 million in amortizing intangibles, which are primarily comprised of core deposit intangibles, pending final valuations.
Insurance and Other Nonbank Acquisitions
During the first six months of 2006, BB&T acquired two nonbank financial services companies. In conjunction with these transactions, BB&T issued approximately 189 thousand shares of common stock and paid $35.0 million in cash. Including subsequent adjustments, approximately $22.7 million in goodwill and $11.1 million of identifiable intangibles were recorded in connection with these transactions. During 2005, BB&T acquired five insurance businesses and four nonbank financial services companies, including the acquisition of a 70% ownership interest in Sterling Capital Management LLC, an investment management services company based in Charlotte, North Carolina. In conjunction with these transactions, BB&T issued approximately 1.2 million shares of common stock and paid approximately $136.4 million in cash. Approximately $104.4 million in goodwill and $85.2 million of identifiable intangible assets were recorded in connection with these transactions. BB&T also acquired client relationships, primarily from insurance companies. Such acquisitions have not been material to BB&T’s financial condition or results of operations.
Merger-Related and Restructuring Activities
BB&T has incurred certain expenses in connection with business combinations. 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, and other costs.
BB&T Corporation Page 11 Second Quarter 2006 10-Q
Summary of Merger-Related and Restructuring Charges (Gains)
In conjunction with the consummation of an acquisition and completion of other requirements, BB&T typically accrues certain merger-related expenses related to estimated severance and other personnel-related 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 costs related to the acquired entity are accrued in accordance with the guidance in EITF 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination”, and generally recorded as adjustments to the purchase price unless they are required to be expensed as incurred. The costs related to existing BB&T facilities and personnel are recorded in accordance with the guidance in SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” and SFAS 112, “Employers’ Accounting for Postemployment Benefits”, as appropriate, and reflected as merger-related and restructuring charges on the Consolidated Statements of Income. The following table presents a summary of BB&T’s merger accrual activity for 2006:
BB&T Corporation Page 12 Second Quarter 2006 10-Q
The following table provides a summary of BB&T’s merger accrual activity, by acquisition, for 2006:
NOTE 3. Securities
The amortized cost and approximate fair values of securities available for sale were as follows:
BB&T Corporation Page 13 Second Quarter 2006 10-Q
On June 30, 2006, BB&T held certain investment securities having continuous unrealized loss positions for more than 12 months. As of June 30, 2006, the unrealized loss on these securities totaled $779.4 million. Substantially all of these investments were in U.S. government-sponsored entity securities and mortgage-backed securities, which primarily consist of securities issued by the Federal Farm Credit Bureau, the Federal Home Loan Bank System, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. These agencies are rated AAA and the unrealized losses are the result of increases in market interest rates rather than the credit quality of the issuers. At June 30, 2006, BB&T had the ability and intent to retain these securities for a period of time sufficient to recover all unrealized losses. Accordingly, BB&T has not recognized other-than-temporary impairment in connection with these securities.
The following tables reflect the gross unrealized losses and fair values of BB&T’s investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at the dates presented.
BB&T Corporation Page 14 Second Quarter 2006 10-Q
NOTE 4. Goodwill and Other Intangible Assets
The changes in the carrying amount of goodwill attributable to each of BB&T’s operating segments for the six months ended June 30, 2006 and the year ended December 31, 2005 are as follows:
The adjustments to goodwill recorded during the first six months of 2006 include $27.5 million of contingent consideration paid subsequent to the dates of acquisition based on the terms of the purchase agreements and $5.3 million related to the receipt of final valuation reports. The adjustments to goodwill recorded during 2005 include $23.2 million of contingent consideration paid subsequent to the dates of acquisition based on the terms of the purchase agreements and $3.1 million related to the accounting for property and equipment leases of acquired companies.
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.
Estimated amortization expense of identifiable intangible assets for the full year 2006 and each of the next four years total $104.3 million, $94.2 million, $79.2 million, $63.8 million and $52.1 million.
BB&T Corporation Page 15 Second Quarter 2006 10-Q
NOTE 5. Long-Term Debt
Long-term debt is summarized as follows:
Subordinated notes that qualify under the risk-based capital guidelines as Tier 2 supplementary capital, subject to certain limitations.
Securities that qualify under the risk-based capital guidelines as Tier 1 capital, subject to certain limitations.
These fixed rate notes were swapped to floating rates based on LIBOR. At June 30, 2006, the effective rates paid on these borrowings ranged from 5.34% to 6.05%.
At June 30, 2006, the weighted average cost of these advances was 5.27% and the weighted average maturity was 9.9 years.
These borrowings are secured primarily by automobile loans and have variable rates based on LIBOR.
These securities were issued by companies acquired by BB&T. At June 30, 2006, the effective rate paid on these borrowings ranged from 8.75% to 10.07%. These securities have varying maturities through 2033.
BB&T Corporation Page 16 Second Quarter 2006 10-Q
In June 2006, BB&T Capital Trust II (“BBTCT”) issued $600 million of 6.75% Capital Securities. BBTCT, a statutory business trust created under the laws of the State of Delaware, was formed by BB&T for the sole purpose of issuing the Capital Securities and investing the proceeds thereof in 6.75% Junior Subordinated Debentures issued by BB&T. BB&T is the sole owner of the common securities of BBTCT and has made guarantees which, taken collectively, fully, irrevocably, and unconditionally guarantee, on a subordinated basis, all of BBTCT’s obligations under the Trust and Capital Securities. BBTCT’s sole asset is the Junior Subordinated Debentures issued by BB&T which mature June 7, 2036, but are subject to early redemption (i) in whole or in part at any time at the option of BB&T pursuant to the optional redemption provisions of such security, or (ii) in whole, but not in part, under certain prescribed limited circumstances. The Capital Securities of BBTCT are subject to mandatory redemption in whole or in part, upon repayment of the Junior Subordinated Debentures at maturity or their earlier redemption.
NOTE 6. Contractual Obligations, Commitments, Contingent Liabilities, and Off-Balance Sheet Arrangements
BB&T utilizes a variety of financial instruments to meet the financing needs of clients and to reduce exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees, and derivatives. BB&T also has commitments to fund certain affordable housing investments and contingent liabilities of certain sold loans.
Standby letters of credit and financial guarantees written are unconditional commitments issued by BB&T to guarantee the performance of a customer to a third party. 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 the issuance of these guarantees is essentially the same as that involved in extending loans to clients and as such, the instruments are collateralized when necessary. As of June 30, 2006, BB&T had issued a total of $3.1 billion in standby letters of credit. The carrying amount of the liability for such guarantees was $5.9 million at June 30, 2006.
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. These instruments include interest-rate swaps, caps, floors, collars, financial forwards and futures contracts, swaptions, when-issued securities, foreign exchange contracts and options written and purchased. BB&T uses derivatives primarily to manage economic risk related to securities, business loans, mortgage servicing rights and mortgage banking operations, Federal funds purchased, other time deposits, long-term debt and institutional certificates of deposit. BB&T also uses derivatives to facilitate transactions on behalf of its clients. BB&T held a variety of derivative financial instruments with notional values of $24.3 billion and $23.7 billion at June 30, 2006 and December 31, 2005, respectively. The fair value of these instruments was $(215.5 million) and $(10.6 million), at June 30, 2006 and December 31, 2005, respectively.
BB&T Corporation Page 17 Second Quarter 2006 10-Q
BB&T invests in certain affordable housing and historic building rehabilitation projects throughout its market area as a means of supporting local communities and receives tax credits related to these investments. 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. BB&T’s outstanding commitments to fund affordable housing investments totaled $134.3 million and $172.4 million at June 30, 2006 and December 31, 2005, respectively. At June 30, 2006, BB&T’s maximum exposure to loss associated with these investments totaled $265.3 million.
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 litigation. BB&T also issues standard representations and warranties in underwriting agreements, merger and acquisition agreements, loan sales, brokerage activities and other similar arrangements. Counterparties in many of these indemnification arrangements 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 of the Company.
Merger and acquisition agreements of 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. As certain provisions of these agreements do not specify dollar limitations, it is not possible to quantify the maximum exposure resulting from these agreements.
BB&T Corporation Page 18 Second Quarter 2006 10-Q
NOTE 7. Benefit Plans
BB&T provides various benefit plans to substantially all employees, including employees of acquired entities. Employees of acquired entities generally participate in existing BB&T plans after consummation of the business combinations. The plans of acquired institutions are typically merged into the BB&T plans after 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, 2005 for descriptions and disclosures about the various benefit plans offered by BB&T.
The following tables summarize the components of net periodic benefit cost (income) recognized for the three month and six month periods ended June 30, 2006 and 2005, respectively:
Management elected to make a discretionary contribution of $80.0 million to the qualified pension plan in the first quarter of 2006, and may make additional contributions in 2006 if determined appropriate.
BB&T Corporation Page 19 Second Quarter 2006 10-Q
NOTE 8. Computation of Earnings per Share
BB&T’s basic and diluted earnings per share amounts for the three and six month periods ended June 30, 2006 and 2005, respectively, were calculated as follows:
For the three months ended June 30, 2006 and 2005, respectively, antidilutive options to purchase 141 thousand shares and 117 thousand shares of common stock were outstanding. For the first six months of 2006 and 2005, respectively, antidilutive options to purchase 126 thousand shares and 116 thousand shares of common stock were outstanding. Antidilutive options outstanding were not included in the computation of diluted earnings per share.
NOTE 9. Comprehensive Income (Loss)
The balances in accumulated other comprehensive loss for the periods indicated are shown in the following tables:
Accumulated Other Comprehensive LossJune 30, 2006
BB&T Corporation Page 20 Second Quarter 2006 10-Q
Accumulated Other Comprehensive LossDecember 31, 2005
The following table summarizes total comprehensive income for the three month and six month periods ended June 30, 2006 and 2005, respectively:
BB&T Corporation Page 21 Second Quarter 2006 10-Q
NOTE 10. Operating Segments
BB&T’s operations are divided into seven reportable business segments: the Banking Network, Residential Mortgage Banking, Trust Services, Insurance Services, Specialized Lending, Investment Banking and Brokerage, and Treasury. These operating segments have been identified based on BB&T’s 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.
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 are 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. 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, 2005, 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:
BB&T Corporation Page 22 Second Quarter 2006 10-Q
BB&T CorporationReportable SegmentsFor the Three Months Ended June 30, 2006 and 2005
(1) Includes financial data from subsidiaries below the quantitative and qualitative thresholds requiring disclosure
BB&T Corporation Page 23 Second Quarter 2006 10-Q
BB&T CorporationReportable SegmentsFor the Six Months Ended June 30, 2006 and 2005
(1) Includes financial data from subsidiaries below the quantitative and qualitative thresholds requiring disclosure.
BB&T Corporation Page 24 Second Quarter 2006 10-Q
The following table presents a reconciliation of segment results to consolidated results:
Other net interest income (expense), other net income (loss) and other, net include amounts applicable to BB&T’s support functions that are not allocated to the reported segments.
BB&T’s reconciliation of total segment results to consolidated results requires the elimination of internal management accounting practices. These adjustments include the elimination of the funds transfer pricing credits and charges, the elimination of the economic provision for loan and lease losses and the elimination of allocated corporate expenses.
Amounts reflect intercompany eliminations to arrive at consolidated results.
NOTE 11. Equity-Based Compensation Plans
At June 30, 2006, BB&T had options, restricted shares and restricted share units outstanding from the following equity-based compensation plans: the 2004 Stock Incentive Plan (“2004 Plan”), the 1995 Omnibus Stock Incentive Plan (“Omnibus Plan”), the Non-Employee Directors’ Stock Option Plan (“Directors’ Plan”), and plans assumed from acquired entities, which are described below. All plans generally allow for accelerated vesting of awards for holders who retire and have met all retirement eligibility requirements and in connection with certain other events. BB&T’s shareholders have approved all equity-based compensation plans with the exception of plans assumed from acquired companies. As of June 30, 2006, the 2004 Plan is the only plan that has shares available for future grants.
BB&T Corporation Page 25 Second Quarter 2006 10-Q
BB&T’s 2004 Plan is intended to assist the Corporation in recruiting and retaining employees, directors and independent contractors and to associate the interests of eligible participants with those of BB&T and its shareholders. At June 30, 2006 there were 6.8 million non-qualified and qualified stock options at prices ranging from $10.90 to $42.94 and 2.5 million restricted shares and restricted share units outstanding under the 2004 Plan. The options outstanding under the 2004 Plan generally vest ratably over five years and have a ten-year term. The restricted shares and restricted share units generally vest five years from the date of grant. At June 30, 2006, there were 15.5 million shares available for future grants under the 2004 Plan.
BB&T’s Omnibus Plan was intended to allow BB&T to recruit and retain employees with ability and initiative and to align the employees’ interests with those of BB&T and its shareholders. At June 30, 2006, 7.6 million qualified stock options at prices ranging from $10.73 to $48.01 and 22.3 million non-qualified stock options at prices ranging from $9.52 to $53.10 were outstanding. The stock options generally vest over 3 to 5 years and have a 10-year term.
The Directors’ Plan was intended to provide incentives to non-employee directors to remain on the Board of Directors and share in the profitability of BB&T. In 2005, the Directors’ Plan was amended and no future grants will be awarded in connection with this Plan. At June 30, 2006, options to purchase 537 thousand shares of common stock at prices ranging from $15.94 to $31.80 were outstanding pursuant to the Directors’ Plan.
BB&T also has equity-based plans outstanding as the result of assuming the plans of acquired companies. At June 30, 2006, there were 369 thousand stock options outstanding in connection with these plans, with option prices ranging from $16.53 to $29.54.
BB&T changed its practices regarding equity-based awards in the first quarter of 2006 and began issuing a combination of restricted share units and nonqualified stock options in connection with its incentive plans. Formerly, the Company had issued substantially all of its equity-based awards in the form of stock options.
BB&T measures the fair value of each option award on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants awarded in the first six months of 2006 and 2005, respectively:
BB&T determines the assumptions used in the Black-Scholes option pricing model as follows: the risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of the grant; the dividend yield is based on the historical dividend yield of BB&T’s stock, adjusted to reflect the expected dividend yield over the expected life of the option; the volatility factor is based on the historical volatility of BB&T’s stock, adjusted to reflect the ways in which current information indicates that the future is reasonably expected to differ from the past; and the weighted-average expected life is based on the historical behavior of employees related to exercises, forfeitures and cancellations.
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BB&T measures the fair value of restricted shares based on the price of BB&T’s common stock on the grant date and the fair value of restricted share units based on the price of BB&T’s common stock on the grant date less the present value of expected dividends that are foregone during the vesting period.
BB&T recorded $10.1 million and $46 thousand in equity-based compensation during the three months ended June 30, 2006 and 2005, respectively, and $36.6 million and $91 thousand during the six months ended June 30, 2006 and 2005, respectively. In connection with this compensation expense, BB&T also recorded $3.9 million and $17 thousand as an income tax benefit during the three months ended June 30, 2006 and 2005, respectively, and $14.0 million and $35 thousand during the six months ended June 30, 2006 and 2005, respectively. The total intrinsic value of options exercised during the six months ended June 30, 2006 and 2005 was $23.7 million and $21.8 million, respectively. The total fair value of options vested during the six months ended June 30, 2006 was $27.9 million. As of June 30, 2006, there was $120.8 million of unrecognized compensation costs related to BB&T’s equity-based awards that is expected to be recognized over a weighted-average life of 3.8 years.
The following table details the activity during the first six months of 2006 related to stock options awarded by BB&T:
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The following tables summarize information about BB&T’s stock option awards as of June 30, 2006:
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The following table details the activity during the first six months of 2006 related to restricted shares and restricted share units awarded by BB&T:
At June 30, 2006, BB&T’s restricted shares and restricted share units had a weighted-average life of 4.6 years. At June 30, 2006, management estimates that 2,047,012 restricted shares and restricted share units will vest over a weighted-average life of 4.6 years.
NOTE 12. Loan Servicing
BB&T has two classes of mortgage servicing rights for which it separately manages the economic risks: residential and commercial. Commercial mortgage servicing rights are recorded as other assets on the Consolidated Balance Sheets at lower of cost or market and amortized in proportion to and over the estimated period that net servicing income is expected to be received based on projections of the amount and timing of estimated future net cash flows. Commercial mortgage servicing rights were $24.2 million and $20.1 million at June 30, 2006 and December 31, 2005, respectively. Residential mortgage servicing rights are recorded on the Consolidated Balance Sheets at fair value with changes in fair value recorded as a component of mortgage banking income on the Consolidated Statements of Income for each period. BB&T uses various derivative instruments to mitigate the income statement effect of changes in fair value, due to change in valuation inputs and assumptions, of its residential mortgage servicing rights. The following is an analysis of BB&T’s residential mortgage servicing rights:
Represents economic amortization associated with the collection and realization of expected net servicing cash flows, expected borrower payments and the passage of time.
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The unpaid principal balances of BB&T’s total residential mortgage servicing portfolio were $42.7 billion and $41.1 billion at June 30, 2006 and December 31, 2005, respectively. The unpaid principal balances of residential mortgage loans serviced for others is comprised primarily of agency conforming fixed-rate mortgage loans and totaled $26.3 billion and $25.8 billion at June 30, 2006 and December 31, 2005, respectively. Mortgage loans serviced for others are not included in loans on the accompanying Consolidated Balance Sheets. BB&T recognized servicing fees of $49.9 million and $47.0 million during the first six months of 2006 and 2005, respectively, as a component of mortgage banking income.
During the first six months of 2006 and 2005, BB&T sold residential mortgage loans with unpaid principal balances of $2.4 billion and $2.3 billion, respectively. The pretax gains recognized during the first six months of 2006 and 2005 were $13.1 million and $18.3 million, respectively, which were recorded in noninterest income as a component of mortgage banking income. BB&T retained the related mortgage servicing rights and receives servicing fees. At June 30, 2006 and December 31, 2005, the approximate weighted average servicing fee was .35% of the outstanding balance of residential mortgage loans. The weighted average coupon interest rate on the portfolio of mortgage loans serviced for others was 5.86% and 5.83% at June 30, 2006 and December 31, 2005, respectively.
At June 30, 2006, BB&T had $244.5 million of residential mortgage loans sold with limited recourse liability. In the event of nonperformance by the borrower, BB&T has maximum recourse exposure of approximately $74.8 million on these mortgage loans.
BB&T uses assumptions and estimates in determining the fair value of capitalized mortgage servicing rights. These assumptions include prepayment speeds, net charge-off experience and discount rates commensurate with the risks involved and are comparable to assumptions used by other market participants to value servicing rights available for sale in the market. At June 30, 2006 the sensitivity of the current fair value of the residential mortgage servicing rights to immediate 10% and 20% adverse changes in key economic assumptions are included in the accompanying table.
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The sensitivity calculations above are hypothetical and should not be viewed as predictive of future performance. As indicated, changes in fair value based on adverse changes in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of an adverse variation in a particular assumption on the fair value of the mortgage servicing rights is calculated without changing any other assumption; while in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the effect of the change.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This report on Form 10-Q contains forward-looking statements with respect to the financial condition, results of operations and businesses of BB&T. These forward-looking statements involve certain risks and uncertainties and are based on the beliefs and assumptions of the management of BB&T and 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:
competitive pressures among depository and other financial institutions may increase significantly;
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;
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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;
legislative or regulatory changes, including changes in accounting standards, may adversely affect the businesses in which BB&T is engaged;
adverse changes may occur in the securities markets;
competitors of BB&T may have greater financial resources and develop products that enable them to compete more successfully than BB&T;
costs or difficulties related to the integration of the businesses of BB&T and its merger partners may be greater than expected;
expected cost savings associated with completed mergers may not be fully realized or realized within the expected time frames; and
deposit attrition, customer loss or revenue loss following completed mergers may be greater than expected.
Regulatory Considerations
BB&T and its subsidiaries and affiliates are subject to numerous examinations by federal and state banking regulators, as well as the Securities and Exchange Commission, the National Association of Securities Dealers, Inc., and various state insurance and securities regulators. BB&T and its subsidiaries have from time to time received requests for information from regulatory authorities in various states, including state insurance commissions and state attorneys general, securities regulators and other regulatory authorities, concerning their business practices. Such requests are considered incidental to the normal conduct of business. Please refer to BB&T’s Annual Report on Form 10-K for the year ended December 31, 2005 for additional disclosures with respect to laws and regulations affecting the Company’s businesses.
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 of America 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 and related disclosures. The more critical accounting and reporting policies include BB&T’s accounting for the allowance for loan and lease losses and reserve for unfunded lending commitments, valuation of mortgage servicing rights, intangible assets and other purchase accounting related adjustments 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 and changes in accounting principles are discussed in detail in Note 1 of the “Notes to Consolidated Financial Statements” in BB&T’s 2005 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. These critical accounting policies are reviewed with BB&T’s Audit Committee on a periodic basis.
Allowance for Loan and Lease Losses and Reserve for Unfunded Lending Commitments
It is the policy of BB&T to maintain an allowance for loan and lease losses and a reserve for unfunded lending commitments that equals management’s best estimate of probable credit losses that are inherent in the portfolio at the balance sheet date. Estimates for 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 for loan and lease losses are considerations with respect to the impact of current economic events, the outcomes of which are uncertain. These events may include, but are not limited to, fluctuations in overall interest rates, political conditions, legislation that may directly or indirectly affect the banking industry and economic conditions affecting specific geographical areas and industries in which BB&T conducts business. The methodology used to determine an estimate for the reserve for unfunded lending commitments is inherently similar to the methodology utilized in calculating the allowance for loans and leases adjusted for factors specific to binding commitments, including the probability of funding and exposure at the time of funding.
Valuation of Mortgage Servicing Rights
BB&T has a significant 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 methodology used to determine the fair value of mortgage servicing rights is subjective and requires the development of a number of assumptions, including anticipated prepayments of loan principal. The value of mortgage servicing rights is significantly affected by mortgage interest rates available in the marketplace, which influence mortgage loan prepayment speeds. 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 has two classes of mortgage servicing rights for which it separately manages the economic risks: residential and commercial. Residential mortgage servicing rights are recorded on the Consolidated Balance Sheets at fair value with changes in fair value recorded as a component of mortgage banking income each period. Commercial mortgage servicing rights are recorded as other assets on the Consolidated Balance Sheets at lower of cost or market and amortized in proportion to, and over the estimated period that, net servicing income is expected to be received based on projections of the amount and timing of estimated future net cash flows. The amount and timing of estimated future net cash flows are updated based on actual results and updated projections.
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Intangible Assets
BB&T’s growth in business, profitability and market share over the past several years has been enhanced significantly by mergers and acquisitions. BB&T’s mergers and acquisitions are accounted for using the purchase method of accounting. Under the purchase method, BB&T is required to record the assets acquired, including identified intangible assets and liabilities assumed at their fair value, which often involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analyses or other valuation techniques, all of which are inherently subjective. The amortization of identified intangible assets is based upon the estimated economic benefits to be received, which is also subjective. These estimates also include the establishment of various accruals and allowances based on planned facility 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. The major assumptions used in the impairment testing process include the estimated future cash flows of each business unit and discount rates. Discount rates are unique to each business unit and are based upon the cost of capital specific to the industry in which the business unit operates.
Pension and Postretirement Benefit Obligations
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.
Income Taxes
The calculation of BB&T’s income tax provision is complex and requires the use of estimates and judgments. 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.
EXECUTIVE SUMMARY
BB&T’s total assets at June 30, 2006 were $116.3 billion, an increase of $7.1 billion, or 6.5%, from December 31, 2005. The asset category that experienced the largest increase was loans and leases, including loans held for sale, which grew $5.3 billion, or 7.0%, during the first half of 2006.
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Total deposits at June 30, 2006, were $78.5 billion, an increase of $4.2 billion, or 5.7%, from December 31, 2005. Long-term debt increased $2.1 billion, or 15.8%, and shorter-term borrowings increased $235.4 million, or 3.6%, during the first six months of 2006. Total shareholders’ equity increased $35.0 million since December 31, 2005.
Consolidated net income for the second quarter of 2006 totaled $429.1 million, an increase of 10.9% compared to $386.8 million earned during the second quarter of 2005. On a diluted per share basis, earnings for the three months ended June 30, 2006 were $.79, compared to $.70 for the same period in 2005, an increase of 12.9%. Net income for the second quarter of 2005 included a one-time, non-cash, after tax adjustment related to property and equipment leases, which totaled $26.6 million, or $.05 per diluted share. BB&T’s results of operations for the second quarter of 2006 produced an annualized return on average assets of 1.53% and an annualized return on average shareholders’ equity of 15.34% compared to prior year ratios of 1.50% and 14.04%, respectively.
Consolidated net income for the first six months of 2006 totaled $860.6 million, an increase of 10.0% compared to $782.2 million earned during the same period in 2005. On a diluted per share basis, earnings for the first six months of 2006 and 2005 were $1.59 and $1.42, respectively, which represents an increase of 12.0%. BB&T’s results of operations for the first six months of 2006 produced an annualized return on average assets of 1.57% and an annualized return on average shareholders’ equity of 15.53% compared to prior year ratios of 1.55% and 14.37%, respectively.
Results during the second quarter of 2006 reflect further improvements in several key drivers of BB&T’s profitability. Among these were strong combined loan and deposit growth, solid growth in noninterest income and continued excellent asset quality. BB&T’s net interest margin declined six basis points during the second quarter as a result of the flat yield curve environment and management’s decision to more aggressively pursue retail deposits, which resulted in higher funding costs.
On June 1, 2006, BB&T completed its merger with Main Street Banks, Inc. (“Main Street”). Main Street had total assets of $2.3 billion, total loans of $1.8 billion and total deposits of $1.7 billion which contributed to the increases in these categories.
On August 1, 2006, BB&T completed its merger with First Citizens Bancorp (“First Citizens”), a bank holding company headquartered in Cleveland, Tennessee. First Citizens has approximately $700 million in assets and operates 19 full-service banking centers.
Please refer to BB&T’s Annual Report on Form 10-K for the year ended December 31, 2005, 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 of 2006 are further discussed in the following sections.
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ANALYSIS OF FINANCIAL CONDITION
Securities
Securities available for sale totaled $20.1 billion at June 30, 2006, an increase of $308.0 million, or 1.6%, compared with December 31, 2005. Securities available for sale had net unrealized losses, net of deferred income taxes, of $535.1 million and $337.6 million at June 30, 2006 and December 31, 2005, respectively. Trading securities totaled $918.6 million, up $212.1 million, or 30.0%, compared to the balance at December 31, 2005. BB&T’s trading portfolio can fluctuate significantly from period to period based on market conditions, which affect the timing of purchases and sales of securities classified as trading.
Average total securities for the first six months of 2006 totaled $21.0 billion, an increase of $905.2 million, or 4.5%, compared to the average balance during the first six months of 2005. Average total securities for the second quarter of 2006 amounted to $21.1 billion, an increase of $467.6 million, or 2.3%, compared to the average balance during the second quarter of 2005. The increase in securities was the result of a combination of factors, including the purchase of securities in 2005 to offset variances in projected loan growth and the securitization of approximately $210 million in mortgage loans in the fourth quarter of 2005 that were held in BB&T’s loan portfolio and subsequently transferred to the securities portfolio.
The annualized fully taxable equivalent (“FTE”) yield on the average securities portfolio for the second quarter of 2006 was 4.33%, which represents an increase of 20 basis points compared to the annualized yield earned during the second quarter of 2005. For the first six months, the annualized FTE yield was 4.36%, which represents a 26 basis point increase compared to the annualized yield earned during the same period of 2005. The fluctuations in the annualized FTE yield on the average securities portfolio were primarily the result of changes in the overall composition of the securities portfolio with a higher percentage of higher-yielding mortgage-backed securities and the replacement of certain lower-yielding securities.
On June 30, 2006, BB&T held certain investment securities having continuous unrealized loss positions for more than 12 months. As of June 30, 2006, the unrealized losses on these securities totaled $779.4 million. Substantially all of these investments were in U.S. government-sponsored entity securities and mortgage-backed securities, which primarily consist of securities issued by the Federal Farm Credit Bureau, the Federal Home Loan Bank System, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. These agencies are rated AAA and the unrealized losses are the result of increases in market interest rates rather than the credit quality of the issuers. At June 30, 2006, BB&T had the ability and intent to retain these securities for a period of time sufficient to recover all unrealized losses. Accordingly, BB&T has not recognized other-than-temporary impairment in connection with these securities.
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, maintaining strong asset quality and achieving an equal mix of consumer and commercial loans. For the second quarter of 2006, average total loans were $78.0 billion, an increase of $7.6 billion, or 10.8%, compared to the same period in 2005. For the first six months of 2006, average total loans were $76.7 billion, an increase of $7.2 billion, or 10.4%, compared to the same period in 2005.
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The following tables present the composition of average loans and leases for the second quarter and the six months ended June 30, 2006 and 2005:
The slight fluctuation in the mix of the loan portfolio during the second quarter and the first six months of 2006 compared to the same periods of 2005 was primarily due to increased growth in the mortgage portfolio, which grew at a faster pace than the consumer portfolio. The slower growth in the consumer portfolio was the result of decreased demand for home equity loans due to the increase in the prime rate, which is the primary index for most home equity loans. In addition, growth in the sales finance component of the consumer portfolio has slowed due to lower sales of automobiles, which are the primary source of loans for BB&T’s sales finance operations.
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The annualized FTE yields on commercial, consumer, mortgage and specialized lending subsidiary loans for the first six months of 2006 were 7.57%, 7.05%, 5.58%, and 15.13%, respectively, resulting in an annualized yield on the total loan portfolio of 7.33%. This reflects an increase of 97 basis points in the annualized yield on the total loan portfolio during the first six months of 2006 in comparison to 2005. The annualized FTE yield for the total loan portfolio for the second quarter of 2006 was 7.47% compared to 6.47% in the second quarter of 2005. These increases in the FTE yield on the loan portfolio were primarily the result of an increase in yield on commercial loans; as variable-rate loans were repriced and fixed-rate loans with lower-yields matured and were replaced with higher-yielding loans and leases. Starting in the second half of 2004, the Federal Reserve Board began to steadily increase the intended Federal funds rate in response to an increase in economic activity and concerns about inflation. As a result, the prime rate, which is the basis for pricing many commercial and consumer loans, increased to 8.25% at June 30, 2006, compared to 6.25% at June 30, 2005. Therefore, as loans gradually reprice at higher rates or mature and are replaced with higher-yielding loans, the annualized yield of the loan portfolio is expected to increase. Evidence of this trend is visible from the changes in the interest yield for the first six months, which improved from 6.36% in 2005 to 7.33% during the same period of 2006. The rise in short-term interest rates, however, was not matched by a similar rise in long-term interest rates. Therefore, mortgage rates, which are influenced by long-term interest rates in the marketplace, increased at a slower pace than other categories of loans compared to last year.
Other Interest Earning Assets
Federal funds sold and securities purchased under resale agreements totaled $365.3 million at June 30, 2006, an increase of $79.0 million, or 27.6%, compared to December 31, 2005. Interest-bearing deposits with banks increased $151.3 million, or 36.9%, compared to year-end 2005. 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 was 4.02% for the first six months of 2006, compared to 2.86% for the same period in 2005. For the second quarter of 2006, the average yield on other interest-earning assets was 4.23%, up from 3.16% in the same period last year. These higher yields were the result of the increase in the Federal funds target rate as previously discussed.
Goodwill and Other Assets
BB&T’s other noninterest-earning assets, excluding premises and equipment and noninterest-bearing cash and due from banks, increased $1.1 billion from December 31, 2005 to June 30, 2006. The increase was due primarily to an increase in goodwill of $474.3 million, which resulted from the acquisition of Main Street and certain contingent payments related to prior acquisitions. In addition, residential mortgage servicing rights increased $68.5 million and the cash surrender value of bank-owned life insurance increased $108.6 million, including $60.4 million related to the acquisition of Main Street, compared to December 31, 2005.
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Deposits
Client deposits generated through the BB&T branch network are the largest source of funds used to support asset growth. Deposits totaled $78.5 billion at June 30, 2006, an increase of $4.2 billion, or 5.7%, from December 31, 2005. Average deposits for the first six months of 2006 increased $6.8 billion, or 10.0%, to $74.9 billion compared to the first six months of 2005. The categories of deposits with the highest average rates of growth were other interest-bearing deposits, which increased $1.5 billion, or 22.4%; client certificates of deposit, which increased $3.3 billion, or 19.2%; and interest checking, which increased $319.2 million, or 18.3%. In addition, noninterest-bearing deposits increased $510.1 million, or 4.1%; and other client deposits, which include money rate savings accounts, investor deposit accounts, savings accounts, individual retirement accounts and other time deposits, increased $1.1 billion, or 3.7%, for the first six months of 2006 compared to the same period in 2005. Average deposits for the second quarter of 2006 increased $6.7 billion, or 9.7%, compared to the same period in 2005. The increase in the second quarter of 2006 compared to 2005 was led by a $4.2 billion, or 24.2% increase in client certificates of deposit. The recent increases in the growth rates of client certificates of deposit were primarily due to a decision by management to more aggressively pursue these types of funding sources to provide for strong loan growth and to fuel organic growth initiatives.
The following tables present the composition of average deposits for the second quarter and the six months ended June 30, 2006 and 2005:
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The change in deposit mix is primarily due to a shift from lower yielding products, such as noninterest-bearing accounts and money rate savings accounts, to higher yielding certificates of deposit as clients began to show a preference for these items due to the higher rate environment. This also reflects management’s decision to more aggressively pursue retail deposits through BB&T’s branch delivery network, which reduces the Corporation’s reliance on other interest-bearing deposits, which consists of negotiable certificates of deposit and Eurodollar deposits. While average other interest-bearing deposits was up 22.4% for the first six months of 2006 compared to the same period for 2005, the balance at June 30, 2006 was down $1.8 billion, or 19.9%, compared to the balance at December 31, 2005.
For the first six months of 2006, the annualized average rate paid on total interest-bearing deposits was 3.05%, an increase of 116 basis points compared to the first six months of 2005. For the second quarter of 2006, the annualized average rate paid on total interest-bearing deposits was 3.19% compared to 1.99% in the same period last year. These increases in the average rate paid on interest-bearing deposits resulted primarily from the higher interest rate environment that existed during the first half of 2006 compared to 2005, competition in the pricing of deposit products and a shift in the deposit mix to higher yield products.
Borrowings
While client deposits remain the primary source for funding loan originations and other balance sheet growth, management uses shorter-term borrowings as a supplementary funding source for loan growth. Shorter-term borrowings utilized by BB&T include federal funds purchased, securities sold under repurchase agreements, master notes, U.S. Treasury tax and loan deposit notes, short-term bank notes, and short-term Federal Home Loan Bank (“FHLB”) advances. At June 30, 2006, shorter-term borrowings totaled $6.8 billion, an increase of $235.4 million, or 3.6%, compared to December 31, 2005. For the second quarter of 2006, average shorter-term borrowed funds were $7.5 billion, a decrease of $711.0 million, or 8.7%, compared to the same period of 2005. For the six months ended June 30, 2006, average shorter-term borrowed funds decreased $556.8 million, or 7.3%, from the comparable period in 2005. The decrease in these funds was primarily due to the growth in deposits, which was able to provide for loan growth during the first half of 2006.
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The average annualized rate paid on shorter-term borrowed funds was 4.14% for the first six months of 2006, an increase of 148 basis points from the average rate of 2.66% paid in the comparable period of 2005. For the second quarter of 2006, the average rate paid on shorter-term borrowings was 4.30% compared to 2.86% during the second quarter of 2005. The higher rates paid on shorter-term borrowed funds mirror the increases in the Federal funds rate over the same time periods.
BB&T also utilizes long-term debt for a variety of funding needs, including the repurchase of common stock, and, to a lesser extent, regulatory capital. Long-term debt consists primarily of FHLB advances to BB&T’s banking subsidiaries and corporate subordinated notes. Long-term debt totaled $15.2 billion at June 30, 2006, an increase of $2.1 billion from the balance at December 31, 2005. The primary reason for the increase was the issuance of $600 million in capital securities, $500 million in medium term bank notes and a $1.0 billion FHLB advance. The acquisition of Main Street also added $117.2 million in long-term debt at June 30, 2006. The issuance of the floating rate medium term bank notes and the FHLB advance was to better stratify debt maturities among short, medium and long term. The proceeds from the issuance of the capital ecurities was used primarily to repurchase shares under BB&T’s share repurchase program.
The average annualized rate paid on long-term debt for the second quarter of 2006 was 5.04%, an increase of 97 basis points compared to the second quarter of 2005. For the first six months of 2006, the average rate paid on long-term debt was 4.91% compared to 4.00% during the same period in 2005. These increases in the cost of long-term funds resulted because most of BB&T’s long-term borrowings were either issued as floating rate instruments or BB&T elected to swap their long-term fixed rates to floating.
Asset Quality
BB&T’s credit quality remains outstanding. Nonperforming assets, which are composed of foreclosed real estate, repossessions, nonaccrual loans and restructured loans, totaled $319.4 million at June 30, 2006, compared to $300.1 million at December 31, 2005. As a percentage of loans and leases plus foreclosed property, nonperforming assets were .40% at June 30, 2006 and December 31, 2005. Loans 90 days or more past due and still accruing interest totaled $90.7 million at June 30, 2006, compared to $103.4 million at year-end 2005. The addition of the portfolios from the Main Street acquisition increased nonperforming assets and loans 90 days or more past due and still accruing interest $26.8 million and $12.5 million, respectively.
BB&T’s net charge-offs totaled $45.3 million for the second quarter and amounted to .23% of average loans and leases, on an annualized basis, compared to $44.6 million, or .25% of average loans and leases, on an annualized basis, in the corresponding period in 2005. For the six months ended June 30, 2006 and 2005, net charge-offs totaled $93.0 million and $91.4 million, respectively, and represented .24% and .27%, respectively, of average loans and leases on an annualized basis.
The allowance for credit losses, which totaled $870.9 million and $829.8 million at June 30, 2006 and December 31, 2005, respectively, consists of the allowance for loan and lease losses, which is presented on the Consolidated Balance Sheets, and the reserve for unfunded lending commitments, which is included in other liabilities on the Consolidated Balance Sheets. The allowance for loan and lease losses totaled $869.9 million at June 30, 2006, compared to $825.3 million at December 31, 2005. This amounted to 1.08% of loans and leases outstanding at June 30, 2006, compared to 1.10% at year-end 2005.
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Asset quality statistics for the last five calendar quarters are presented in the accompanying tables.
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Table 3Asset Quality Analysis
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Asset Quality Ratios
ANALYSIS OF RESULTS OF OPERATIONS
Consolidated net income for the second quarter of 2006 totaled $429.1 million, an increase of $42.3 million, or 10.9%, compared to $386.8 million earned during the second quarter of 2005. On a diluted per share basis, earnings for the three months ended June 30, 2006 were $.79, an increase of 12.9% compared to $.70 for the same period in 2005. Net income for the second quarter of 2005 included a one-time, non-cash adjustment related to property and equipment leases, which totaled $26.6 million after-tax, or $.05 per diluted share. BB&T’s results of operations for the second quarter of 2006 produced an annualized return on average assets of 1.53% and an annualized return on average shareholders’ equity of 15.34%, compared to prior year ratios of 1.50% and 14.04%, respectively.
Consolidated net income for the first six months of 2006 totaled $860.6 million, an increase of 10.0%, compared to $782.2 million earned during the same period of 2005. On a diluted per share basis, earnings for the first six months of 2006 and 2005 were $1.59 and $1.42, respectively, which represents an increase of 12.0%. BB&T’s results of operations for the first six months of 2006 produced an annualized return on average assets of 1.57% and an annualized return on average shareholders’ equity of 15.53% compared to prior year ratios of 1.55% and 14.37%, respectively.
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The following table sets forth selected financial ratios for the last five calendar quarters:
Table 4AnnualizedProfitability Measures
Mergers and acquisitions have played an important role in the development of BB&T’s franchise. BB&T has been an active acquirer of financial institutions, insurance agencies and other nonbank fee income producing businesses for many years. BB&T recorded certain merger-related items and restructuring costs during both 2006 and 2005. During the second quarter of 2006, BB&T recorded $1.0 million in net after-tax charges primarily due to the acquisition of Main Street. During the second quarter of 2005, BB&T recorded $249 thousand in net after-tax merger-related credits or gains primarily associated with sale of duplicate facilities and the finalization of severance and other personnel-related liabilities associated with recent acquisitions. The above charges and credits are reflected in BB&T’s Consolidated Statements of Income as a category of noninterest expense.
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. Merger-related charges also include professional fees, advertising and asset write-offs incurred in connection with the mergers.
The following table presents the components of merger-related and restructuring charges (gains) included in noninterest expenses. This table includes changes 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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Table 5-1Summary of Merger-Related and Restructuring Charges (Gains)
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 or reversals of previously estimated amounts, which typically occur in corporate support and data processing functions.
Occupancy and equipment charges or credits represent merger-related costs or gains 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 composed of asset and supply inventory write-offs, litigation accruals 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 and other personnel 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 an acquisition. The following table presents a summary of activity with respect to BB&T’s merger and restructuring accruals. This table includes costs reflected as expenses, as presented in the table above, and accruals recorded through purchase accounting adjustments.
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The remaining accruals at June 30, 2006 are related primarily to costs associated with severance payments to certain executive officers and costs to exit certain leases and to dispose of excess facilities and equipment. These liabilities will be utilized in the future because 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 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. The remaining liabilities for systems conversions and related items relate to expenses necessary to convert and combine the acquired branches and operations of merged companies. Such liabilities will be utilized upon termination of the various leases, sale of duplicate property, and conversion of systems and operations. The other merger-related liabilities relate to litigation and other similar charges.
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. 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, 2006 are expected to be utilized during 2006, unless they relate to specific contracts that expire in later years.
Net Interest Income and Net Interest Margin
Net interest income on an FTE basis was $938.6 million for the second quarter of 2006 compared to $897.5 million for the same period in 2005, an increase of $41.1 million, or 4.6%. For the quarter ended June 30, 2006, average earning assets increased $8.4 billion, or 9.1%, compared to the same period of 2005, while average interest-bearing liabilities increased $7.8 billion, or 10.3%, and the net interest margin decreased from 3.92% in the second quarter of 2005 to 3.76% in the current quarter. The decrease in the net interest margin was caused by a combination of factors. The flattening of the yield curve in recent quarters and management’s decision to more aggressively pursue retail deposits to fund loan growth has resulted in an increase in funding costs that has outpaced the rise in yields on earning assets. In addition, the margin was negatively affected by the additional interest expense incurred in connection with BB&T’s stock repurchase program.
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For the first six months of 2006, net interest income on an FTE basis was $1.9 billion, an increase of $91.2 million compared to $1.8 billion earned during the same period in 2005. Average earning assets for the first six months of 2006 were $98.6 billion, an increase of 9.3% compared to the prior year average of $90.2 billion, while average interest-bearing liabilities increased $7.7 billion, or 10.3%, compared to the first six months of 2005. The net interest margin for the first six months of 2006 was 3.79%, a decrease of 15 basis points compared to 3.94% during the first half of 2005. The decline in the net interest margin for the first six months of 2006 was largely due to the same factors that caused the decline during the second quarter as 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 the first six months of 2006 compared to the same periods in 2005, and the variances between the periods caused by changes in interest rates versus changes in volumes.
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Table 6FTE Net Interest Income and Rate / Volume AnalysisFor the Three Months Ended June 30, 2006 and 2005
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.
Includes Federal funds sold, securities purchased under resale agreements or similar arrangements, interest-bearing deposits with banks, and other earning assets.
Loan fees, which are not material for any of the periods shown, have been included for rate calculation purposes.
Nonaccrual loans have been included in the average balances. Only the interest collected on such loans has been included as income.
Includes assets which were held for sale or available for sale at amortized cost and trading securities at estimated fair value.
Includes stock issued by the FHLB of Atlanta.
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Table 6FTE Net Interest Income and Rate / Volume AnalysisFor the Six Months Ended June 30, 2006 and 2005
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Provision for Credit Losses
The provision for credit losses totaled $57.7 million for the second quarter of 2006, compared to $49.4 million for the second quarter of 2005. For the first six months of 2006 the provision for credit losses totaled $105.3 million, an increase of $14.8 million, or 16.4%, compared to the provision of $90.5 million for the same period in 2005. The increase in the provision for credit losses was driven by growth in the lending portfolio, offset by improving credit quality. Net charge-offs were .23% of average loans and leases for the second quarter compared to .25% of average loans and leases for the same period in 2005. The allowance for loan and lease losses was 1.08% of loans and leases outstanding and was 3.63x total nonaccrual and restructured loans and leases at June 30, 2006, compared to 1.13% and 3.51x, respectively, at June 30, 2005.
Noninterest Income
Noninterest income as a percentage of total revenues has increased in recent years due to BB&T’s emphasis on growing and expanding its fee-based businesses. Fee-based service revenues lessen BB&T’s dependence on traditional spread-based interest income and are a relatively stable revenue source during periods of changing interest rates. Noninterest income for the three months ended June 30, 2006 totaled $650.7 million, compared to $584.9 million for the same period in 2005, an increase of $65.8 million, or 11.2%. The growth in noninterest income was primarily attributable to commissions from BB&T’s insurance operations, other nondeposit fees and commissions and income generated from mortgage banking operations. For the six months ended June 30, 2006, noninterest income totaled $1.3 billion, an increase of $157.3 million, or 14.3%, compared to the same period in 2005. The overall growth in noninterest income also reflects the impact of acquisitions.
Insurance commissions, which have become BB&T’s largest source of noninterest income, totaled $214.1 million for the second quarter of 2006, an increase of $32.5 million, or 17.9%, compared to the same three month period of 2005. For the first six months of 2006, insurance commissions totaled $390.6 million, up $56.7 million, or 17.0%, compared to the same period last year. The increase in insurance revenues for the quarter and the first six months of 2006 was primarily the result of growth in commissions from the sale of property and casualty coverage, and improved sales of employee benefits-related insurance products. This growth includes the acquisition of several insurance agencies during 2005 and the acquisition of Main Street’s insurance subsidiary in June 2006.
Service charges on deposits totaled $138.1 million for the second quarter of 2006, down $1.1 million, compared to the second quarter of 2005. For the first six months of 2006, service charges on deposits totaled $269.4 million, an increase of $9.4 million, or 3.6%, compared to the same period in 2005. The decrease during the quarter was primarily attributable to a decline in monthly account service fees due to an increase in free checking accounts and free online services, and higher earnings credits paid for compensating balances, offset by higher revenues from overdraft items. For the first six months of 2006, higher revenues from overdraft items outpaced the decline in monthly account service fees due to the migration to free checking accounts and free online services and the higher earnings credit paid during the first half of 2006 compared to the same period last year.
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Investment banking and brokerage fees and commissions totaled $78.2 million for the second quarter of 2006, a decrease of $2.8 million, or 3.5%, from $81.0 million earned in the second quarter of 2005. For the first six months of 2006, investment banking and brokerage fees and commissions totaled $159.5 million, up $9.6 million, or 6.4%, compared to the same period last year. The decrease during the second quarter was primarily attributable to a decrease in investment banking fees, which was partially offset by an increase in revenues from retail brokerage accounts. While for the first six months of 2006, commissions from investment banking activities, as well as revenues from retail brokerage accounts were higher than for the same period in 2005.
Mortgage banking income totaled $29.1 million in the second quarter of 2006, an increase of $16.8 million, compared to $12.4 million earned in the second quarter of 2005. The increase in net mortgage banking income was largely the result of fluctuations in the fair value of residential mortgage servicing rights and the related derivative hedge as well as increased revenues from commercial mortgage banking revenues, net of amortization of mortgage servicing rights, which increased $3.0 million, or 55.5%, compared to the same period in 2005. The following table provides a breakdown of the various components of mortgage banking income and other statistical information for the second quarters of 2006 and 2005:
Table 7-1Mortgage Banking Income and Related Statistical Information
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For the first six months of 2006, mortgage banking income totaled $61.4 million, an increase of $18.9 million, or 44.3%, compared to the same period of 2005. The increase in net mortgage banking income was primarily caused by the same factors that affected the quarterly increase in revenues, which included the fluctuation in the fair value of residential mortgage servicing rights and the related derivative hedge as well as increased revenues from commercial mortgage banking revenues, net of amortization of mortgage servicing rights. The following table provides a breakdown of the various components of mortgage banking income for the six month periods ended June 30, 2006 and 2005, respectively:
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Table 7-2Mortgage Banking Income and Related Statistical Information
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Other nondeposit fees and commissions, including bankcard fees and merchant discounts, totaled $111.5 million for the second quarter of 2006, an increase of $19.9 million, or 21.8%, compared to the second quarter of 2005. For the six months ended June 30, 2006, other nondeposit fees and commissions, including bankcard fees and merchant discounts, totaled $213.1 million, up $41.2 million, or 24.0%, from the same period in 2005. The principal drivers of the second quarter increase were check card and debit card interchange fees, bankcard income and official check outsourcing fees, which increased $5.7 million, $3.5 million and $1.6 million, respectively, compared to the same period in 2005. The 24.0% increase for the first six months of 2006 was primarily driven by the same factors as the quarter, including increases in check card and debit card interchange fees, bankcard income and official check outsourcing fees of $12.8 million, $6.7 million and $3.2 million, respectively.
Trust income totaled $37.7 million for the second quarter of 2006, an increase of $1.0 million, or 2.8%, compared to the second quarter of 2005. For the six months ended June 30, 2006, trust income totaled $74.8 million, up $7.6 million, or 11.4%, compared to the same period in 2005. Trust revenues are based on the types of services provided as well as the overall market value of assets managed, which is affected by market conditions. The increase in trust income for the first six months of 2006 resulted primarily from higher asset management fees as a result of the acquisition of a majority stake in Sterling Capital Management LLC, on April 1, 2005, as well as growth in wealth management income.
Other income totaled $41.7 million for the second quarter of 2006, a slight decrease compared to the second quarter of 2005. For the first six months of 2006, other income totaled $89.9 million, an increase of $13.8 million compared to the first half of 2005. The increase during the first six months of 2006 compared to 2005 resulted primarily from a $12.6 million gain on the sale of an investment held by a majority-owned small business investment company that invests in debt and equity securities of qualifying small businesses recorded during the first quarter of 2006.
Noninterest Expense
Noninterest expenses totaled $859.6 million for the second quarter of 2006, compared to $831.3 million for the same period a year ago, an increase of $28.3 million, or 3.4%. For the first six months of 2006, noninterest expenses totaled $1.7 billion, an increase of $116.8 million, or 7.5%, compared to the same period in 2005. Noninterest expenses for the second quarter and the first six months of 2006 include $1.6 million in net pre-tax merger-related charges and $1.3 million in net pre-tax merger-related gains, respectively. Noninterest expenses for the second quarter and the first six months of 2005 include $404 thousand and $3.0 million, respectively, in net pre-tax merger-related gains.
Personnel expense, the largest component of noninterest expense, was $505.6 million for the current quarter compared to $450.7 million for the same period in 2005, an increase of $54.8 million, or 12.2%. This increase was attributable to higher incentive compensation expenses and salaries and wages, which increased $14.9 million and $36.4 million, respectively, compared to the second quarter last year. In addition, BB&T began recognizing expense for equity-based compensation on January 1, 2006 and recorded $10.1 million of expense during the current quarter. Incentive compensation increased primarily as a result of growth in BB&T’s insurance services operations. Salaries and wages increased as a result of the higher number of full-time equivalent employees in the current quarter compared to last year, due in part to the acquisition of Main Street and several insurance and nonbank financial services companies since the end of the second quarter of 2005. For the first six months of 2006, personnel expense totaled $1.0 billion compared to $865.8 million in 2005, an increase of $153.7 million, or 17.8%. The increase resulted primarily from the same factors as the quarterly increase, including higher incentive compensation expenses and salaries and wages, which increased $45.6 million and $70.5 million, respectively. In addition, BB&T recorded $36.6 million in expense for equity-based compensation during the first six months of 2006.
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Occupancy and equipment expense for the three months ended June 30, 2006 totaled $109.7 million, compared to $148.1 million for the second quarter of 2005, representing a decrease of $38.4 million, or 25.9%. The decrease is primarily related to the $44.0 million pre-tax one-time, non-cash lease adjustment that was recorded in the second quarter of 2005 to account for escalating lease payments and the amortization of leasehold improvements. For the first six months of 2006, occupancy and equipment expense totaled $217.5 million, down $36.3 million, or 14.3%, compared to 2005. This decrease was also primarily related to the one-time, non-cash lease adjustment recorded in the second quarter of 2005.
The amortization of intangible assets totaled $25.2 million for the current quarter, a decrease of $3.4 million, or 11.8%, compared to $28.6 million incurred in the second quarter of 2005. For the six months ended June 30, 2006, amortization of intangible assets totaled $50.3 million, a decrease of $6.4 million compared to the same period last year. See Note 2 to the Consolidated Financial Statements herein for a summary of completed mergers and acquisitions.
Other noninterest expenses, including professional services, totaled $217.5 million for the current quarter, an increase of $16.2 million, or 8.0%, compared to the same period of 2005. The increase was primarily due to a $6.3 million increase in advertising and marketing expenses and a $5.8 million increase in professional services as compared to the same period last year. The increase in professional fees was primarily attributable to legal fees and consulting fees. The increase in advertising and marketing expenses was primarily attributable to the new branding campaign. For the first six months of 2006, other noninterest expenses, including professional services, totaled $392.8 million, up $7.1 million, or 1.8%, compared to the same period in 2005. The principal reasons for the increase are the same as for the quarter, including an increase of $15.7 million and $13.0 million, respectively, in professional services and advertising and marketing expenses. These increases were offset by a $28.2 million pre-tax gain on the sale of duplicate facilities during the first quarter of 2006.
The effective management of noninterest operating costs is another key contributor to BB&T’s financial success, especially as BB&T becomes a larger and more diverse company. In 2004, management announced plans to implement cost savings and revenue enhancement initiatives with the goal of producing $175 million in combined annual cost savings and revenue enhancements. Implementation of the initiatives began in the fourth quarter of 2004, and management projected that approximately $60 million of the goal would be realized in 2005 pursuant to this effort. Management estimates that approximately $75 million in cost savings and revenue enhancements were achieved during 2005. Management currently estimates that substantially all of the $175 million of annual benefits will be achieved by mid-year 2007.
Provision for Income Taxes
The provision for income taxes totaled $221.0 million for the second quarter of 2006, an increase of $26.6 million compared to the same period of 2005, primarily due to higher pretax income in the current quarter compared to the second quarter last year. BB&T’s effective income tax rates for the second quarters of 2006 and 2005 were 34.0% and 33.4%, respectively. The slight increase in the effective tax rate for the second quarter of 2006 was caused by an increase in state tax accruals, which were offset by a reduction in federal tax reserves as described below.
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BB&T has extended credit to, and invested in the obligations of, states and municipalities and their agencies, and has made other investments and loans that produce tax-exempt income. 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 2006 and 2005.
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 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 income recognition 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 the tax law and regulations applicable 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. Early in the fourth quarter of 2004, BB&T filed a lawsuit in the United States District Court for the Middle District of North Carolina to pursue a refund of $3.3 million in taxes plus interest assessed by the IRS related to a leveraged lease transaction entered into during 1997. During the second quarter of 2006, BB&T filed a second lawsuit to pursue a refund of the remaining $56.0 million in taxes, plus interest, assessed by the IRS related to similar leveraged lease transactions entered into during 1998. Depending on the outcome of the litigation, or if management otherwise determines that the projected income tax cash flows relating to its leveraged lease transactions will change, BB&T may be required to record a one-time charge to retained earnings as a result of the release of FSP FAS 13-2 and FIN 48. Please refer to Note 1 of the consolidated financial statements for additional disclosures regarding the potential impacts of these new accounting pronouncements.
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During the second quarter of 2006, the IRS concluded its examination of BB&T’s federal income tax returns for the years ended December 31, 1999, 2000, 2001 and 2002. Upon the completion of their examination, the IRS issued a Notice of Proposed Adjustments relating to the leveraged leases entered into during the years under examination and the continued treatment of leveraged leases currently subject to litigation. BB&T has filed a protest to the proposed assessment with the IRS Appeals Office. Management continues to believe that BB&T’s treatment of these leveraged leases was appropriate and in compliance with the tax law and regulations applicable to the years examined. In connection with the conclusion of this examination, BB&T released certain federal tax reserves that did not pertain to leveraged leases. The release of these federal tax reserves was offset by an increase in state tax reserves that was recorded to reflect additional taxes, interest and penalties resulting from combined income tax reporting for separate entities selected by state taxing authorities. The net change in federal and state tax reserves did not have a material effect on BB&T’s provision for income taxes.
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; however, market risk also includes product liquidity risk, price risk and volatility risk. The primary objective of interest rate risk management is to minimize any adverse effect that changes in interest rates may 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 Market Risk and Liquidity Committee 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 Market Risk and Liquidity Committee 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 Market Risk and Liquidity Committee also sets policy guidelines and establishes long-term strategies with respect to interest rate risk exposure and liquidity. The Market Risk and Liquidity Committee 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.
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 the Market Risk and Liquidity Committee, management believes that BB&T is positioned to respond to changing needs for liquidity, changes in interest rates and inflationary trends.
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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 made 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 management believes that 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 the 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 interest sensitive income as projected for the next twelve 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 interest sensitive income reflects the level of sensitivity that interest sensitive income has in relation to changing interest rates.
Table 8Interest Sensitivity Simulation Analysis
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Management has established parameters for asset/liability management, which prescribe a maximum negative impact on interest sensitive income of 3% for the next 12 months for a linear increase of 150 basis points for six months followed by a flat interest rate scenario for the remaining six month period, and a maximum negative impact of 6% for a linear increase of 300 basis points for 12 months.
Derivative Financial Instruments
BB&T utilizes a variety of financial instruments to manage various financial risks. These instruments, commonly referred to as 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 manage risk related to securities, 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 and do not represent amounts to be exchanged between parties, and are not a measure of financial risk. On June 30, 2006, BB&T had derivative financial instruments outstanding with notional amounts totaling $24.3 billion. The estimated net fair value of open contracts was $(215.5 million) at June 30, 2006. This compares to $23.7 billion in notional derivatives with a fair value of $(10.6 million) at December 31, 2005. The majority of the decrease in fair value relates to interest-rate swaps hedging the fair value of certain issuances of BB&T’s long-term debt.
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 only with derivatives dealers that are 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, 2006 was not material.
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The following tables set forth certain information concerning BB&T’s derivative financial instruments at June 30, 2006 and December 31, 2005:
Table 9-1Derivative Classifications and Hedging Relationships
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Table 9-2Derivative Financial Instruments
BB&T’s receive fixed swaps had weighted average receive rates of 4.93% and 4.74% and weighted average pay rates of 5.17% and 4.28% at June 30, 2006 and December 31, 2005, respectively. In addition, BB&T’s pay fixed swaps had weighted average receive rates of 5.10% and 4.29% and weighted average pay rates of 4.31% and 3.97%, at June 30, 2006 and December 31, 2005, respectively.
Contractual Obligations, Commitments, Contingent Liabilities, Off-Balance Sheet Arrangements and Related Party Transactions
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 other 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, 2005, 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 $11.2 billion at June 30, 2006, compared to $11.1 billion at December 31, 2005. BB&T’s book value per common share at June 30, 2006 was $20.79, compared to $20.49 at December 31, 2005. BB&T’s tangible shareholders’ equity was $5.9 billion at June 30, 2006, a decrease of $445.2 million, or 7.0%, compared to $6.4 billion at December 31, 2005. BB&T’s tangible book value per common share at June 30, 2006 was $11.06 compared to $11.76 at December 31, 2005.
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 credit 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 also have 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 ratios for the last five calendar quarters are set forth in the following table:
Table 10Capital 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 June 27, 2006 BB&T’s Board of Directors granted authority under a new plan (the “2006 Plan”) for the repurchase of up to 50.0 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.
On August 26, 2003, BB&T’s Board of Directors granted authority for the repurchase of up to 50.0 million shares of BB&T’s common stock as needed for general corporate purposes (the “2003 Plan”). Approximately 48.9 million shares have been repurchased under the 2003 plan. The 2006 plan also authorizes the repurchase of the remaining 1.1 million shares from the 2003 plan.
During the second quarter of 2006, BB&T executed an accelerated share repurchase program to facilitate the purchase of 14.0 million shares of BB&T common stock. As of June 30, 2006, BB&T had 51.1 million shares remaining under the current authorization. The following table presents the common stock repurchases made by BB&T during the second quarter of 2006:
Repurchases include shares exchanged or surrendered in connection with the exercise of stock options under BB&T's stock option plans.
Excludes commissions.
In June 2006, the Board of Directors approved a new plan to repurchase up to 50 million shares of BB&T's common stock and to permit the Corporation to repurchase the remaining shares under the previous authorization.
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. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, the management of the Company, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, carried out an evaluation of the effectiveness of the Company’s disclosure controls and procedures as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective so as to 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 was no change in the Company’s internal control over financial reporting that occurred during the period covered by this report that has materially affected, or is 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 and other 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. Based on information currently available, advice of counsel, available insurance coverage and established reserves, BB&T’s management believes that the liabilities, if any, arising from these proceedings will not have a materially adverse effect on the consolidated financial position, consolidated results of operations or consolidated cash flows of BB&T. However, in the event of unexpected future developments, it is possible that the ultimate resolution of these matters, if unfavorable, may be material to BB&T’s consolidated financial position, consolidated results of operations or consolidated cash flows.
Item 1A. Risk Factors
Please refer to BB&T’s Annual Report on Form 10-K for the year ended December 31, 2005 for a discussion of risk factors relating to BB&T’s business.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(c) Please refer to “Share Repurchase Activity” in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section herein.
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Item 4. Submission of Matters to a Vote of Security Holders
BB&T held its Annual Meeting of Shareholders on April 25, 2006, to consider and vote on the matters listed below. A total of 412,919,930 of the Company’s shares were present or represented by proxy at the meeting. This represented approximately 77% of the Company’s outstanding shares.
The proposal to amend Article III, Section 2 of the Company’s bylaws, effectively eliminating the classified board structure of BB&T’s Board of Directors, was approved with 401,413,392 shares voting for, 6,740,644 shares voting against, and 4,765,894 shares abstaining.
The proposal to amend Article III, Section 2 of the Company’s bylaws, effectively eliminating the requirement that the Board of Directors possess the qualifications required for national bank directors under federal law and regulation, was approved with 400,086,360 shares voting for, 7,505,897 shares voting against, and 5,327,672 shares abstaining.
The individuals named below were re-elected to serve as directors of the Corporation for a one-year term expiring in 2007:
The proposal to re-approve the Company’s short-term incentive plan was approved, with 394,959,118 shares voting for, 12,487,935 shares voting against, and 5,472,872 shares abstaining.
The proposal to ratify the reappointment of PricewaterhouseCoopers LLP as the Company’s independent registered public accounting firm was approved, with 405,355,824 shares voting for, 2,533,177 shares voting against, and 3,789,903 shares abstaining.
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Item 6. Exhibits
Statement re Computation of Earnings Per Share.
Statement re Computation of Ratios.
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
Chief Executive Officer Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Chief Financial Officer Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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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EXHIBIT INDEX
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