UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2008
OR
For the transition period from to
COMMISSION FILE NUMBER 001-12307
ZIONS BANCORPORATION
(Exact name of registrant as specified in its charter)
UTAH
87-0227400
(State or other jurisdiction
of incorporation or organization)
(I.R.S. Employer
Identification No.)
ONE SOUTH MAIN, 15TH FLOOR
SALT LAKE CITY, UTAH
84133
Registrant’s telephone number, including area code: (801) 524-4787
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
ZIONS BANCORPORATION AND SUBSIDIARIES
INDEX
Financial Statements (Unaudited)
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive Income
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Quantitative and Qualitative Disclosures About Market Risk
Controls and Procedures
Legal Proceedings
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Exhibits
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (Unaudited)
CONSOLIDATED BALANCE SHEETS
ASSETS
Cash and due from banks
Money market investments:
Interest-bearing deposits and commercial paper
Federal funds sold
Security resell agreements
Investment securities:
Held-to-maturity, at adjusted cost (approximate fair value $1,587,006, $702,148 and $686,026)
Available-for-sale, at fair value
Trading account, at fair value (includes $531, $741 and $22 transferred as collateral under repurchase agreements)
Loans:
Loans held for sale
Loans and leases
Less:
Unearned income and fees, net of related costs
Allowance for loan losses
Loans and leases, net of allowance
Other noninterest-bearing investments
Premises and equipment, net
Goodwill
Core deposit and other intangibles
Other real estate owned
Other assets
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing demand
Interest-bearing:
Savings and NOW
Money market
Internet money market
Time under $100,000
Time $100,000 and over
Foreign
Securities sold, not yet purchased
Federal funds purchased
Security repurchase agreements
Other liabilities
Commercial paper
Federal Home Loan Bank advances and other borrowings:
One year or less
Over one year
Long-term debt
Total liabilities
Minority interest
Shareholders’ equity:
Capital stock:
Preferred stock, without par value, authorized 3,000,000 shares:
Series A and C (liquidation preference $1,000 per share); issued and outstanding 240,000 and 46,949 shares
Common stock, without par value; authorized 350,000,000 shares; issued and outstanding 115,302,598, 107,116,505 and 106,934,360 shares
Retained earnings
Accumulated other comprehensive income (loss)
Deferred compensation
Total shareholders’ equity
See accompanying notes to consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
Interest income:
Interest and fees on loans
Interest on loans held for sale
Lease financing
Interest on money market investments
Interest on securities:
Held-to-maturity – taxable
Held-to-maturity – nontaxable
Available-for-sale – taxable
Available-for-sale – nontaxable
Trading account
Total interest income
Interest expense:
Interest on savings and money market deposits
Interest on time and foreign deposits
Interest on short-term borrowings
Interest on long-term borrowings
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
Noninterest income:
Service charges and fees on deposit accounts
Other service charges, commissions and fees
Trust and wealth management income
Capital markets and foreign exchange
Dividends and other investment income
Loan sales and servicing income
Income from securities conduit
Fair value and nonhedge derivative loss
Equity securities gains, net
Fixed income securities gains, net
Impairment losses on investment securities and valuation losses on securities purchased from Lockhart Funding
Other
Total noninterest income
Noninterest expense:
Salaries and employee benefits
Occupancy, net
Furniture and equipment
Legal and professional services
Postage and supplies
Advertising
Impairment losses on long-lived assets
Merger related expense
Amortization of core deposit and other intangibles
Provision (credit) for unfunded lending commitments
Total noninterest expense
Income before income taxes and minority interest
Income taxes
Net income
Preferred stock dividends
Net earnings applicable to common shareholders
Weighted average common shares outstanding during the period:
Basic shares
Diluted shares
Net earnings per common share:
Basic
Diluted
4
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
Common stock
Balance, December 31, 2007
Cumulative effect of change in accounting principle, adoption of SFAS 159
Comprehensive income:
Net income for the period
Other comprehensive loss, net of tax:
Net realized and unrealized holding losses on investments and retained interests
Foreign currency translation
Reclassification for net realized losses on investments recorded in operations
Net unrealized gains on derivative instruments
Pension and postretirement
Other comprehensive loss
Total comprehensive income
Issuance of preferred stock
Issuance of common stock
Stock issued under dividend reinvestment plan
Net stock issued under employee plans and related tax benefits
Dividends declared on preferred stock
Dividends on common stock, $1.29 per share
Change in deferred compensation
Balance, September 30, 2008
Balance, December 31, 2006
Cumulative effect of change in accounting principle, adoption of FIN 48
Reclassification for net realized gains on investments recorded in operations
Common stock issued in acquisition
Stock redeemed and retired
Dividends on common stock, $1.25 per share
Balance, September 30, 2007
Total comprehensive income for the three months ended September 30, 2008 and 2007 was $38,780 and $161,658, respectively.
5
CONSOLIDATED STATEMENTS OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities:
Impairment and valuation losses on investment securities and long-lived assets
Depreciation of premises and equipment
Amortization
Deferred income tax benefit
Share-based compensation
Common stock issued for 401(k) employer match
Excess tax benefits from share-based compensation
Gain (loss) allocated to minority interest
Net decrease (increase) in trading securities
Principal payments on and proceeds from sales of loans held for sale
Additions to loans held for sale
Net losses (gains) on sales of loans, leases and other assets
Income from increase in cash surrender value of bank-owned life insurance
Change in accrued income taxes
Change in accrued interest receivable
Change in other assets
Change in other liabilities
Change in accrued interest payable
Other, net
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES:
Net decrease (increase) in money market investments
Proceeds from maturities of investment securities held-to-maturity
Purchases of investment securities held-to-maturity
Proceeds from sales of investment securities available-for-sale
Proceeds from maturities of investment securities available-for-sale
Purchases of investment securities available-for-sale
Proceeds from sales of loans and leases
Securitized loans purchased
Net increase in loans and leases
Net decrease (increase) in other noninterest-bearing investments
Proceeds from sales of premises and equipment and other assets
Purchases of premises and equipment
Proceeds from sales of other real estate owned
Net cash received from (paid for) acquisitions
Net cash received from sale of subsidiary
Net cash provided by (used in) investing activities
6
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase (decrease) in deposits
Net change in short-term funds borrowed
Proceeds from FHLB advances and other borrowings over one year
Payments on FHLB advances and other borrowings over one year
Proceeds from issuance of long-term debt
Debt issuance costs
Payments on long-term debt
Proceeds from issuance of preferred stock
Proceeds from issuance of common stock
Payments to redeem common stock
Dividends paid on preferred stock
Dividends paid on common stock
Net cash provided by (used in) financing activities
Net decrease in cash and due from banks
Cash and due from banks at beginning of period
Cash and due from banks at end of period
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for:
Interest
Noncash items:
Investment securities available-for-sale transferred to investment securities held-to-maturity
Loans transferred to other real estate owned
Acquisitions:
Common stock issued
Assets acquired
Liabilities assumed
7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2008
1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of Zions Bancorporation (“the Parent”) and its majority-owned subsidiaries (collectively “the Company,” “Zions,” “we,” “our,” “us”) have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Certain prior period amounts have been reclassified to conform to the current period presentation. These reclassifications did not affect net income or shareholders’ equity.
Operating results for the three- and nine-month periods ended September 30, 2008 are not necessarily indicative of the results that may be expected in future periods. The consolidated balance sheet at December 31, 2007 is from the audited financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
The Company provides a full range of banking and related services through banking subsidiaries in ten Western and Southwestern states as follows: Zions First National Bank (“Zions Bank”), in Utah and Idaho; California Bank & Trust (“CB&T”); Amegy Corporation (“Amegy”) and its subsidiary, Amegy Bank, in Texas; National Bank of Arizona (“NBA”); Nevada State Bank (“NSB”); Vectra Bank Colorado (“Vectra”), in Colorado and New Mexico; The Commerce Bank of Washington (“TCBW”); and The Commerce Bank of Oregon (“TCBO”). The Parent also owns and operates certain nonbank subsidiaries that engage in the development and sale of financial technologies and related services.
2. CERTAIN RECENT ACCOUNTING PRONOUNCEMENTS
In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133. SFAS 161, among other things, requires greater transparency in disclosing information about derivatives including the objectives for their use, the volume of derivative activity, tabular disclosure of financial statement amounts, and any credit-risk-related features. The Statement is effective for annual and interim financial statements beginning after November 15, 2008. Earlier application is encouraged but not required. Management is evaluating the impact this Statement may have on the Company’s financial statements.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations, and SFAS No. 160,Accounting and Reporting of Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51. These new standards will significantly change the financial accounting and reporting of business combination transactions and noncontrolling (or minority) interests in consolidated financial statements. Both Statements are effective for annual and interim financial statements beginning on or after December 15, 2008. Generally, adoption is prospective and early adoption is prohibited. Management is evaluating the impact these Statements may have on the Company’s financial statements.
8
Effective January 1, 2008, we adopted the provisions of FASB Staff Position (“FSP”) FIN 39-1, Offsetting of Amounts Related to Certain Contracts. FSP FIN 39-1 permits entities to offset fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) against recognized fair value amounts of derivatives executed with the same counterparty under a master netting arrangement. At September 30, 2008, cash collateral was used to reduce recorded amounts of derivative assets by approximately $69 million. The reduction of derivative liabilities was insignificant.
Additional accounting pronouncements recently adopted are discussed where applicable in the Notes to Consolidated Financial Statements.
3. ACQUISITION
Effective September 5, 2008, the Company acquired from the FDIC the insured deposits and certain assets of the failed Silver State Bank, headquartered in Henderson, Nevada. The acquisition was made through the Company’s Nevada State Bank and National Bank of Arizona subsidiaries and included approximately $737 million of deposits and $66 million of assets.
4. INVESTMENT SECURITIES
As a result of an ongoing valuation review of our investment securities portfolio, we recognized a pretax charge of approximately $28.0 million during the third quarter of 2008 for certain investment securities deemed to have other-than-temporary impairment (“OTTI”). Details of this OTTI are as follows:
$19.2 million for three bank and insurance trust preferred collateralized debt obligations (“CDOs”)
$1.3 million for two bank and insurance income notes (OTTI also taken previously)
$4.1 million for three trust preferred CDOs related to real estate investment trusts (“REITs”) (OTTI also taken previously)
$3.4 million for two structured asset-backed (“ABS”) CDOs
For the first nine months of 2008, total OTTI was $107.6 million. As discussed in Note 5, valuation losses on securities purchased from Lockhart Funding, LLC (“Lockhart”) during the first quarter of 2008 were $5.2 million. The total of these amounts comprises the “Impairment losses on investment securities and valuation losses on securities purchased from Lockhart Funding” in the statement of income for the first nine months of 2008.
During the second quarter of 2008, we reassessed the classification of certain asset-backed and trust preferred CDOs. On April 28, 2008, we reclassified approximately $1.2 billion at fair value of these available-for-sale (“AFS”) securities to held-to-maturity (“HTM”). The related unrealized pretax loss of approximately $273 million included in accumulated other comprehensive income (“OCI”) remained in OCI and is being amortized as a yield adjustment through earnings over the remaining terms of the securities. No gain or loss was recognized at the time of reclassification. We consider the HTM classification to be more appropriate because we have the ability and the intent to hold these securities to maturity.
At September 30, 2008, unrealized pretax losses recognized in OCI were $248.5 million for HTM securities and $145.8 million for AFS securities.
9
5. OFF-BALANCE SHEET ARRANGEMENT
Zions Bank provides a liquidity facility for a fee to Lockhart, which is an off-balance sheet qualifying special-purpose entity (“QSPE”) securities conduit. Lockhart was structured to purchase floating rate U.S. Government and AAA-rated securities with funds from the issuance of asset-backed commercial paper. Zions Bank also provides interest rate hedging support and administrative and investment advisory services for a fee.
Pursuant to the Liquidity Agreement, Zions Bank is required to purchase nondefaulted securities from Lockhart to provide funds for Lockhart to repay maturing commercial paper upon Lockhart’s inability to access a sufficient amount of funding in the commercial paper market, or upon a commercial paper market disruption as specified in governing documents for Lockhart. Pursuant to the governing documents, including the Liquidity Agreement, if any security in Lockhart is downgraded below AA-, or the downgrade of one or more securities results in more than ten securities having ratings of AA+ to AA-, Zions Bank must either 1) place its letter of credit on the security, 2) obtain credit enhancement from a third party, or 3) purchase the security from Lockhart at book value. Zions Bank may incur losses if it is required to purchase securities from Lockhart when the fair value of the securities at the time of purchase is less than book value.
During the first and second quarters of 2008, Zions Bank purchased an aggregate of $1,067 million of securities and related accrued interest at book value from Lockhart. Of these purchases, $792 million were required by the Liquidity Agreement when the securities, and MBIA Inc. which insured certain of the securities, were downgraded below AA-. The remaining $275 million were due to the inability of Lockhart to issue a sufficient amount of commercial paper.
The securities purchased included $987 million which comprised the entire remaining small business loan securitizations created by Zions Bank and held by Lockhart. No gain or loss was recognized on these purchases. Upon dissolution of the securitization trusts (including a total of $170 million of related securities owned by the Parent), Zions Bank recorded $1,180 million of loans on its balance sheet including $23 million of premium. See further discussion of this premium in Note 9.
The commitment of Zions Bank to Lockhart cannot exceed the book value of Lockhart’s securities portfolio, which was approximately $828 million at September 30, 2008. Lockhart is limited in size by program agreements, agreements with rating agencies, and the size of the liquidity facility. The book value of Lockhart’s remaining securities portfolio exceeded the fair value of the securities by approximately $110 million at September 30, 2008. During the first quarter of 2008, Zions Bank recorded valuation losses of approximately $5.2 million when it purchased certain securities from Lockhart.
As permitted by the governing documents, the Company has also purchased asset-backed commercial paper from Lockhart and held approximately $557 million on its balance sheet at September 30, 2008. The average amount of Lockhart commercial paper included in money market investments for the three months ended September 30, 2008 was approximately $597 million. These purchases were made to provide liquidity to Lockhart due to ongoing contraction and disruptions in the asset-backed commercial paper markets. If at any given time the Company were to own more than 90% of Lockhart’s outstanding commercial paper (beneficial interest), Lockhart would cease to be a QSPE and the Company would be required to consolidate Lockhart in its financial statements.
On September 15, 2008, the FASB issued a proposed amendment, Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140, that among other things, would remove the concept of a QSPE and remove the exception from applying FIN 46R to QSPEs. The proposed amendment would be effective for calendar-year companies beginning in 2010. Management is monitoring these developments as they relate to the operations and existence of Lockhart.
10
6. DEBT
During the third quarter and first nine months of 2008, the Company issued a net amount of $28.5 million and $261.3 million, respectively, of one- and two-year senior medium-term notes at coupon rates ranging from 4.50% to 5.65%. Interest is payable semiannually. These unsecured notes were sold via Zions’ online auction process and direct sales. They were issued under the Company’s existing shelf registration with the Securities and Exchange Commission (“SEC”).
The Company repaid senior medium-term notes of $137 million and $155 million during the third quarter and first nine months of 2008, respectively.
7. INCOME TAXES
The lower effective tax rate during the third quarter of 2008 is mainly due to lower taxable income in 2008, which increased the proportion of nontaxable income relative to total income. Income tax expense for the first nine months of 2008 included a net benefit of approximately $5.3 million primarily from a settlement with governmental authorities during the second quarter that allowed the Company to reduce its liability and related interest for uncertain tax positions under the provisions of FIN 48.
11
8. SHAREHOLDERS’ EQUITY
Changes in accumulated other comprehensive income (loss) are summarized as follows (in thousands):
Nine Months Ended September 30, 2008:
Other comprehensive income (loss), net of tax:
Net realized and unrealized holding losses, net of income tax benefit of $130,611
Reclassification for net realized losses recorded in operations, net of income tax benefit of $41,582
Net unrealized gains, net of reclassification to operations of $40,219 and income tax expense of $20,927
Pension and postretirement, net of income tax expense of $477
Other comprehensive income (loss)
Nine Months Ended September 30, 2007:
Net realized and unrealized holding losses, net of income tax benefit of $30,562
Reclassification for net realized gains recorded in operations, net of income tax expense of $2,409
Net unrealized gains, net of reclassification to operations of $(33,432) and income tax expense of $27,953
On July 2, 2008, the Company completed a $47 million offering of 9.50% Series C Fixed-Rate Non-Cumulative Perpetual Preferred Stock. The Company issued 46,949 shares in the form of 1,877,971 depositary shares with each depositary share representing a 1/40th ownership interest in a share of the preferred stock. Terms and conditions, except for the dividend amount, are generally similar to the existing issuance of Series A floating rate preferred stock described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. The offering was sold via Zions’ online auction process and direct sales primarily by the Company’s broker/dealer subsidiary.
During September 8-11, 2008, the Company issued $250 million of new common stock consisting of 7,194,079 shares at an average price of $34.75 per share. Net of issuance costs and fees, this issuance added $244.9 million to common shareholders’ equity.
12
On October 27, 2008, the U.S. Department of the Treasury gave preliminary approval to the Company’s application to receive a capital investment of $1.4 billion. The application was made under the Treasury’s Capital Purchase Program announced on October 14, 2008. The capital investment is expected to be received prior to year-end and will be in the form of nonvoting senior preferred shares pari passu with the Company’s existing preferred shares. The Company will also issue to the Treasury warrants exercisable for 10 years to purchase $210 million of the Company’s common shares. The number of common shares issuable under the warrants will be determined from the average share price during a specified 20-day trading period. The preferred shares will qualify for regulatory Tier 1 capital and may be redeemed after three years. They will have a dividend rate of 5% for the first five years, increasing to 9% thereafter. Among other things, the Company will be subject to restrictions and conditions including those related to common dividends, share repurchases, executive compensation, and corporate governance.
9. FAIR VALUE
Effective January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements, and SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. Both Standards address the application of fair value accounting and reporting.
Fair Value Measurements
SFAS 157 defines fair value, establishes a consistent framework for measuring fair value, and enhances disclosures about fair value measurements. In February 2008, the FASB amended SFAS 157 with the issuance of FSP FAS 157-1, which excludes with certain exceptions SFAS No. 13, Accounting for Leases, from the scope of SFAS 157, and FSP FAS 157-2, which delayed the adoption of SFAS 157 for one year for the measurement of nonfinancial assets and nonfinancial liabilities. There was no material effect from the adoption of SFAS 157 on the Company’s consolidated financial statements.
SFAS 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. To measure fair value, SFAS 157 has established a hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs. This hierarchy uses three levels of inputs to measure the fair value of assets and liabilities as follows:
Level 1 – Quoted prices in active markets for identical assets or liabilities; includes certain U.S. Treasury and other U.S. Government and agency securities actively traded in over-the-counter markets; certain securities sold, not yet purchased; and certain derivatives.
Level 2 – Observable inputs other than Level 1 including quoted prices for similar assets or liabilities, quoted prices in less active markets, or other observable inputs that can be corroborated by observable market data; also includes derivative contracts whose value is determined using a pricing model with observable market inputs or can be derived principally from or corroborated by observable market data. This category generally includes certain U.S. Government and agency securities; certain CDO securities; corporate debt securities; certain private equity investments; certain securities sold, not yet purchased; and certain derivatives.
Level 3 – Unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation; also includes observable inputs for nonbinding single dealer quotes not corroborated by observable market data. This category generally includes certain CDO securities, certain private equity investments, and retained interests from securitizations.
13
The Company uses fair value to measure certain assets and liabilities on a recurring basis when fair value is the primary measure for accounting. This is done primarily for available-for-sale and trading investment securities; certain private equity investments; certain retained interests from securitizations; securities sold, not yet purchased; and derivatives. Fair value is used on a nonrecurring basis to measure certain assets when applying lower of cost or market accounting or when adjusting carrying values, such as for loans held for sale, impaired loans, certain private equity investments, and other real estate owned. Fair value is also used when evaluating impairment on certain assets, including held-to-maturity and available-for-sale securities, goodwill, and core deposit and other intangibles, and for annual disclosures required by SFAS No. 107, Disclosures about Fair Value of Financial Instruments.
Available-for-sale and trading investment securities are fair valued under Level 1 using quoted market prices when available for identical securities. When quoted prices are not available, fair values are determined under Level 2 using quoted prices for similar securities or independent pricing services that incorporate observable market data when possible. Available-for-sale securities include certain CDOs that consist of trust preferred securities related to banks and insurance companies and to REITs. Where possible, the fair value of these CDOs is priced under Level 2 using a whole market price quote method that incorporates matrix pricing and uses the prices of securities of similar type and rating to value comparable securities held by the Company. This method is described more fully in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. If sufficient information is not available for matrix pricing, fair value is determined under Level 3 using nonbinding single dealer quotes or the model pricing discussed subsequently.
At September 30, 2008 due to the market conditions subsequently described, the Company determined that certain CDOs with an amortized cost of $1,878 million at September 30, 2008 previously fair valued under a Level 2 matrix approach would be more appropriately fair valued under a Level 3 cash flow modeling approach. Additional securities of $190 million at amortized cost previously fair valued with Level 3 single dealer quotes were also moved to a Level 3 cash flow modeling approach. The total of these amounts, or $2,068 million, included approximately $1,353 million accounted for as HTM securities.
Because of recent market disruptions, particularly during the third quarter of 2008, both the SEC on September 30, 2008 (Release No. 2008-234) and the FASB on October 10, 2008 (FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active) issued additional guidance on fair value accounting when markets become distressed and inactive. In general, this guidance clarifies under such market conditions when and how an entity might appropriately determine fair value using unobservable inputs under Level 3 rather than using observable inputs under Level 2, particularly when significant adjustments become necessary under Level 2 and extensive judgment must be employed to evaluate inputs and results in estimating fair value.
The Company values its CDO portfolio using several methodologies that primarily include internal and third party models and to a lesser extent dealer quotes and pricing services. A licensed model is used internally to fair value bank and insurance trust preferred CDOs. This model uses estimated values of expected losses on underlying collateral and applies market-based discount rates on resultant cash flows to estimate fair value. Third party models are used to fair value certain REIT and ABS CDOs. These models utilize relevant data assumptions, which are evaluated by the Company for reasonableness. These assumptions include but are not limited to probability of default, collateral recovery rates, discount rates, over-collateralization levels, and rating transition probability matrices from rating agencies. The model prices obtained from third party services were evaluated for reasonableness including quarter to quarter changes in assumptions and comparison to other available data which included third party and internal model results and valuations. The Company’s decision to use Level 3 model pricing for certain CDOs was made due to continued trading contraction of these securities and the lack of observable market inputs to value such securities.
14
Private equity investments valued under Level 2 on a recurring basis are investments in partnerships that invest in financial institutions. Fair values are determined from net asset values provided by the partnerships. Private equity investments valued under Level 3 on a nonrecurring basis are recorded initially at acquisition cost, which is considered the best indication of fair value unless there have been significant subsequent positive or negative developments that justify an adjustment in the fair value estimate. Subsequent adjustments to recorded amounts are based as necessary on current and projected financial performance, recent financing activities, economic and market conditions, market comparables, market liquidity, sales restrictions, and other factors.
Retained interests from securitizations are fair valued under Level 3 based on the modeling techniques previously described. The assumptions used in the models are evaluated quarterly.
Derivatives are fair valued primarily under Level 2 using third party services. Observable market inputs include yield curves, option volatilities, counterparty credit risk, and other related data. Certain foreign exchange derivatives have been fair valued under Level 1 because they are traded in active markets. Amounts disclosed in the following table are net of the cash collateral offsets pursuant to the guidance of FSP FIN 39-1, as discussed in Note 2.
Securities sold, not yet purchased are fair valued under Level 1 when quoted prices are available for the securities involved. Those under Level 2 are fair valued similar to trading account investment securities.
Assets and liabilities measured at fair value on a recurring basis, including those elected under SFAS 159, are summarized as follows at September 30, 2008 (in thousands):
Available-for-sale
Other noninterest-bearing investments:
Private equity
Other assets:
Derivatives
LIABILITIES
Other liabilities:
15
The following reconciles the beginning and ending balances of assets and liabilities for the three- and nine-month periods ended September 30, 2008 that are measured at fair value on a recurring basis using Level 3 inputs (in thousands):
Balance at June 30, 2008
Total net gains (losses) included in:
Statement of income (2):
Fair value and nonhedge derivative income (loss)
Impairment losses on available-for sale securities
Other noninterest expense
Purchases, sales, issuances, and settlements, net
Net transfers in (out)
Balance at September 30, 2008
Balance at January 1, 2008
Impairment losses on available-for sale securities and valuation losses on securities purchased from Lockhart Funding
Proceeds from ESOARS auction
Fair value of available-for-sale securities transferred to held-to-maturity
16
Assets measured at fair value on a nonrecurring basis are summarized as follows (in thousands):
Impaired loans
Loans held for sale relate to loans purchased under the Small Business Administration 7(a) program. They are fair valued under Level 2 based on quotes of comparable instruments.
Impaired loans that are collateral-dependent are fair valued under Level 2 based on the fair value of the collateral, which is determined when appropriate from appraisals and other observable market data.
Fair Value Option
SFAS 159 allows for the option to report certain financial assets and liabilities at fair value initially and at subsequent measurement dates with changes in fair value included in earnings. The option may be applied instrument by instrument, but is on an irrevocable basis. As of January 1, 2008, the Company elected the fair value option for one available-for-sale REIT trust preferred CDO security and three retained interests on selected small business loan securitizations. The cumulative effect of adopting SFAS 159 decreased retained earnings at January 1, 2008 by approximately $11.5 million.
The REIT trust preferred CDO was selected as part of a directional hedging program to hedge the credit exposure the Company has to homebuilders in its REIT CDO portfolio. This allows the Company to avoid complex hedge accounting provisions associated with the implemented hedging program. Management selected this security because it had the most exposure to the homebuilder market compared to the other REIT CDOs in the Company’s portfolio, both in dollar amount and as a percentage, and was therefore considered the most suitable for hedging.
The retained interests were selected to more appropriately reflect their fair value and to account for increases and decreases in their fair value through earnings. Net decreases in fair value of approximately $2.1 million during the first and second quarters of 2008 were recognized in fair value and nonhedge derivative income (loss) in the statement of income. However as discussed in Note 5, during the first and second quarters of 2008, Zions Bank purchased securities from Lockhart that comprised the entire remaining small business loan securitizations created by Zions Bank and held by Lockhart. These retained interests related to the securities purchased and, as part of the purchase transaction, were included with the $23 million premium amount recorded with the loan balances at Zions Bank.
17
10. GUARANTEES AND COMMITMENTS
The following are guarantees issued by the Company (in thousands):
Standby letters of credit:
Financial
Performance
The Company’s Annual Report on Form 10-K for the year ended December 31, 2007 contains further information on these letters of credit including their terms and collateral requirements. At September 30, 2008, the carrying value recorded by the Company as a liability for these guarantees was $5.6 million.
As of September 30, 2008, the Parent has guaranteed approximately $300.4 million of debt primarily issued by affiliated trusts issuing trust preferred securities.
During the first quarter of 2008, the Company’s subsidiary banks recorded an aggregate pretax cash gain of approximately $12.4 million from the partial redemption of their equity interests in Visa Inc. The redemption approximated 39% of the subsidiary banks’ equity interests and was included in equity securities gains (losses), net in the statement of income for the nine months ended September 30, 2008. Also during the first quarter of 2008, the Company reversed approximately $5.6 million of the $8.1 million accrual established during the fourth quarter of 2007 for indemnification liabilities related to certain Visa (SM) litigation. The effect of this reversal is included in other noninterest expense in the statement of income for the nine months ended September 30, 2008. In accordance with generally accepted accounting principles and recent guidance from the SEC, the Company’s subsidiary banks have not recognized any value for their remaining investment in Visa.
See Note 5 for a discussion of Zions Bank’s commitment to Lockhart.
11. RETIREMENT PLANS
The following discloses the net periodic benefit cost (credit) and its components for the Company’s pension and postretirement plans (in thousands):
Service cost
Interest cost
Expected return on plan assets
Amortization of prior service cost (credit)
Amortization of transition liability
Settlement gain
Amortization of net actuarial (gain) loss
Net periodic benefit cost (credit)
18
As disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, the Company has frozen its participation and benefit accruals for the pension plan and its contributions for individual benefit payments in the postretirement benefit plan. The settlement gain resulted from the Company’s curtailment of coverage effective June 1, 2008 for certain participants in the postretirement benefit plan and was accounted for in accordance with applicable accounting standards.
12. OPERATING SEGMENT INFORMATION
We manage our operations and prepare management reports and other information with a primary focus on geographical area. As of September 30, 2008, we operate eight community/regional banks in distinct geographical areas. Performance assessment and resource allocation are based upon this geographical structure. Zions Bank operates 114 branches in Utah and 25 branches in Idaho. CB&T operates 90 branches in California. Amegy operates 87 branches in Texas. NBA operates 78 branches in Arizona. NSB operates 71 branches in Nevada. Vectra operates 40 branches in Colorado and one branch in New Mexico. TCBW operates one branch in the state of Washington. TCBO operates one branch in Oregon. Additionally, Zions Bank, CB&T, Amegy, NBA, Vectra, and TCBW each operate a foreign branch in the Grand Cayman Islands. NSB has an application pending to open a foreign branch. In addition, as of September 30, 2008, NBA operated 4 branches and NSB operated 13 branches from the failed Silver State Bank, which the Company acquired as discussed in Note 3. Subsequent to September 30, 2008, NBA and NSB closed certain of these branches and are still determining which of the remaining branches will continue to be operated.
On September 15, 2008, the Company announced it had entered into a definitive agreement to exit 49 grocery store branches (28 in Nevada and 21 in Utah). The leases on these branches are being assumed by another bank; however, all loans and deposits will be transferred to nearby Company branch locations. In connection with this transaction, the Company recorded $2.2 million in impairment losses on the associated leasehold improvements. The amount is separately reflected as impairment losses on long-lived assets in the statement of income.
The operating segment identified as “Other” includes the Parent, Zions Management Services Company (“ZMSC”), certain nonbank financial service and financial technology subsidiaries, other smaller nonbank operating units, TCBO, and eliminations of transactions between segments. ZMSC provides internal technology and operational services to affiliated operating businesses of the Company. ZMSC charges most of its costs to the affiliates on an approximate break-even basis.
The accounting policies of the individual operating segments are the same as those of the Company. Transactions between operating segments are primarily conducted at fair value, resulting in profits that are eliminated for reporting consolidated results of operations. Operating segments pay for centrally provided services based upon estimated or actual usage of those services.
19
The following table presents selected operating segment information for the three months ended September 30, 2008 and 2007:
CONDENSED INCOME STATEMENT
Impairment losses on investment securities
Other noninterest income
Noninterest expense
Income (loss) before income taxes and minority interest
Income taxes (benefit)
Net income (loss)
Preferred stock dividend
AVERAGE BALANCE SHEET DATA
Total assets
Net loans and leases
Total deposits
Shareholder’s equity:
Preferred equity
Common equity
Total shareholder’s equity
20
The following table presents selected operating segment information for the nine months ended September 30, 2008 and 2007:
21
FINANCIAL HIGHLIGHTS
EARNINGS
Taxable-equivalent net interest income
Taxable-equivalent revenue
Noninterest income
PER COMMON SHARE
Net earnings (diluted)
Dividends
Book value per common share
SELECTED RATIOS
Return on average assets
Return on average common equity
Efficiency ratio
Net interest margin
22
FINANCIAL HIGHLIGHTS (Continued)
AVERAGE BALANCES
Total interest-earning assets
Securities
Core deposits (1)
Weighted average common and common-equivalent shares outstanding
AT PERIOD END
Reserve for unfunded lending commitments
Common shares outstanding
Average equity to average assets
Common dividend payout
Tangible equity ratio
Nonperforming assets
Accruing loans past due 90 days or more
Nonperforming assets to net loans and leases and other real estate owned at period end
23
FORWARD-LOOKING INFORMATION
Statements in Management’s Discussion and Analysis that are based on other than historical data are forward-looking, within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations or forecasts of future events and include, among others:
statements with respect to the beliefs, plans, objectives, goals, guidelines, expectations, anticipations, and future financial condition, results of operations and performance of Zions Bancorporation (“the Parent”) and its subsidiaries (collectively “the Company,” “Zions,” “we,” “our,” “us”);
statements preceded by, followed by or that include the words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” “projects,” or similar expressions.
These forward-looking statements are not guarantees of future performance, nor should they be relied upon as representing management’s views as of any subsequent date. Forward-looking statements involve significant risks and uncertainties and actual results may differ materially from those presented, either expressed or implied, in the Management’s Discussion and Analysis. Factors that might cause such differences include, but are not limited to:
the Company’s ability to successfully execute its business plans, manage its risks, and achieve its objectives;
changes in political and economic conditions, including the economic effects of terrorist attacks against the United States and related events;
changes in financial market conditions, either internationally, nationally or locally in areas in which the Company conducts its operations, including without limitation, reduced rates of business formation and growth, commercial and residential real estate development and real estate prices;
fluctuations in markets for equity, fixed-income, commercial paper and other securities, including availability, market liquidity levels, and pricing;
changes in interest rates, the quality and composition of the loan and securities portfolios, demand for loan products, deposit flows and competition;
acquisitions and integration of acquired businesses;
increases in the levels of losses, customer bankruptcies, claims and assessments;
changes in fiscal, monetary, regulatory, trade and tax policies and laws, including policies of the U.S. Department of Treasury and the Federal Reserve Board;
the Company’s participation or lack of participation in governmental programs implemented under the Emergency Economic Stabilization Act, including without limitation the Troubled Asset Relief Program and the Capital Purchase Program, and the impact of such programs and related regulations on the Company and on international, national, and local economic and financial markets and conditions;
continuing consolidation in the financial services industry;
new litigation or changes in existing litigation;
success in gaining regulatory approvals, when required;
changes in consumer spending and savings habits;
increased competitive challenges and expanding product and pricing pressures among financial institutions;
demand for financial services in the Company’s market areas;
inflation and deflation;
technological changes and the Company’s implementation of new technologies;
the Company’s ability to develop and maintain secure and reliable information technology systems;
legislation or regulatory changes which adversely affect the Company’s operations or business;
the Company’s ability to comply with applicable laws and regulations;
24
changes in accounting policies or procedures as may be required by the Financial Accounting Standards Board or regulatory agencies; and
increased costs of deposit insurance and changes with respect to FDIC insurance coverage levels.
Additional factors that could cause actual results to differ materially from those expressed in the forward-looking statements are discussed in the 2007 Annual Report on Form 10-K of Zions Bancorporation filed with the Securities and Exchange Commission (“SEC”) and available at the SEC’s Internet site (http://www.sec.gov).
The Company specifically disclaims any obligation to update any factors or to publicly announce the result of revisions to any of the forward-looking statements included herein to reflect future events or developments.
CRITICAL ACCOUNTING POLICIES AND SIGNIFICANT ESTIMATES
The Company has made no significant changes in its critical accounting policies and significant estimates from those disclosed in its Annual Report on Form 10-K for the year ended December 31, 2007, except as noted below.
Fair Value Accounting
Effective January 1, 2008, the Company adopted SFAS No. 157, Fair Value Measurements and SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS 157 defines fair value, establishes a consistent framework for measuring fair value, and enhances disclosures about fair value measurements. Adoption of SFAS 157 has been delayed one year for the measurement of all nonfinancial assets and nonfinancial liabilities. The adoption of SFAS 157 did not have a material effect on the Company’s consolidated financial statements, but significantly expanded the disclosure requirements for fair value measurements.
Level 2 – Observable inputs other than Level 1 including quoted prices for similar assets or liabilities, quoted prices in less active markets, or other observable inputs that can be corroborated by observable market data; also includes derivative contracts whose value is determined using a pricing model with observable market inputs or can be derived principally from or corroborated by observable market data. This category generally includes certain U.S. Government and agency securities; certain collateralized debt obligations (“CDO”) securities; corporate debt securities; certain private equity investments; certain securities sold, not yet purchased; and certain derivatives.
Level 3 – Unobservable inputs supported by little or no market activity for financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Additionally, observable inputs such as nonbinding single dealer quotes that are not corroborated by observable market data are included in this category. This category generally includes certain private equity investments, retained interests in securitizations, and certain CDO securities.
25
The Company uses models when quotations are not available for certain securities or in markets where trading activity has slowed or ceased. When quotations are not available, and are not provided by third party pricing services, management judgment is necessary to determine fair value. In situations involving management judgment, fair value is determined using discounted cash flow analysis or other valuation models, which incorporate available market information, including appropriate benchmarking to similar instruments, analysis of default and recovery rates, estimation of prepayment characteristics and implied volatilities.
At September 30, 2008, approximately 5.9% of total assets, or $3.2 billion, consisted of financial instruments recorded at fair value on a recurring basis. Approximately 75.6% or $2.4 billion of these financial instruments used valuation methodologies involving market-based or market-derived information, collectively Level 1 and 2 measurements, to measure fair value. Approximately 24.4% or $772 million of these financial assets are measured using model-based techniques or nonbinding single dealer quotes, both of which constitute Level 3 measurements. At September 30, 2008, approximately 0.40% of total liabilities, or $196 million, consisted of financial instruments recorded at fair value on a recurring basis. At September 30, 2008, approximately 0.52% of total assets, or $281 million of financial assets were valued on a nonrecurring basis. Of the $281 million of assets valued on a nonrecurring basis, approximately $217 million were valued at Level 2 and $64 million were valued at Level 3.
SFAS 159 allows for the option to report certain financial assets and liabilities at fair value initially and at subsequent measurement dates with changes in fair value included in earnings. The option may be applied instrument by instrument, but is on an irrevocable basis. On January 1, 2008, the Company applied the fair value option to one available-for-sale real estate investment trust (“REIT”) trust preferred CDO security and three retained interests on selected small business loan securitizations. The REIT CDO and retained interests were valued using Level 3 models. The cumulative effect of adopting SFAS 159 reduced the beginning balance of retained earnings at January 1, 2008 by approximately $11.5 million, comprised of a decrease of $11.7 million for the REIT CDO and an increase of $0.2 million for the three retained interests. During the third quarter of 2008, the net change in fair value for the REIT CDO decreased pretax earnings by approximately $0.3 million. During the first nine months of 2008, the net change in fair value decreased pretax earnings by approximately $4.8 million, consisting of $2.7 million for the REIT CDO security and $2.1 million for the retained interests. These adjustments to fair value are included in fair value and nonhedge derivative income (loss) in the statement of income.
The Company elected the fair value option for the REIT CDO security as part of a directional hedging program in an effort to hedge the credit exposure the Company has to homebuilders in its REIT CDO portfolio. Management selected this security because it had the most exposure to the homebuilder market compared to the other REIT CDO securities in the Company’s portfolio, both in dollar amount and as a percentage, and was therefore considered the most suitable for hedging. The fair value option adoption for the REIT CDO allows the Company to avoid the complex hedge accounting provisions under SFAS No. 133, Accounting for Derivatives, associated with the implemented hedging program.
On June 23, 2008, Zions Bank purchased $787 million of securities from Lockhart, which comprised the entire remaining small business loan securitizations created by Zions Bank and held by Lockhart. As a result, the three small business securitization retained interests elected under the fair value option were included in this transaction and were part of the premium amount recorded with the loan balances at Zions Bank. See “Off-Balance Sheet Arrangement” for further discussion of these securities purchased.
26
Estimates of Fair Value
The Company measures or monitors many of its assets and liabilities on a fair value basis. Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Examples of these include derivative instruments, available-for-sale and trading securities, certain private equity investments and certain residual interests from Company-sponsored securitizations. Additionally, fair value is used on a nonrecurring basis to evaluate assets or liabilities for impairment or for disclosure purposes in accordance with SFAS No. 107, Disclosures about Fair Value of Financial Instruments. Examples of these nonrecurring uses of fair value include loans held for sale accounted for at the lower of cost or fair value, certain private equity investments, impaired loans, long-lived assets, goodwill, and core deposit and other intangible assets. Depending on the nature of the asset or liability, the Company uses various valuation techniques and assumptions when estimating the instrument’s fair value. These valuation techniques and assumptions are in accordance with SFAS 157.
Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. If observable market prices are not available, then fair value is estimated using modeling techniques such as discounted cash flow analyses. These modeling techniques utilize assumptions that market participants would use in pricing the asset or the liability, including assumptions about the risk inherent in a particular valuation technique, the effect of a restriction on the sale or use of an asset, and the risk of nonperformance. To increase consistency and comparability in fair value measures, SFAS 157 established a three-level hierarchy to prioritize the inputs used in valuation techniques between observable inputs that reflect quoted prices in active markets, inputs other than quoted prices with observable market data, and unobservable data such as the Company’s own data or single dealer nonbinding pricing quotes.
Fair values for investment securities, trading assets, and most derivative financial instruments are based on independent, third party market prices, or if identical market prices are not available they are based on the market prices of similar instruments. If market prices of similar instruments are not available, instruments are valued based on the best available data, some of which may not be readily observable in the market. The fair values of loans are typically based on quotes from market participants. The fair values of OREO and other repossessed assets are typically determined based on appraisals by third parties, less estimated selling costs.
Estimates of fair value are also required when performing an impairment analysis of long-lived assets, goodwill, and core deposit and other intangible assets. The Company reviews goodwill for impairment at the reporting unit level on an annual basis, or more often if events or circumstances indicate the carrying value may not be recoverable. The goodwill impairment test compares the fair value of the reporting unit with its carrying value. If the carrying amount of the Company’s investment in the reporting unit exceeds its fair value, an additional analysis must be performed to determine the amount, if any, by which goodwill is impaired. In determining the fair value of the Company’s reporting units, management uses discounted cash flow models which require assumptions about growth rates of the reporting units and the cost of equity. To the extent that adequate data is available, other valuation techniques relying on market data may be incorporated into the estimate of a reporting unit’s fair value. The selection and weighting of the various fair value techniques may result in a higher or lower fair value. Judgment is applied in determining the amount that is most representative of fair value. For long-lived assets and intangible assets subject to amortization, an impairment loss is recognized if the carrying amount of the asset is not recoverable and exceeds its fair value. In determining the fair value, management uses models which require assumptions about growth rates, the life of the asset, and/or the fair value of the assets. The Company tests long-lived assets for impairment whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable.
Valuation of Collateralized Debt Obligations
The Company values CDO available-for-sale and held-to-maturity securities using several methodologies based on the appropriate fair value hierarchy consistent with current available market information. At September 30, 2008, the Company valued substantially all of the CDO portfolio using Level 3 pricing methods as follows:
27
Trust preferred securities – bankand insurance:
Internal model
Third party models
Dealer quotes
Level 2
Trust preferred securities – realestate investment trusts:
Small business loan-backed:
Other:
Monoline CDS spreads
Total
Internal Model
At September 30, 2008, the Company determined that the $1,878 million of bank and insurance trust preferred securities at amortized cost that had previously been valued using a Level 2 matrix pricing approach would require a Level 3 cash flow modeling approach. An additional $190 million of securities at amortized cost previously valued with Level 3 single dealer quotes were also moved to a Level 3 cash flow modeling approach. Four market developments in the bank and insurance trust preferred asset class led management to this determination.
Market activity in the sector became increasingly illiquid, disordered and dominated by if not limited to forced sellers. Substantiating actual trading levels and the “willingness” of sellers executing at certain levels became increasingly difficult. The determination of inactivity/ illiquidity was based on discussion with dealers and CDO managers specializing in the sector as well as a review of bid lists, execution levels of forced trades, and any other information available on trades.
Secondly, bank failures and announced deferrals of interest payments on trust preferred securities contained within the CDOs impacted differently each tranche of each CDO held. Each tranche is unique in the amount of performing, deferring and defaulting collateral, remaining collateral quality and waterfall mechanics.
Thirdly, rating agency watch listing and downgrading of CDO tranches occurred in July and August. S&P, Moody’s and Fitch are reassessing their ratings model assumptions. This resulted in an increasing lack of consistency in rating levels for CDO tranches. The matrix pricing methodology used from September 2007 to June of 2008 was dependent on securities being substantially similar. In management’s judgment, an operational definition of “substantially similar” securities capable of supporting the requirements of Level 2 pricing could no longer be created without the addition of significant adjustments based on unobservable inputs.
28
Finally, a joint statement of the SEC Office of the Chief Accountant and the FASB staff on September 30, 2008 and FASB’s October 10, 2008 issuance of FSP FAS 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active, provided additional guidance on determining fair value of financial assets when the market for such assets is not active. These statements clarified when and how an entity might, given an inactive market, appropriately determine that the use of an income approach valuation technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs may be equally or more representative of fair value than a market approach valuation.
The Company uses a licensed internal model to value substantially all bank and insurance trust preferred CDOs. The model uses market-based estimates of expected loss for the individual pieces of underlying collateral to arrive at a pool-level expected loss rate for each CDO. These loss assumptions are applied to the CDO’s structure to generate cash flow projections for each tranche of the CDO. The fair value of each tranche is determined by discounting its resultant loss-adjusted cash flows with appropriate market based discount rates. At September 30, 2008, the discount rate primarily referenced current collateralized loan obligation spreads obtained from a third party.
The method for deriving loss expectation for collateral underlying the CDOs depends on whether the collateral is from a public or private company. For public companies, a term structure of Probabilities of Default (“PDs”) is obtained from a commercially available service. The service estimates PDs using a proprietary reduced form model derived using logistic regression on a historical default database. Because the service’s model requires equity valuation related inputs (along with other macro and firm specific inputs) to produce default probabilities, the service does not produce results for private firms and some very small public firms that do not have readily available data.
For private companies (and the few small public companies not evaluated by the service) PDs are estimated based on credit ratings. The credit ratings come from two external rating sources; one specific to banks, and the other to insurers. The Company has credit ratings for each piece of collateral whether private or public. Using the PD data on the public companies obtained from the commercial service, the Company calculates the average PD for each credit rating level by industry. The rating level average is then applied to all corresponding credits within each rating level that do not have a PD from the commercial service.
The PDs for the underlying collateral are then used to develop CDO deal-level expected loss curves. An external service which models the unique cash-flow waterfall and structure of each CDO deal is used to generate tranche-level cash flows using the Company’s derived CDO deal-level loss assumptions (along with other relevant assumptions). The resultant cash-flows are discounted using current market spreads approximated from related structured product markets. The discount rate assumption includes both credit and liquidity components.
The Company did find evidence of one forced trade during the third quarter in a tranche of a CDO that is owned by the Company. The forced trade occurred at a price of 35% of face value. This particular CDO had amortized down considerably from issuance and the tranche was currently the most senior in the CDO. At the time of the trade the underlying collateral consisted of only five bank obligations and a Freddie Mac zero-coupon principal-only security strip due 2031. Two of the five bank obligations were from Wells Fargo Corporation, which also has publicly available secondary market trading levels on a similar public trust preferred issuance. Even under the assumption that all three of the non-Wells Fargo obligations in the CDO immediately defaulted with no recovery, the projected tranche cash-flows, discounted at the yield of the public Wells Fargo trust preferred issue, resulted in a value of 68% of face value. Based on this analysis, the observed trade at 35% does not reflect the level at which an informed market participant would value the security. As a comparison, the Company’s model produced a price of 58%. The Company feels that the difference between the model price of 58% and the above outlined scenario price of 68% reflects an appropriate liquidity discount given the lack of activity in CDO markets compared to publicly traded trust preferred markets.
29
The following schedule sets forth the sensitivity of the current CDO fair values using an internal model to changes in the most significant assumptions utilized in the model:
SENSITIVITY OF BANK AND INSURANCE CDO VALUATIONS TO ADVERSE
CHANGES OF CURRENT MODEL KEY VALUATION ASSUMPTIONS
Fair value balance at September 30, 2008
Expected cumulative credit losses (1)
Weighted average:
1-year
5-year
30-year
Increase (decrease) in fair value due to adverse change
Discount rate (2)
Weighted average spread
Decrease in fair value due to adverse change
The AFS portfolio is composed primarily of more senior CDO tranches. In general these senior tranches receive accelerated principal payments under scenarios of high credit losses provided that the credit losses do not exceed the available subordination in the CDO deal. Therefore, under 25% and 50% higher credit losses the value of the AFS portfolio increases. By contrast more junior tranches which are in our HTM portfolio absorb credit losses and defer principal and interest payments and thus decrease in value.
Third Party Models
At September 30, 2008, the Company utilized third party valuation services for 18 securities with an aggregate amortized cost of $171 million in the ABS CDO and trust preferred asset classes. These securities continued to have insufficient observable market data available to directly determine prices. The Company reviewed the methodologies employed by third party models. This included a review of all relevant data inputs and the appropriateness of key model assumptions. These assumptions included, but were not limited to, probability of default, collateral recovery rates, discount rates, over-collateralization levels, and rating transition probability matrices from rating agencies. The model valuations obtained from third party services were evaluated for reasonableness including quarter to quarter changes in assumptions and comparison to other available data which included third party and internal model results and valuations. A range of value estimates is not provided because third party vendors utilized point estimates.
30
Dealer Quotes
The $63 million of asset backed securities at amortized cost are valued using nonbinding and unadjusted dealer quotes. Multiple quotes are not available and the values provided are based on a combination of proprietary dealer quotes. Broker disclosure levels vary and the Company seeks to minimize dependence on this Level 3 source. Of the $63 million of securities, $42 million are AAA rated.
Monoline CDS Spreads
A total of $48 million at amortized cost of AA rated AMBAC insured securities purchased out of Lockhart Funding were valued using AMBAC credit derivative levels.
See Note 9 of the Notes to Consolidated Financial Statements and “Investment Securities Portfolio” for further information.
Derivative Financial Instruments Fair Value Accounting
The Company uses interest rate swaps and options to manage its interest rate risk. Additionally, the Company executes derivative instruments, including interest rate swaps and options, forward currency exchange contracts, and energy commodity swaps, with commercial banking customers to facilitate their respective risk management strategies. Those derivatives are immediately hedged by offsetting derivative contracts, such that the Company minimizes its net risk exposure resulting from such transactions. When quoted market prices are not available, the valuation of derivative instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves, foreign exchange rates, and implied volatilities. The Company does not use credit default swaps in its investment or hedging operations.
Derivative contracts can be exchange-traded or over-the-counter (“OTC”). The Company’s exchange-traded derivatives consist of forward currency exchange contracts, which are part of the Company’s services provided to commercial customers. Exchange-traded derivatives are classified as Level 1 in the fair value hierarchy, as the values of these derivatives are obtained from quoted prices in active markets for identical contracts.
The Company’s OTC derivatives consist of interest rate swaps and options, as well as energy commodity derivatives for customers. The Company has classified its OTC derivatives in Level 2 of the fair value hierarchy, as the significant inputs to the overall valuations are based on market-observable data or information derived from or corroborated by market-observable data, including market-based inputs to models, model calibration to market-clearing transactions, broker or dealer quotations, or alternative pricing sources with reasonable levels of price transparency. Where models are used, the selection of a particular model to value an OTC derivative depends upon the contractual terms of, and specific risks inherent in, the instrument as well as the availability of pricing information in the market. The Company generally uses similar models to value similar instruments. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, and correlations of such inputs. For OTC derivatives that trade in liquid markets, such as generic forwards, swaps and options, model inputs can generally be verified and model selection does not involve significant management judgment.
To comply with the provisions of SFAS No. 157, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements of its OTC derivatives. The credit valuation adjustments are calculated by determining the total expected exposure of the derivatives (the current plus potential future exposure) and then applying each counterparty’s credit spread to the applicable exposure. In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings, counterparty credit rating thresholds, mutual puts, and guarantees. Additionally, the Company actively monitors counterparty credit ratings for significant changes. The income statement impact of nonperformance risk included in the fair value of OTC derivatives is approximately $1.6 million in noninterest income for the first nine months of 2008.
31
Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties. However, as of September 30, 2008, the Company has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives. As a result, the Company has classified its OTC derivative valuations in Level 2 of the fair value hierarchy.
When appropriate, valuations are also adjusted for various factors such as liquidity, bid/offer spreads and credit considerations. Such adjustments are generally based on available market evidence. In the absence of such evidence, management’s best estimate is used.
RESULTS OF OPERATIONS
The Company reported net earnings applicable to common shareholders of $33.4 million or $0.31 per diluted share for the third quarter of 2008 compared with $132.0 million or $1.22 per diluted share for the third quarter of 2007. The decrease is mainly due to a $101.3 million increase in the provision for loan losses, a $17.0 million decrease in the fair value and interest on nonhedge derivatives due to decreasing spreads between the London Interbank Offer Rate (“LIBOR”) and prime rates, and $28.0 million of impairment losses on investment securities recognized during the third quarter of 2008.
The annualized return on average assets was 0.28% for the third quarter of 2008 and 1.10% for the third quarter of 2007. For the same comparative periods, the annualized return on average common equity was 2.59% compared to 10.50%. The efficiency ratio for the third quarter of 2008 was 63.4% compared to 56.0% for the third quarter of 2007.
Net earnings applicable to common shareholders for the first nine months of 2008 were $207.4 million or $1.93 per diluted share, compared to $437.2 million or $4.01 per diluted share for the first nine months of 2007. The decrease reflects a $280.9 million increase in the provision for loan losses and $112.8 million of impairment losses on investment securities and valuation losses on securities purchased from Lockhart.
The annualized return on average assets was 0.54% for the first nine months of 2008 compared to 1.24% for the first nine months of 2007. For the same comparative periods, the annualized return on average common equity was 5.42% compared to 11.74%. The efficiency ratio for the first nine months of 2008 was 61.4% compared to 56.7% for the same period in 2007.
Net Interest Income, Margin and Interest Rate Spreads
Taxable-equivalent net interest income for the third quarter of 2008 increased 3.0% to $497.8 million compared with $483.1 million for the comparable period of 2007. This growth reflects the significant increase in earning assets driven by loan growth the last three months of 2007 and the first nine months of 2008. The tax rate used for calculating all taxable-equivalent adjustments was 35% for all periods presented.
The Company’s net interest margin was 4.13% for the third quarter of 2008 compared to 4.18% for the second quarter of 2008 and 4.44% for third quarter of 2007. The margin decrease for the third quarter of 2008 compared to the second quarter of 2008 primarily resulted from lower average asset yields driven by the increase in nonperforming assets during the quarter and increased money market deposit rates. The margin
32
decrease for the third quarter of 2008 compared to the third quarter of 2007 resulted from a decline in noninterest-bearing demand deposits, increased reliance on nondeposit borrowings to fund loan growth and asset-backed commercial paper purchased from Lockhart, and also from increased nonperforming assets. We expect that the net interest margin will continue to be under pressure in the next few quarters due to the persistence of these factors.
Although deposit rates did decline slightly during the third quarter, competitive pressures on deposit rates may impede our ability to reprice deposits in the future, which may have a negative impact on the net interest margin during future quarters. See “Interest Rate Risk” for further information.
The spread on average interest-bearing funds for the third quarter of 2008 was 3.67%, which decreased from 3.71% for the second quarter of 2008 and increased from 3.55% for the third quarter of 2007. The spread on average interest-bearing funds for 2008 has benefited from improved loan spreads on newly originated and renewed loans; however increased nonperforming assets throughout the year negatively impacted the affect of the aforementioned improved loan spreads.
The Company expects to continue its efforts over the long run to maintain a slightly “asset-sensitive” position with regard to interest rate risk. Our estimates of the Company’s actual rate risk position is highly dependent upon changes in both short-term and long-term interest rates, modeling assumptions, and the actions of competitors and customers in response to those changes.
33
CONSOLIDATED AVERAGE BALANCE SHEETS, YIELDS AND RATES
Money market investments
Securities:
Held-to-maturity
Total securities
Net loans and leases (2)
Total loans and leases
Interest-bearing deposits:
Total interest-bearing deposits
Borrowed funds:
Federal funds purchased and security repurchase agreements
FHLB advances and other borrowings:
Total borrowed funds
Total interest-bearing liabilities
Noninterest-bearing deposits
Total liabilities and shareholders’ equity
Spread on average interest-bearing funds
Taxable-equivalent net interest income and net
yield on interest-earning assets
34
CONSOLIDATED AVERAGE BALANCE SHEETS, YIELDS AND RATES (Continued)
Taxable-equivalent net interest income and net yield on interest-earning assets
35
Provisions for Credit Losses
The provision for loan losses is the amount of expense that, based on our judgment, is required to maintain the allowance for loan losses at an adequate level based upon the inherent risks in the portfolio. The provision for unfunded lending commitments is used to maintain the reserve for unfunded lending commitments at an adequate level. In determining adequate levels of the allowance and reserve, we perform periodic evaluations of the Company’s various portfolios, the levels of actual charge-offs, and statistical trends and other economic factors. See “Credit Risk Management” for more information on how we determine the appropriate level for the allowance for loan and lease losses and the reserve for unfunded lending commitments.
The provision for loan losses for the third quarter of 2008 was $156.6 million compared to $55.4 million for the same period of 2007. On an annualized basis, the provision was 1.49% of average loans for the third quarter of 2008 compared to 0.60% for the third quarter of 2007. Net loan and lease charge-offs increased to $95.3 million in third quarter of 2008 up from $18.1 million in same period of 2007. The increased provision and net charge-offs for the third quarter of 2008 resulted primarily from weakness in residential land acquisition, development and construction loans in the Southwest and Utah and some weakening in commercial loan portfolios. See “Nonperforming Assets” and “Allowance and Reserve for Credit Losses” for further details. The provision for unfunded lending commitments was $(3.3) million for the third quarter of 2008 compared to $0.2 million for the third quarter of 2007. From period to period, the amounts of unfunded lending commitments may be subject to sizeable fluctuation due to changes in the timing and volume of loan originations and fundings, and by changes in the creditworthiness of borrowers with unfunded commitments. The related provision will generally reflect these fluctuations. When combined, the provisions for credit losses for the third quarter of 2008 were $153.3 million compared to $55.5 million for the third quarter of 2007.
The Company’s expectation is that credit conditions will continue to soften in most of our markets. We believe general economic conditions may continue to weaken, impacting commercial borrowers. We expect to continue to build reserves over the next several quarters.
The provision for loan losses for the first nine months of 2008 was $363.1 million, 341.6% higher than the $82.2 million provision for the first nine months of 2007. The increased loan loss provision for the first nine months of 2008 compared to 2007 is primarily the result of weakness in residential land acquisition, development and construction loans as previously described. The provision for unfunded lending commitments was $2.0 million for the first nine months of 2008 compared to $1.7 million for the first nine months of 2007.
Noninterest Income
For the third quarter of 2008, noninterest income decreased 38.5% to $89.6 million compared to $145.8 million for the third quarter of 2007. The decrease is primarily due to $28.0 million of impairment losses on investment securities and an $18.9 million increase in fair value and nonhedge derivative losses during the third quarter of 2008 compared to the third quarter of 2007.
Service charges and fees on deposit accounts increased $6.8 million or 14.4% for the third quarter of 2008 compared to the third quarter of 2007.
Dividends and other investment income decreased 52.2% to $7.0 million for the third quarter of 2008 from $14.7 million for the third quarter of 2007. The decrease is due to an $8.2 million pretax loss on our investment in Farmer Mac due to their losses in securities holdings in Lehman Brothers, Fannie Mae, and Freddie Mac.
Loan sales and servicing income for the third quarter of 2008 decreased $8.0 million or 68.7% compared to the third quarter of 2007. The decreased income is primarily due to the lower amount of sold loans being serviced, which was $0.6 billion at September 30, 2008 compared to $2.0 billion at September 30, 2007.
36
Income from securities conduit decreased $2.9 million or 89.6% for the third quarter of 2008 compared to the third quarter of 2007. This servicing income represents fees we receive from Lockhart and decreased because of the higher cost of asset-backed commercial paper due to disruptions in the commercial paper markets and because of the diminishing size of Lockhart’s securities portfolio. The book value of Lockhart’s securities portfolio declined to $828 million at September 30, 2008 from $2.1 billion at December 31, 2007 and $3.3 billion at September 30, 2007 mainly due to purchases of Lockhart’s securities and also due to principal repayments. We expect that the book value of the Lockhart portfolio will continue to decrease and income from the securities conduit will not be significant. All else being equal, net interest income is increased if and as Lockhart-related assets are brought onto the Company’s balance sheet, roughly offsetting the noninterest income impact.
Fair value and nonhedge derivative loss for the third quarter of 2008 was $26.2 million compared to loss of $9.4 million for the third quarter of 2007. The increased loss is primarily due to decreases in the fair value of nonhedge derivatives resulting from decreasing spreads between LIBOR and prime rates.
Net equity securities gains were $13.0 million for the third quarter of 2008 compared to $11.1 million of gains for the third quarter of 2007. Net gains in the third quarter of 2008 included $5.4 million of net gains on venture capital investments. Net of related minority interest of $3.8 million, income taxes and other expenses, the venture capital gains increased net income for the quarter by approximately $0.8 million. Net gains in the third quarter of 2008 also included a $7.7 million gain on the sale of the Company’s interest in a mutual fund management company.
The Company recognized impairment losses on investment securities of $28.0 million during the third quarter of 2008. These other-than-temporary impairment (“OTTI”) losses were for certain CDOs, including bank and insurance CDOs, ABS CDOs, bank and insurance income notes, and REIT trust preferred CDOs. See “Investment Securities Portfolio” for additional information.
Noninterest income of $273.0 million for the first nine months of 2008 decreased 36.9% from $432.6 million for the first nine months of 2007. Explanations previously provided for the quarterly changes also apply to the year-to-date changes. Additional explanations of variances follow.
Loan sales and servicing income for the first nine months of 2008 decreased $9.9 million or 33.2% compared to the first nine months of 2007. However, the 2007 amount included $9.3 million of impairment charges on retained interests from certain previous loan securitizations. The decreased income in 2008 is primarily due to the lower amount of sold loans being serviced, which was $0.6 billion at September 30, 2008 compared to $2.0 billion at September 30, 2007.
Impairment losses on investment securities and valuation losses on securities purchased from Lockhart for the first nine months of 2008 were $112.8 million. OTTI losses of $107.6 million were for certain CDOs, including bank and insurance CDOs, ABS CDOs, bank and insurance income notes, and REIT trust preferred CDOs. The valuation losses on securities purchased from Lockhart were $5.2 million and were related to fair value adjustments when the securities were purchased at par from Lockhart and recorded on the Company’s balance sheet at fair value. See “Off-Balance Sheet Arrangement” for additional information.
Noninterest Expense
Noninterest expense for the third quarter of 2008 was $372.3 million, an increase of 5.8% from $352.0 million for the third quarter of 2007. The Company’s efficiency ratio for the third quarter of 2008 was 63.4% compared to 56.0% for the third quarter of 2007, mainly reflecting the decrease in noninterest income, as previously discussed.
37
Salaries and employee benefits increased $4.5 million or 2.2% compared to the third quarter of 2007. The increase reflects moderate increases in compensation, partially offset by decreased accruals for long-term incentive and profit sharing plans based upon Company performance.
Occupancy expense increased $3.3 million or 12.3% compared to the third quarter of 2007. The increase includes expenses associated with damage to branches and other facilities caused by Hurricane Ike during the third quarter of 2008.
Impairment losses on long-lived assets were $2.2 million for the third quarter of 2008. The impairment losses were related to impaired leasehold improvements associated with the 49 in-store branches the Company has contracted to exit. Leases on these branches are being assumed by another bank and all loans and deposits will be transferred to nearby Company branch locations. Of the total 49 in-store branches 28 are located in Nevada and the remaining 21 are located in Utah.
Provision for unfunded lending commitments decreased $3.4 million as compared to the third quarter of 2007. The decrease is due in part to a reduction in unfunded lending commitments and improvements in credit quality of unfunded lending commitments.
Other noninterest expense for the third quarter of 2008 increased $17.2 million or 30.5% compared to the third quarter of 2007. The other noninterest expense increase included increased other real estate owned expenses of $6.2 million, increased FDIC assessment fees of $4.3 million, increased credit expenses of $3.4 million and increased Employee Stock Option Appreciation Rights Securities expense of $1.8 million compared to the third quarter of 2007.
Noninterest expense for the first nine months of 2008 of $1,076.8 million increased 2.4% from $1,051.6 million for the first nine months of 2007. The Company’s efficiency ratio was 61.4% for the first nine months of 2008 compared to 56.7% for the same period of 2007. Explanations previously provided for the quarterly changes also apply to the year-to-date changes. Additional explanations of variances follow.
Merger related expense decreased $3.6 million or 78.8% compared to the first nine months of 2007. The decrease is mainly due to the completion of the Stockmen’s acquisition and system conversion during the first nine months of 2007.
At September 30, 2008, the Company had 10,971 full-time equivalent employees, 525 domestic branches, and 617 ATMs, compared to 11,007 full-time equivalent employees, 520 domestic branches, and 628 ATMs at September 30, 2007.
Income Taxes
The Company’s income tax expense decreased to $11.2 million for the third quarter of 2008 compared to $71.9 million for the same period in 2007. The Company’s effective income tax rates, including the effects of minority interest, were 22.9% and 34.6% for the third quarters of 2008 and 2007, respectively. The effective income tax rates for the first nine months of 2008 and 2007 were 27.7% and 35.5%. The lower third quarter of 2008 tax rate compared to 2007 is mainly due to the lower taxable income in 2008, which increased the proportion of nontaxable income relative to total income. During the first nine months of 2008 and under the provisions of FIN 48, the Company reduced its liability and related interest for uncertain tax positions by $5.3 million due primarily to the income statement impact of the settlement of uncertain tax positions with governmental authorities during the second quarter of 2008. Also, income taxes for the first quarter of 2007 included approximately $2.9 million of taxes and penalties for the one time redemption of certain bank-owned life insurance contracts. As discussed in previous filings, the Company has received federal income tax credits under the U.S. Government’s Community Development Financial Institutions Fund that are recognized over a seven-year period from the year of investment. The effect of these tax credits was to reduce income tax expense by $4.4 million and $4.2 million for the first nine months of 2008 and 2007, respectively.
38
BALANCE SHEET ANALYSIS
Interest-Earning Assets
Interest-earning assets are those assets that have interest rates or yields associated with them and consist of money market investments, securities and loans.
Average interest-earning assets increased 11.8% to $47.3 billion for the nine months ended September 30, 2008 compared to $42.4 billion for the same period in 2007. Average interest-earning assets as a percentage of total average assets for the first nine months of 2008 was 88.5% compared to 88.0% for the comparable period of 2007.
Average money market investments, consisting of interest-bearing deposits and commercial paper, federal funds sold and security resell agreements, increased 184.7% to $1,766 million for the first nine months of 2008 compared to $620 million for the first nine months of 2007. Average money market investments for the first nine months of 2008 include $962 million of asset-backed commercial paper that subsidiary companies purchased from Lockhart. Average money market investments for the third quarter of 2008 included $597 million of asset-backed commercial paper that subsidiary companies purchased from Lockhart as compared to $232 million during the third quarter of 2007. See discussion at “Liquidity Risk Management” for further details.
39
Investment Securities Portfolio
The following tables present the Company’s held-to-maturity and available-for-sale investment securities:
HELD-TO-MATURITY:
Municipal securities
Asset-backed securities:
Trust preferred securities – banks and insurance
AA rated
A rated
BBB rated
Trust preferred securities – real estate investment trusts
AAA rated
AVAILABLE-FOR-SALE:
U.S. Treasury securities
U.S. Government agencies and corporations:
Agency securities
Agency guaranteed mortgage-backed securities
Small Business Administration loan-backed securities
Not rated
Noninvestment grade
Small business loan-backed
Other securities:
Mutual funds and stock
Ratings categories include entire range. For example, “A rated” includes A+, A and A-. Split rated securities with two ratings are categorized at the higher of the rating levels. If three ratings exist, classification is at the common or middle rating level.
40
The amortized cost of investment securities at September 30, 2008 decreased 15.2% from the balance at December 31, 2007. The change was largely due to security sales, security maturity paydowns, and OTTI write-downs, offset in part by Zions Bank purchasing securities from Lockhart. See further discussion of securities purchases from Lockhart in “Off-Balance Sheet Arrangement.” As discussed further in “Risk Elements: Market Risk – Fixed Income,” changes in fair value on available-for-sale securities have been reflected in shareholders’ equity through accumulated other comprehensive income (“OCI”).
At September 30, 2008, 94% of the $2.5 billion of available-for-sale securities, excluding mutual funds and stock, consisted of AAA-rated structured securities, municipal securities, and government and agency guaranteed securities, 1% consisted of AA-rated securities, 1% consisted of A-rated securities and 1% consisted of BBB rated securities. In addition, 3% of the portfolio was unrated or below investment grade securities. The $1.9 billion of held-to-maturity securities held at adjusted amortized cost was comprised of 39% of AAA-rated securities and municipal securities, 1% of AA-rated securities, 53% of A-rated securities, and 7% of BBB-rated securities.
Included in asset-backed securities at September 30, 2008 are CDOs collateralized by trust preferred securities issued by banks, insurance companies, or REITs. The REIT CDOs have some exposure to the subprime market. In addition, the $146 million of held-to-maturity and available-for-sale “Asset-backed securities – Other” includes $64 million of certain structured asset-backed collateralized debt obligations (“ABS CDOs”) (also known as diversified structured finance CDOs) purchased from Lockhart, which have minimal exposure to non-Zions’ originated subprime and home equity mortgage securitizations. The $64 million of ABS CDOs includes approximately $13 million of subprime mortgage securities and $9 million of home equity credit line securities. See further discussion of certain CDOs held by Lockhart in “Off-Balance Sheet Arrangement.”
41
At September 30, 2008, 1.5% of the $2.8 billion of fair value of available-for-sale securities portfolio as shown previously was valued at Level 1, 71.1% was valued at Level 2, and 27.4% was valued at Level 3 under the SFAS 157 valuation hierarchy. See Note 9 of the Notes to Consolidated Financial Statements for further discussion of fair value accounting.
The amortized cost of available-for-sale investment securities valued at Level 3 was $903 million and the fair value of these securities was $766 million. The securities valued at Level 3 were comprised of CDOs. For these Level 3 securities, net pretax unrealized loss recognized in OCI in the third quarter was $57 million. As of September 30, 2008, we believe that the par amounts of the Level 3 available-for-sale securities for which no OTTI has been recognized do not differ from the amounts we currently anticipate realizing on settlement or maturity. See “Critical Accounting Policies and Significant Estimates” for further details about the CDO securities pricing methodologies.
We review investment securities on an ongoing basis for the presence of OTTI, taking into consideration current market conditions, fair value in relationship to cost, extent and nature of change in fair value, issuer rating changes and trends, volatility of earnings, current analysts’ evaluations, our ability and intent to hold investments until a recovery of fair value, which may be maturity, and other factors. The Company recognized OTTI during the third quarter of 2008 of approximately $28.0 million pretax. Approximately, $22.6 million of the amount resulted from write-downs of three bank and insurance trust preferred CDOs and two ABS CDOs that were first deemed to have OTTI this quarter. The remaining $5.4 million resulted from write-downs of three REIT trust preferred CDOs and two bank and insurance income note for which OTTI had previously been recognized. OTTI previously recognized on a pretax basis was $38.8 million during the second quarter of 2008, $40.8 million during the first quarter of 2008 and $108.6 million during the fourth quarter of 2007. The decision to deem these securities OTTI was based on the near term financial prospects for collateral in each CDO, a specific analysis of the structure of each security, and an evaluation of the underlying collateral using information and industry knowledge available to Zions. Future reviews for OTTI will consider the particular facts and circumstances during the reporting period in review.
During the second quarter of 2008, the Company reassessed the classification of certain asset-backed and trust preferred CDOs. On April 28, 2008, the Company reclassified approximately $1.2 billion at fair value of these available-for-sale securities to held-to-maturity. The related unrealized pretax loss of approximately $273 million included in OCI remained in OCI and is being amortized as a yield adjustment through earnings over the remaining terms of the securities. No gain or loss was recognized at the time of reclassification. The Company considers the held-to-maturity classification to be more appropriate because it has the ability and the intent to hold these securities to maturity.
The investment securities portfolio at September 30, 2008 includes $720 million of nonrated fixed income securities. These securities include $680 million of nonrated municipal securities underwritten and structured by Zions Bank in accordance with its established municipal credit standards, $13 million of securitized small business loan trust securities from a previous securitization, and $27 million of individual and pooled trust preferred bank and insurance securities. Nonrated fixed income securities were $908 million at December 31, 2007 and $873 million at September 30, 2007.
Loan Portfolio
Net loans and leases at September 30, 2008 were $41.9 billion, an annualized increase of 9.6% from December 31, 2007 and an increase of 10.7% over the balance at September 30, 2007. These percentage increases include the effects of both “organic” loan growth and the purchase of securitized loans from Lockhart.
42
The following table sets forth the loan portfolio by type of loan:
Commercial lending:
Commercial and industrial
Leasing
Owner occupied (1)
Total commercial lending
Commercial real estate:
Construction and land development
Term
Total commercial real estate
Consumer:
Home equity credit line
1-4 family residential
Construction and other consumer real estate (2)
Bankcard and other revolving plans
Total consumer
Foreign loans
Total loans
Loan growth during the first nine months was concentrated primarily in commercial lending and secondarily in commercial term real estate loans, principally at Zions Bank and Amegy Bank of Texas; we also had loan growth in Vectra, California Bank & Trust, and in our Commerce Banks in Washington and Oregon. Construction and land development loans declined $487 million in California, Arizona and Nevada during the first nine months, offset by growth in Texas. The increase in loans includes $1,180 million of loans resulting from the purchase of certain securities from Lockhart, as discussed in “Off-Balance Sheet Arrangement.” These securities were backed by loans originated or underwritten by Zions Bank and are reflected on the Company’s balance sheet primarily as owner occupied commercial loans.
Loan growth during the third quarter of 2008 was only $14.7 million reflecting the Company’s efforts to actively manage loan growth during the quarter in accordance with its stated desire to conserve capital and build capital ratios in the current uncertain economic environment.
Sold Loans Being Serviced
The Company performs loan servicing both on loans that it holds in its portfolios and also on loans that are owned by third party investor-owned trusts. The Company has used asset securitizations to sell loans and in many instances provides the servicing on these loans as a condition of the sale.
43
Small business loans
SBA 7(a) loans
Farmer Mac
Leases
Securitized loans being serviced for others totaled $0.6 billion at September 30, 2008 compared to $1.9 billion at December 31, 2007, and $2.0 billion at September 30, 2007 reflecting the purchases from Lockhart as discussed in “Off-Balance Sheet Arrangement.” The Company did not complete a small business loan securitization during 2007 or the first nine months of 2008, discontinued selling new home equity credit line originations during the fourth quarter of 2006, and completed a clean-up repurchase of the securitization during the third quarter of 2008.
As of September 30, 2008, the Company had recorded assets, comprised of subordinated retained interests and capitalized residual cash flows, in the amount of $19 million in connection with the $0.6 billion of sold loans being serviced. As is a common practice with securitized transactions, the Company had subordinated retained interests in the securitized assets that totaled $13 million at September 30, 2008, which represented junior positions to the other investors in the trust securities. The capitalized residual cash flows, which are sometimes referred to as “excess servicing,” of $6 million primarily represent the present value of the excess cash flows that have been projected over the lives of the sold loans.
As of September 30, 2008, conforming long-term first mortgage real estate loans being serviced for others were $1,197 million, compared with $1,232 million at December 31, 2007 and $1,230 million at September 30, 2007.
Other Noninterest-Bearing Investments
The following table sets forth the Company’s other noninterest-bearing investments:
Bank-owned life insurance
Federal Home Loan Bank and Federal Reserve stock
SBIC investments (1)
Non-SBIC investment funds and other
Other public companies
Other nonpublic companies
Trust preferred securities
Federal Home Loan Bank and Federal Reserve stock investments increased $108 million from December 31, 2007. The increase is mainly due to increased investments that subsidiary banks made at the Federal Home Loan Banks to increase their borrowing capacity.
44
Deposits
Average total deposits for the first nine months of 2008 increased 3.5% compared to the same period in 2007, with interest-bearing deposits increasing 6.2% and noninterest-bearing deposits decreasing 3.9%.
Total deposits at the end of the third quarter of 2008 increased to $38.6 billion, an annualized increase of 6.0% from the balances reported at December 31, 2007, and increased 7.9% over the September 30, 2007 amounts. Core deposits at September 30, 2008 increased 5.8% annualized compared to the December 31, 2007 balance and 8.6% compared to the balance at September 30, 2007. Actual and average deposits for the third quarter of 2008 include deposits related to the failed Silver State Bank acquisition.
Demand, savings and money market deposits comprised 72.1% of total deposits at the end of the third quarter, compared with 72.0% and 72.2% as of December 31, 2007 and September 30, 2007, respectively.
During the third quarter, the Company increased brokered deposits to serve as an additional source of liquidity for the Company. At September 30, 2008, total deposits included $791 million of brokered deposits compared to $124 million at June 30, 2008 and $77 million at December 31, 2007. The average balance of brokered deposits for the third quarter was $303 million and for the first nine months of 2008 was $153 million.
Off-Balance Sheet Arrangement
The Company administers one QSPE securities conduit, Lockhart, which was established in 2000. Lockhart was structured to purchase securities that are collateralized by small business loans originated or purchased by Zions Bank; such loans were originated during and prior to 2005. Lockhart obtains funding through the issuance of asset-backed commercial paper and holds securities, which include U.S. Government agency securities collateralized by small business loans and AAA/AA-rated securities.
Liquidity Agreement
Zions Bank is the sole provider of a liquidity facility to Lockhart. Pursuant to the Liquidity Agreement, Zions Bank is required to purchase nondefaulted securities from Lockhart to provide funds to repay maturing commercial paper upon Lockhart’s inability to access the commercial paper market for sufficient funding, or upon a commercial paper market disruption, as specified in the governing documents of Lockhart. In addition, pursuant to the governing documents, including the Liquidity Agreement, if any security in Lockhart is downgraded to below AA- or the downgrade of one or more securities results in more than ten securities having ratings of AA+ to AA-, Zions Bank must either 1) place its letter of credit on the security, 2) obtain a credit enhancement on the security from a third party, or 3) purchase the security from Lockhart at book value.
The maximum amount of liquidity that Zions Bank can be required to provide pursuant to the Liquidity Agreement is limited to the total amount of securities held by Lockhart. This maximum amount was $828 million at September 30, 2008, $862 million at June 30, 2008, $1.75 billion at March 31, 2008 and $2.12 billion at December 31, 2007.
In addition to providing the Liquidity Agreement, Zions Bank receives a fee in exchange for providing hedge support and administrative and investment advisory services to Lockhart.
A hedge agreement between Lockhart and Zions Bank provides for the bank to pay Lockhart should Lockhart’s monthly cost of funds exceed its monthly asset yield. Due to the extreme dislocation in short term Libor at the end of September, Lockhart’s cost of funds exceeded its asset yield for the first time in September. The spread between Lockhart’s monthly asset yield and cost of funds has narrowed as a result of increased commercial paper rates resulting from the ongoing contraction, disruption, and volatility in the credit markets. It is possible that this hedge agreement may be triggered in the future.
45
In addition to rating agency downgrades of securities held by Lockhart that would require Zions Bank to purchase securities from Lockhart, the following rating agency actions may result in security purchases under the Liquidity Agreement:
downgrades of Lockhart’s commercial paper below P-1 by Moody’s or below F1 by Fitch, which would prevent issuance of commercial paper by Lockhart;
downgrades of bond insurer Ambac that trigger Lockhart securities’ downgrades, which may require Zions Bank to purchase assets.
At September 30, 2008, Lockhart owned one $78 million security insured by Ambac and rated Aa3 by Moody’s Investors Service. The Ambac-insured security had an underlying public rating of AAA from Fitch and no underlying rating from Moody’s Investors Service. On November 5, 2008, this security was downgraded by Moody’s from Aa3 to Baal. Zions Bank purchased the security at book value on November 6, 2008.
On June 19, 2008, MBIA, Inc. was downgraded by Moody’s to below AA-, and as a result the MBIA, Inc. insured assets held by Lockhart were downgraded to below AA-. Therefore, on June 23, 2008, Zions Bank purchased $787 million of securities from Lockhart as required by the Liquidity Agreement. The purchases comprised the entire remaining small business loan securitizations created by Zions Bank and held by Lockhart. No gain or loss was recognized on these purchases. Upon dissolution of the securitization trusts (including $87 million of related securities owned by the Parent), the Company recorded $897 million of loans on its balance sheet including $23 million of premium. The retained interests related to the securities purchased were included in the purchase transaction and recorded with the premium amount.
In the first quarter of 2008, certain assets held by Lockhart were downgraded by rating agencies and Lockhart was unable to sell certain amounts of commercial paper at times due to continued deterioration in the asset-backed commercial paper markets. These events caused purchases by Zions Bank of securities from Lockhart, as follows:
On February 5, 2008, a $5 million security held by Lockhart was downgraded by Moody’s from Aa1 to Baa1. Zions Bank purchased this security at book value and recorded the related pretax write-down of $0.8 million in adjusting the security to fair value. In addition, Lockhart was unable to sell sufficient commercial paper to fund commercial paper maturities and Zions Bank purchased $115 million of MBIA-insured securities from Lockhart. These securities consisted of securitizations of small business loans from Zions Bank and their purchase resulted in no gain or loss. Upon dissolution of the securitization trusts, the loans were recorded on Zions Bank’s balance sheet.
On March 5, 2008, Lockhart was unable to sell sufficient commercial paper to fund commercial paper maturities and Zions Bank purchased $85 million of MBIA-insured securities and a $75 million bank trust preferred CDO from Lockhart. The MBIA-insured securities consisted of securitizations of small business loans from Zions Bank and their purchase resulted in no gain or loss. Upon dissolution of the securitization trusts, the loans were recorded on Zions Bank’s balance sheet. A pretax write-down of $4.4 million was recorded by Zions Bank in adjusting the bank trust preferred CDO security to fair value.
If Lockhart is unable to issue additional commercial paper to finance maturing commercial paper, or if additional assets of Lockhart are downgraded below the ratings described above, Zions Bank will be obligated to purchase additional assets from Lockhart. Because these purchases are transacted at book value, Zions Bank may incur losses if the assets’ book value exceeds their fair value. At September 30, 2008, the book value of Lockhart’s $828 million of assets exceeded their fair value by approximately $110 million. The Company does not expect Lockhart’s securities portfolio to ever again exceed $828 million.
46
Assets Held by Lockhart
The following schedule summarizes Lockhart’s assets by category, related amortized cost, fair value and ratings.
Rating
range
Assets:
Small Business Administration loan-backed securities (1)
At September 30, 2008, the weighted average interest rate reset of Lockhart’s assets was 3.3 months and the weighted average life of Lockhart’s assets was estimated at 4.0 years. The weighted average life of Lockhart’s asset-backed commercial paper was 3.5 days.
Possible Consolidation of Lockhart
As a QSPE currently defined by the provisions of SFAS 140, Lockhart remains off-balance sheet and is not consolidated in the Company’s financial statements. Should the Parent and its subsidiaries together own more than 90% of the outstanding commercial paper (beneficial interest) of Lockhart, Lockhart would cease to be a QSPE and would be required to be consolidated.
At September 30, 2008, Lockhart’s assets totaled $828 million at book value and the Company owned $557 million of Lockhart commercial paper.
See “Critical Accounting Policies and Significant Estimates” and “Liquidity Risk Management” for additional information on Lockhart.
RISK ELEMENTS
Since risk is inherent in substantially all of the Company’s operations, management of risk is an integral part of its operations and is also a key determinant of its overall performance. We apply various strategies to reduce the risks to which the Company’s operations are exposed, including credit, interest rate and market, liquidity and operational risks.
Credit Risk Management
Credit risk is the possibility of loss from the failure of a borrower or contractual counterparty to fully perform under the terms of a credit-related contract. Credit risk arises primarily from the Company’s lending activities, as well as from off-balance sheet credit instruments.
47
Credit risk is managed centrally through a uniform credit policy, credit administration, and credit exam functions at the parent. Effective management of credit risk is essential in maintaining a safe, sound and profitable financial institution. We have structured the organization to separate the lending function from the credit administration function, which provides strength to the control over and the independent evaluation of credit activities. Formal loan policies and procedures provide the Company with a framework for consistent underwriting and a basis for sound credit decisions. In addition, the Company has a well-defined set of standards for evaluating its loan portfolio, and management utilizes a comprehensive loan grading system to determine the risk potential in the portfolio. Further, an independent, internal credit examination department periodically conducts examinations of the Company’s lending departments. These examinations are designed to review credit quality, adequacy of documentation, appropriate loan grading administration and compliance with lending policies, and reports thereon are submitted to management and to the Credit Review Committee of the Board of Directors.
Both the credit policy and the credit examination functions are managed centrally. Each affiliate bank is permitted to modify corporate credit policy to be more conservative; however, corporate approval must be obtained if a bank wishes to create a more liberal policy. Historically, only a limited number of such modifications have been approved. This entire process has been designed to place an emphasis on strong underwriting standards and early detection of potential problem credits so that action plans can be developed and implemented on a timely basis to mitigate any potential losses.
With regard to credit risk associated with counterparties in off-balance sheet credit instruments, Zions Bank and Amegy have International Swap Dealer Association (“ISDA”) agreements in place under which derivative transactions are entered into with major derivative dealers. Each ISDA agreement details the collateral arrangements between Zions Bank and Amegy and their counterparties. In every case, the amount of the collateral required to secure the exposed party in the derivative transaction is determined by the fair value on the derivative and the credit rating of the party with the obligation. The credit rating used in these situations is provided by either Moody’s or Standard & Poor’s. This means that a counterparty with a “AAA” rating would be obligated to provide less collateral to secure a major credit exposure than one with an “A” rating. All derivative gains and losses between Zions Bank or Amegy and a single counterparty are netted to determine the net credit exposure and therefore the collateral required. We have no exposure to credit default swaps.
The Company also has off-balance sheet credit risk associated with a Liquidity Agreement provided by Zions Bank to the QSPE securities conduit, Lockhart. See “Off-Balance Sheet Arrangement” for further details.
Another aspect of the Company’s credit risk management strategy is to pursue the diversification of the loan portfolio. The Company maintains a diversified loan portfolio with some emphasis in real estate. As set forth in the following table, at September 30, 2008 no single loan category exceeded 27% of the Company’s total loan portfolio.
48
The Company attempts to avoid the risk of an undue concentration of credits in a particular industry, trade group, property type, or with an individual customer or counterparty. The majority of the Company’s business activity is with customers located within the geographical footprint of its banking subsidiaries.
Lending to finance residential land acquisition, development and construction is a core business for the Company. In some geographic markets, significant declines in the availability of mortgage financing to buyers of newly constructed homes and uncertainty in the residential real estate market are having an adverse impact on the operations of some of the Company’s developer and builder customers.
As discussed in the following sections, the Company’s level of credit quality continued to weaken during the third quarter of 2008. The deterioration in credit quality is mainly related to the weakness in residential development and construction activity in the Southwest that started in the latter half of 2007 and began to show signs of deterioration in Utah/Idaho during the first quarter of 2008. Residential construction and land development loans in Arizona and Nevada remain the most troubled segment of the portfolio. The most meaningful declines in commercial real estate credit quality during the quarter occurred in Arizona and Texas. The Company experienced increased criticized and classified loans in its commercial loan portfolio during the quarter in Utah and Texas. We expect continued credit quality deterioration over the next few quarters.
A more comprehensive discussion of our credit risk management is contained in Zions’ Annual Report on Form 10-K for the year ended December 31, 2007.
49
Commercial Real Estate Loans
Selected information regarding our commercial real estate (“CRE”) loan portfolio is presented in the following table:
COMMERCIAL REAL ESTATE PORTFOLIO BY LOAN TYPE AND GEOGRAPHY
Commercial term
Balance outstanding
% of loan type
Delinquency rates (2):
30-89 days
³90 days
Accruing past due
90 days
Nonaccrual loans
Commercial construction and land development
Residential construction and land development
Total construction and land development
Approximately 30% of the commercial term loans consist of mini-perm loans on which construction is complete and the project is either in the process of stabilization or has stabilized, and the owner is waiting to seek permanent financing given the current volatile conditions in the financial markets. Mini-perm loans generally have maturities of 3 to 7 years. The remaining 70% are term loans with initial maturities generally of 15 to 20 years. Stabilization criteria differ by product and are dependent on cash flow created by lease-up for office, industrial and retail products and occupancy for retail and apartment products.
Approximately 31% of the commercial construction and land development portfolio is designated as acquisition and development. Most of these A&D properties are tied to specific retail, apartment, office or other projects. Underwriting on commercial properties is primarily based on the economic viability of the
50
project with heavy consideration given to the creditworthiness of the sponsor. The owners’ equity is always expected to be injected prior to bank advances. Re-margining requirements are often included in the loan agreement along with guarantees of the sponsor. Recognizing that debt is paid via cash flow, the projected economics of the project are primary in the underwriting because it determines the ultimate value of the property and the ability to service debt. Therefore, in most projects (with the exception of multi-family projects) we look for substantial pre-leasing in our underwriting and we generally require a minimum projected stabilized debt service ratio of 1.20.
Although residential construction and development deals with a different product type, many of the requirements previously mentioned, such as credit worthiness of the developer, up-front injection of the developer’s equity, re-margining requirements, and the viability of the project are also important in underwriting a residential development loan. Heavy consideration is given to market acceptance of the product, location, strength of the developer, and the ability of the developer to stay within budget. Progress inspections performed by qualified independent inspectors are routinely performed before disbursements are made. Loan agreements generally include limitations on the number of model homes and homes built on a spec basis, with preference given to pre-sold homes.
Real estate appraisals are ordered independently of the credit officer and the borrower, generally by the banks’ appraisal review function, which is staffed by qualified appraisers. Appraisals are ordered from outside appraisers at the inception, renewal, or for CRE loans, upon the occurrence of any event causing a “criticized” or “classified” grade to be assigned to the credit. The frequency for obtaining updated appraisals for these adversely graded credits is increased when declining market conditions exist. Advance rates will vary based on the viability of the project and the creditworthiness of the sponsor, but corporate guidelines generally limit advances to 50-65% for raw land, 65-75% for land development, 65-75% for finished commercial lots, 75-80% for finished residential lots, 80% for pre-sold homes, 75-80% for models and spec homes, and 75-80% for commercial properties. Exceptions may be granted on a case-by-case basis.
Loan agreements require regular financial information on the project and the sponsor in addition to lease schedules, rent rolls, and on construction projects, independent progress inspection reports. The receipt of these schedules is closely monitored and calculations are made to determine adherence to the covenants set forth in the loan agreement. Additionally, the frequency of loan-by-loan reviews has been increased to a quarterly basis for all commercial and residential land acquisition, development, and construction loans at California Bank & Trust, National Bank of Arizona, and Nevada State Bank.
We have not been involved to any meaningful extent with insurance arrangements, credit derivatives, or any other default agreements as a mitigation strategy for commercial real estate loans. However, we do make use of personal or other guarantees as risk mitigation strategies.
The Company stress tests its CRE loan portfolio on a quarterly basis. This testing is back tested and the results of the testing are reviewed quarterly with the rating agencies and banking regulators. The stress testing methodology includes a loan-by-loan Monte Carlo simulation, which is an approach that measures potential loss of principal and related revenues. The Monte Carlo simulation stresses the probability of default and loss given default for CRE loans based on a variety of factors including regional economic factors, loan grade, loan-to-value, collateral type, and geography.
Nonperforming Assets
Nonperforming assets include nonaccrual loans, restructured loans, and other real estate owned. Loans are generally placed on nonaccrual status when the loan is 90 days or more past due as to principal or interest, unless the loan is both well secured and in the process of collection. Consumer loans are not normally placed on nonaccrual status. Generally, closed-end non-real estate secured consumer loans are charged off when
51
they become 120 days past due. Open-end consumer loans are charged off when they become 180 days past due unless they are adequately secured by real estate at which point they are placed on nonaccrual status. Loans occasionally may be restructured to provide a reduction or deferral of interest or principal payments. This generally occurs when the financial condition of a borrower deteriorates to the point that the borrower needs to be given temporary or permanent relief from the original contractual terms of the loan. Other real estate owned is acquired primarily through or in lieu of foreclosure on loans secured by real estate.
The following table sets forth the Company’s nonperforming assets:
Restructured loans
% of net loans and leases* and other real estate owned
% of net loans and leases*
* Includes loans held for sale.
Total nonperforming assets increased $640 million or 226% as of September 30, 2008 compared with the balance at December 31, 2007 and increased $727 million or 370% from the $197 million balance at September 30, 2007. The increase in nonperforming assets consisted primarily of residential construction and land development loans in Nevada State Bank, National Bank of Arizona, California Bank & Trust, and Zions Bank and commercial and industrial loans in California Bank & Trust and Zions Bank. Total nonaccrual loans at September 30, 2008 increased $506 million from the balances at December 31, 2007, which included increases of $333 million for nonaccrual construction and land development loans and $123 million for commercial lending. Nonperforming assets are expected to increase further over the next several quarters. Nonperforming assets increased $227 million during the quarter compared to an increase of $263 million during the second quarter.
Included in nonaccrual loans are loans that we have determined to be impaired. Loans, other than those included in large groups of smaller-balance homogeneous loans, are considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due in accordance with the contractual terms of the loan agreement, including scheduled interest payments. The amount of the impairment is measured based on the present value of expected cash flows, the observable fair value of the loan, or the fair value of the collateral securing the loan.
The Company’s total recorded investment in impaired loans was $646 million at September 30, 2008, compared with $226 million at December 31, 2007 and $188 million at September 30, 2007. Estimated losses on impaired loans are included in the allowance for loan losses. At September 30, 2008, the allowance for loan losses included $32 million for impaired loans with a recorded investment of $235 million. At December 31, 2007, the allowance included $21 million for impaired loans with a $103 million recorded investment, and at September 30, 2007 the allowance included $9 million for impaired loans with a $70 million recorded investment.
52
The amount of accruing loans past due 90 days or more increased to $98 million at September 30, 2008 up from $77 million at December 31, 2007 and $65 million at September 30, 2007.
Allowance and Reserve for Credit Losses
Allowance for Loan Losses – The allowance for loan losses is established for estimated losses in the loan portfolio outstanding at the balance sheet date. In analyzing the adequacy of the allowance for loan losses, we utilize a comprehensive loan grading system to determine the risk potential in the portfolio and also consider the results of independent internal credit reviews. To determine the adequacy of the allowance, the Company’s loan and lease portfolio is broken into segments based on loan type.
For commercial loans, we use historical loss experience factors by loan segment, adjusted for changes in trends and conditions, to help determine an indicated allowance for each portfolio segment. These factors are evaluated and updated using migration analysis techniques and other considerations based on the makeup of the specific segment. These other considerations include:
volumes and trends of delinquencies;
levels of nonaccruals, repossessions and bankruptcies;
trends in criticized and classified loans;
expected losses on real estate secured loans;
new credit products and policies;
economic conditions;
concentrations of credit risk; and
experience and abilities of the Company’s lending personnel.
In addition to the segment evaluations, nonaccrual loans graded substandard or doubtful with an outstanding balance of $500 thousand or more are individually evaluated in accordance with SFAS No. 114,Accounting by Creditors for Impairment of a Loan, to determine the level of impairment and establish a specific reserve. A specific allowance is established for loans adversely graded below $500 thousand when it is determined that the risk associated with the loan differs significantly from the risk factor amounts established for its loan segment.
The allowance for consumer loans is determined using historically developed loss experience rates at which loans migrate from one delinquency level to the next higher level. Using average roll rates for the most recent twelve-month period and comparing projected losses to actual loss experience, the model estimates expected losses in dollars for the forecasted period. By refreshing the model with updated data, it is able to project losses for a new twelve-month period each month, segmenting the portfolio into nine product groupings with similar risk profiles. This methodology is an accepted industry practice, and the Company believes it has a sufficient volume of information to produce reliable projections.
As a final step to the evaluation process, we perform an additional review of the adequacy of the allowance based on the loan portfolio in its entirety. This enables us to mitigate the imprecision inherent in most estimates of expected credit losses. This review of the allowance includes our judgmental consideration of any adjustments necessary for subjective factors such as economic uncertainties and excessive concentration risks.
The methodology used by Amegy to estimate its allowance for loan losses has not yet been conformed to the process used by the other affiliate banks. However, the process used by Amegy is not significantly different than the process used by our other affiliate banks.
53
The Company has initiated a comprehensive review of its allowance for loan losses methodology with a view towards updating and conforming this methodology across all of its banking subsidiaries. The Company began implementing this updated methodology in 2007 and expects to complete the implementation in 2009.
The following table shows the changes in the allowance for loan losses and a summary of loan loss experience:
Loans* and leases outstanding (net of unearned income) at end of period
Average loans* and leases outstanding
(net of unearned income)
Allowance for loan losses:
Balance at beginning of period
Allowance of companies acquired
Allowance of loans sold with branches
Allowance associated with purchased securitized loans and loans sold
Provision charged against earnings
Loans and leases charged off:
Commercial lending
Commercial real estate
Consumer
Recoveries:
Net loan and lease charge-offs
Balance at end of period
Ratio of annualized net charge-offs to average loans and leases
Ratio of allowance for loan losses to net loans and leases at end of period
Ratio of allowance for loan losses to nonperforming loans
Ratio of allowance for loan losses to nonaccrual loans and accruing loans past due 90 days or more
Net loan and lease charge-offs, along with their annualized ratios to average loans and leases, are shown in the preceding table for the periods presented. The same respective amounts for the third quarter of 2008 were $95 million and 0.91%.
The total allowance for loan losses at September 30, 2008 increased $150 million from the level at year-end 2007. The amount of the allowance included for criticized and classified commercial and commercial real
54
estate loans increased $99 million. Of this increase, $33 million was for commercial lending, and $66 million was for commercial real estate loans. The level of the allowance for noncriticized and nonclassified commercial and commercial real estate loans increased $28 million. The allowance for consumer loans increased $23 million compared to December 31, 2007.
Reserve for Unfunded Lending Commitments – The Company also estimates a reserve for potential losses associated with off-balance sheet commitments and standby letters of credit. We determine the reserve for unfunded lending commitments using a process that is similar to the one we use for commercial lending and commercial real estate loans. Based on historical experience, we have developed experience-based loss factors that we apply to the Company’s unfunded lending commitments to estimate the potential for loss in that portfolio.
The following table sets forth the reserve for unfunded lending commitments:
Reserve of company acquired
The following table sets forth the total allowance and reserve for credit losses:
Total allowance and reserve for credit losses
Interest Rate and Market Risk Management
Interest rate and market risk are managed centrally. Interest rate risk is the potential for loss resulting from adverse changes in the level of interest rates on the Company’s net interest income. Market risk is the potential for loss arising from adverse changes in the fair value of fixed income securities, equity securities, other earning assets and derivative financial instruments as a result of changes in interest rates or other factors. As a financial institution that engages in transactions involving an array of financial products, the Company is exposed to both interest rate risk and market risk.
Interest Rate Risk
Interest rate risk is one of the most significant risks to which the Company is regularly exposed. In general, our goal in managing interest rate risk is to have the net interest margin increase slightly in a rising interest rate environment. We refer to this goal as being slightly “asset-sensitive.” This approach is based on our belief that in a rising interest rate environment, the market cost of equity, or implied rate at which future earnings are discounted, would also tend to rise.
We attempt to minimize the impact of changing interest rates on net interest income primarily through the use of interest rate swaps, and by avoiding large exposures to fixed rate interest-earning assets that have significant negative convexity. The prime lending rate and the LIBOR curves are the primary indices used for pricing the Company’s loans. The interest rates paid on deposit accounts are set by individual banks so as to be competitive in each local market.
55
We monitor interest rate risk through the use of two complementary measurement methods: duration of equity and income simulation. In the duration of equity method, we measure the expected changes in the fair values of equity in response to changes in interest rates. In the income simulation method, we analyze the expected changes in income in response to changes in interest rates. For income simulation, Company policy requires that interest sensitive income from a static balance sheet be limited to a decline of no more than 10% during one year if rates were to immediately rise or fall in parallel by 200 basis points.
As of the dates indicated, the following table shows the Company’s estimated range of duration of equity and percentage change in interest sensitive income, based on a static balance sheet, in the first year after the rate change if interest rates were to sustain an immediate parallel change of 200 basis points; the “low” and “high” results differ based on the assumed speed of repricing of administered-rate deposits (money market, interest-on-checking, and savings):
Duration of equity:
Range (in years)
Base case
Increase interest rates by 200 bp
Income simulation – change in interest sensitive income:
Decrease interest rates by 200 bp
As discussed previously under the section “Net Interest Income, Margin and Interest Rate Spreads,” the Company believes that in recent quarters, the dynamic balance sheet changes with regard to changes in the mix of deposits and other funding sources have tended to have a somewhat larger effect on the net interest spread and net interest margin than has the Company’s interest rate risk position. However, as also discussed in that section, competitive pressures on deposit rates may impede our ability to reprice deposits, which would have a negative impact on the net interest margin during the remaining three months of 2008.
Market Risk – Fixed Income – The Company engages in the underwriting and trading of municipal and corporate securities. This trading activity exposes the Company to a risk of loss arising from adverse changes in the prices of these fixed income securities held by the Company.
At September 30, 2008, the Company had $45.8 million of trading account assets and $29.5 million of securities sold, not yet purchased compared with $21.8 million and $15.5 million of trading assets and $224.3 million and $21.0 million of securities sold, not yet purchased at December 31, 2007 and September 30, 2007, respectively. The higher securities sold, not yet purchased balance in comparison to trading account assets as of December 31, 2007 is related to bank subsidiaries sweep products.
The Company is exposed to market risk through changes in fair value and other than temporary impairment of held-to-maturity and available-for-sale securities. The Company also is exposed to market risk for interest rate swaps used to hedge interest rate risk. Changes in fair value in available-for-sale securities and interest rate swaps are included in OCI each quarter. During the third quarter of 2008, the after-tax change in OCI
56
attributable to available-for-sale securities was $(34.3) million. The after-tax change in OCI attributable to held-to-maturity securities transferred from available-for-sale in the second quarter of 2008 was $8.9 million. The change attributable to interest rate swaps was $25.5 million, for a net increase to shareholders’ equity of $0.1 million. If any of the available-for-sale securities or HTM securities transferred from AFS becomes other than temporarily impaired, any loss in OCI is reversed and the impairment is charged to operations. See “Investment Securities Portfolio” for additional information on other-than-temporary impairment.
Market Risk – Equity Investments – Through its equity investment activities, the Company owns equity securities that are publicly traded and subject to fluctuations in their market prices or values. In addition, the Company owns equity securities in companies that are not publicly traded and that are accounted for under cost, fair value, equity, or full consolidation methods of accounting, depending upon the Company’s ownership position and degree of involvement in influencing the investees’ affairs. In either case, the value of the Company’s investment is subject to fluctuation. Since the fair value associated with these securities may fall below the Company’s investment costs, the Company is exposed to the possibility of loss. These equity investments are approved, monitored and evaluated by the Company’s Equity Investment Committee.
The Company generally conducts minority investing in prepublic venture capital companies in which it does not have strategic involvement, through four funds collectively referred to as Epic Venture Funds (“Epic”) (formerly Wasatch Venture Funds). Epic screens investment opportunities and makes investment decisions based on its assessment of business prospects and potential returns. After an investment is made, Epic actively monitors the performance of each company in which it has invested, and often has representation on the board of directors of the company.
In addition to the program described above, Amegy has in place an alternative investments program. These investments are primarily directed towards equity buyout and mezzanine funds with a key strategy of deriving ancillary commercial banking business from the portfolio companies. Early stage venture capital funds are not part of the strategy since the underlying companies are typically not credit worthy.
The Company also, from time to time, either starts and funds businesses or makes significant investments in companies of strategic interest. These investments may result in either minority or majority ownership positions, and usually give board representation to Zions or its subsidiaries. These strategic investments generally are in companies that are financial services or financial technologies providers. At September 30, 2008, such investments included $19 million in Farmer Mac.
A more comprehensive discussion of the Company’s interest rate and market risk management is contained in Zions’ Annual Report on Form 10-K for the year ended December 31, 2007.
Liquidity Risk Management
Liquidity is managed centrally for both the Parent and its subsidiary banks. The Parent’s cash requirements consist primarily of debt service, investment in and advances to subsidiaries, operating expenses, income taxes, dividends to shareholders and share repurchases. The Parent’s cash needs are met through dividends from its subsidiaries, investment income, subsidiaries’ proportionate share of current income taxes, management and other fees, bank lines, equity contributed through the exercise of stock options, commercial paper, and long-term debt and equity issuances.
On October 28, 2008, the Company announced its intent to participate in the Treasury’s Capital Purchase Program. See “Capital Management” for further discussion.
57
Operating cash flows, while normally constituting a funding source for the Company, are not large enough to provide funding in the amounts that fulfill the needs of the Parent and its subsidiary banks. For the first nine months of 2008, operations contributed $784 million toward these needs. As a result, the Company utilizes other sources at its disposal to manage its liquidity needs.
During the first nine months of 2008, the Parent received $78 million in cash dividends from its subsidiaries. At September 30, 2008, $331 million of dividend capacity was available for the subsidiary banks to pay to the Parent under regulatory guidelines.
The Parent also has a program to issue short-term commercial paper. At September 30, 2008, outstanding commercial paper was $40 million as compared to $298 million at December 31, 2007. This decline reflects both deteriorating financial market conditions nationally, as well as the downgrade (discussed below) of the Company’s commercial paper ratings. In addition, at September 30, 2008, the Company has lines of credit of $395 million with certain of its subsidiary banks. No amounts were outstanding under these lines at September 30, 2008. Interest on these lines is at a variable rate based on specified indices. Actual amounts that may be borrowed at any given time are based on determined collateral requirements.
On February 28, 2008, Moody’s downgraded its ratings for the Parent on long-term issuer/senior debt to A3, on subordinated debt to Baa1, and on short-term/commercial paper to P-2; it also changed its outlook from Negative to Stable. Also, Moody’s downgraded its ratings for the three largest subsidiary banks on long-term issuer/senior debt and certificates of deposit to A2, affirmed the short-term/commercial paper rating of P-1, and changed its outlook from Negative to Stable.
On August 11, 2008 Moody’s changed its rating outlook to Watch Negative for the Parent and the three largest subsidiary banks. On September 3, 2008, S&P changed its long term issuer ratings outlook to Outlook Negative for the Parent and the largest subsidiary bank.
During the third quarter and first nine months of 2008, the Company issued a net amount of $28.5 million and $261.3 million, respectively, of one- and two-year senior medium-term notes at coupon rates ranging from 4.50% to 5.65%. Interest is payable semiannually. These unsecured notes were sold via Zions’ online auction process and direct sales. They were issued under the Company’s existing shelf registration with the SEC.
The subsidiary banks’ primary source of funding is their core deposits, consisting of demand, savings and money market deposits, time deposits under $100,000 and foreign deposits. At September 30, 2008, these
58
core deposits, in aggregate, constituted 87.7% of consolidated deposits, compared with 87.9% of consolidated deposits at December 31, 2007. The Company has also obtained brokered deposits to serve as an additional source of liquidity for the Company. At September 30, 2008, total brokered deposits were $791 million, up from $124 million at June 30, 2008 and $77 million at March 31, 2008. For the first nine months of 2008, increases in deposits resulted in net cash inflows of $936 million.
On October 3, 2008, the FDIC increased deposit insurance to $250,000 through December 31, 2009. In addition, the FDIC implemented a program to provide full deposit insurance coverage for noninterest-bearing transaction deposit accounts through December 31, 2009, unless insured banks elect to opt out of the program. The Company intends to inform its customers that it will not opt out of this program.
The Federal Home Loan Bank (“FHLB”) system is also a significant source of liquidity for each of the Company’s subsidiary banks. Zions Bank and TCBW are members of the FHLB of Seattle. CB&T, NSB, and NBA are members of the FHLB of San Francisco. Vectra is a member of the FHLB of Topeka and Amegy Bank is a member of the FHLB of Dallas. The FHLB allows member banks to borrow against their eligible loans to satisfy liquidity requirements. For the first nine months of 2008, the activity in short-term FHLB borrowings resulted in a net cash inflow of approximately $1,025 million. The subsidiary banks are required to invest in FHLB stock to maintain their borrowing capacity. At September 30, 2008, the subsidiary banks’ total investment in FHLB stock was $252 million.
The Federal Reserve Board has a temporary program to make 28- and 84-day loans to banks in the United States and to foreign banks through foreign central banks. The program has been extended through January 30, 2009. These loans are made using an auction process. Zions Bank is currently participating in this program and will continue to do so as long as money can be borrowed at an attractive rate. Amounts that can be borrowed are based upon the amount of collateral pledged to the Federal Reserve Bank. Borrowings outstanding at Zions Bank under this program were $700 million at September 30, 2008 and $450 million at December 31, 2007.
At September 30, 2008, the amount available for additional FHLB and Federal Reserve borrowings was approximately $9.5 billion. An additional $2.3 billion could be borrowed upon the pledging of additional available collateral.
Zions Bank has in prior years used asset securitizations to sell loans and provide a flexible alternative source of funding. As a QSPE securities conduit sponsored by Zions Bank, Lockhart has purchased and held credit-enhanced securitized assets resulting from certain small business loan securitizations. During the second quarter of 2008, the entire remaining amount of these small business loans securitizations was purchased by Zions Bank. Under the Liquidity Agreement, Zions Bank has also purchased assets due to security ratings downgrades and the inability of Lockhart to issue commercial paper. See “Off-Balance Sheet Arrangement” for information about Lockhart and the Liquidity Agreement.
The Company’s investment activities can also provide or use cash. For the first nine months of 2008, investment securities activities resulted in a decrease in investment securities holdings and a net increase of cash in the amount of $820 million.
Maturing balances in the various loan portfolios also provide additional flexibility in managing cash flows. In most cases, however, loan growth has resulted in net cash outflows from a funding standpoint. For the first nine months of 2008, organic loan growth resulted in a net cash outflow of $2.3 billion.
A more comprehensive discussion of our liquidity management is contained in Zions’ Annual Report on Form 10-K for the year ended December 31, 2007.
59
Operational Risk Management
Operational risk is the potential for unexpected losses attributable to human error, systems failures, fraud, or inadequate internal controls and procedures. In its ongoing efforts to identify and manage operational risk, the Company has created a Corporate Risk Management Department whose responsibility is to help Company management identify and assess key risks and monitor the key internal controls and processes that the Company has in place to mitigate operational risk. We have documented controls and the Control Self Assessment related to financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002 and the Federal Deposit Insurance Corporation Improvement Act of 1991.
To manage and minimize its operating risk, the Company has in place transactional documentation requirements, systems and procedures to monitor transactions and positions, regulatory compliance reviews, and periodic reviews by the Company’s internal audit and credit examination departments. In addition, reconciliation procedures have been established to ensure that data processing systems consistently and accurately capture critical data. Further, we maintain contingency plans and systems for operations support in the event of natural or other disasters. Efforts are underway to improve the Company’s oversight of operational risk, including enhancement of risk-control self assessments and of antifraud measures.
CAPITAL MANAGEMENT
The Company has a fundamental financial objective to consistently produce superior risk-adjusted returns on its shareholders’ capital. We believe that a strong capital position is vital to continued profitability and to promoting depositor and investor confidence.
Total shareholders’ equity on September 30, 2008 was $5,566 million compared to $5,274 million at June 30, 2008, $5,293 million at December 31, 2007, and $5,257 million at September 30, 2007. The Company’s capital ratios were as follows:
Tangible common equity ratio
Average equity to average assets(three months ended)
Risk-based capital ratios:
Tier 1 leverage
Tier 1 risk-based capital
Total risk-based capital
The Parent and its subsidiary banks are required to maintain adequate levels of capital as measured by several regulatory capital ratios. As of September 30, 2008, the Company and each of its subsidiary banks exceeded the “well capitalized” guidelines under regulatory standards.
The Company has stated that its long-term target range for the tangible equity ratio is 6.25% to 6.50%. However, during current distressed financial market and economic conditions, the Company believes that maintaining capital ratios above that range is appropriate. The actual ratio at September 30, 2008 was 6.60%, at June 30, 2008 was 5.97%, at December 31, 2007 was 6.17% and at September 30, 2007 was 6.40%. The increase in total shareholders’ equity from June 30, 2008 is primarily due to net proceeds of $245 million from the issuance of common stock and $46 million from the issuance of preferred stock during the third quarter of 2008. During the first nine months of 2008, total shareholders equity has been negatively impacted by increased after tax unrealized losses of $129 million on investment securities included in OCI.
60
On October 27, 2008, the U.S. Department of the Treasury gave preliminary approval to the Company’s application to receive a capital investment of $1.4 billion. The application was made under the Treasury’s Capital Purchase Program announced on October 14, 2008. The capital investment is expected to be received prior to year-end and will be in the form of nonvoting senior preferred shares pari passu with the Company’s existing preferred shares. The Company will also issue to the Treasury warrants exercisable for 10 years to purchase $210 million of the Company’s common shares. The number of common shares issuable under the warrants will be determined from the average share price during a specified 20-day trading period. The preferred shares will qualify for regulatory Tier 1 capital and may be redeemed after three years. They will have a dividend rate of 5% for the first five years, increasing to 9% thereafter. Among other things, the Company will be subject to restrictions and conditions including those related to common dividends, share repurchases, executive compensation, and corporate governance. This new capital will significantly strengthen the Company’s capital base, which was already well above the “well capitalized” regulatory benchmarks. The Company expects to deploy this new capital mainly in the form of prudent new lending in its markets throughout the western United States; it may also pursue the acquisition of failed banks being offered by the FDIC, and other business opportunities.
As of September 30, 2008, the Company has a $56.3 million remaining authorization from its Board of Directors for the repurchase of common stock. The Company has not repurchased any shares since August 2007 and in compliance with the conditions of the Capital Purchase Program, the Company will not repurchase any common shares during the period the senior preferred shares are outstanding without permission from the U.S. Department of the Treasury.
On July 2, 2008, the Company completed a $47 million offering of 9.50% Series C Fixed-Rate Non-Cumulative Perpetual Preferred Stock. The Company issued 46,949 shares in the form of 1,877,971 depositary shares with each depositary share representing a 1/40th ownership interest in a share of the preferred stock. Terms and conditions, except for the dividend amount, are generally similar to the existing issuance of $240 million Series A floating rate preferred stock in December 2006 and described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. The offering was sold via Zions’ online auction process and direct sales primarily by the Company’s broker/dealer subsidiary.
During September 8-11, 2008, the Company issued $250 million of new common stock consisting of 7,194,079 shares at an average price of $34.75 per share. Net of issuance costs and fees, this added $244.9 million to common equity. The registered sales took place through the previously announced ATM Equity Offering (SM) Sales Agreement with Merrill Lynch.
Dividends of $0.43 per common share were paid in the third quarters of both 2008 and 2007. For the three months ended September 30, 2008, the Company paid $45.5 million in dividends on common stock compared to $46.1 million in the same period of 2007. At its October 2008 meeting, the Company’s Board of Directors declared a dividend of $0.32 per share of common stock. The dividend is payable November 19, 2008 to shareholders of record as of the close of business on November 5, 2008. Under the terms of the Capital Purchase Program, the Company may not increase the dividend on its common stock during the period the senior preferred shares are outstanding without permission from the U.S. Department of the Treasury.
During the nine months ended September 30, 2008, the Company declared and set aside funds of $9.3 million for preferred dividends compared to $11.0 million during the comparable period in 2007. The Company declared and set aside $4.4 million for preferred dividends during the third quarter of 2008 and $3.8 million during the third quarter of 2007.
Interest rate and market risks are among the most significant risks regularly undertaken by the Company, and they are closely monitored as previously discussed. A discussion regarding the Company’s management of interest rate and market risk is included in the section entitled “Interest Rate and Market Risk Management” in this Form 10-Q.
61
An evaluation was carried out by the Company’s management, with the participation of the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, these disclosure controls and procedures were effective. There have been no changes in the Company’s internal control over financial reporting during the period covered by this report that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.
PART II. OTHER INFORMATION
The Company is a defendant in various legal proceedings arising in the normal course of business. The Company does not believe that the outcome of any such proceedings will have a material effect on its consolidated financial position, operations, or liquidity.
Other than discussed in the following paragraphs, the Company believes there have been no significant changes in risk factors compared to the factors identified in Zions Bancorporation’s Annual Report on Form 10-K for the year ended December 31, 2007; however, this filing contains updated disclosures related to significant risk factors discussed in “Credit Risk Management,” “Market Risk – Fixed Income,” and “Liquidity Risk Management.”
There can be no assurance that the actions of the U.S. government, Federal Reserve and other governmental and regulatory bodies for the purpose of stabilizing the financial markets, or market response to those actions, will achieve the intended effect. Our business may not benefit from these actions and further government or market developments could adversely impact us.
In response to the financial issues affecting the banking system and financial markets and going concern threats to investment banks and other financial institutions, the Emergency Economic Stabilization Act of 2008, or EESA, was recently enacted. The EESA provides the U.S. Secretary of the Treasury with the authority to establish a Troubled Asset Relief Program, or TARP, to purchase from financial institutions up to $700 billion of residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, as well as any other financial instrument that the U.S. Secretary of the Treasury, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, upon transmittal of such determination, in writing, to the appropriate committees of the U.S. Congress. The EESA also provides for a program that would allow companies to insure their troubled assets, and also provides the authority under which the Treasury may acquire preferred stock and warrants for common stock from financial institutions pursuant to a Capital Purchase Program (“CPP”).
62
There can be no assurance that the EESA will have a beneficial impact on the financial markets, including current extreme levels of volatility. To the extent the market does not respond favorably to the TARP or CPP or the TARP or CPP does not function as intended, our business may not receive the anticipated positive impact from the legislation. In addition, the U.S. Government, Federal Reserve and other governmental and regulatory bodies have taken or are considering taking other actions to address the financial crisis. We cannot predict whether or when such actions may occur or what impact, if any, such actions could have on our business, results of operations and financial condition.
Share Repurchases
The following table summarizes the Company’s share repurchases for the third quarter of 2008:
Period
Total number
of shares
repurchased (1)
Average
price paid
per share
Total number of shares
purchased as part of
publicly announced
plans or programs
Approximate dollar
value of shares that
may yet be purchased
under the plan
July
August
September
Quarter
Description
63
64
S I G N A T U R E S
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.
/S/ HARRIS H. SIMMONS
Harris H. Simmons, Chairman, President
and Chief Executive Officer
/S/ DOYLE L. ARNOLD
Doyle L. Arnold, Vice Chairman
and Chief Financial Officer
Date: November 7, 2008
65