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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the quarterly period ended September 30, 2003
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from to
---------------------- ----------------
Commission file Number 000-10535
CITIZENS BANKING CORPORATION
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
MICHIGAN 38-2378932
- --------------------------------------------- --------------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
328 S. Saginaw St., Flint, Michigan 48502
- --------------------------------------------- --------------------------
(Address of principal executive offices) (Zip Code)
(810) 766-7500
----------------------------------------------------
(Registrant's telephone number, including area code)
None
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(Former name, former address and former fiscal year,
if changed since last report)
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
[X] Yes [ ] No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
[X] Yes [ ] No
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class Outstanding at November 3, 2003
- -------------------------- -------------------------------
Common Stock, No Par Value 43,293,253 Shares
CITIZENS BANKING CORPORATION
Index to Form 10-Q
PAGE
----
PART I - FINANCIAL INFORMATION
Item 1 - Consolidated Financial Statements..................................................................... 3
Item 2 - Management's Discussion and Analysis of Financial Condition
and Results of Operations........................................................................... 13
Item 3. - Quantitative and Qualitative Disclosures about Market Risk........................................... 32
Item 4. - Controls and Procedures.............................................................................. 32
PART II - OTHER INFORMATION
Item 6 - Exhibits and Reports on Form 8-K...................................................................... 33
SIGNATURES.......................................................................................................... 34
EXHIBIT INDEX....................................................................................................... 35
2
PART I - FINANCIAL INFORMATION
ITEM 1 - CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
CITIZENS BANKING CORPORATION AND SUBSIDIARIES
SEPTEMBER 30, December 31,
(in thousands) 2003 2002
- -------------------------------------------------------------------------------------------------
(UNAUDITED) (Note 1)
ASSETS
Cash and due from banks $ 180,896 $ 171,864
Money market investments:
Federal funds sold -- 69,000
Interest-bearing deposits with banks 2,368 2,332
------------- -------------
Total money market investments 2,368 71,332
Investment Securities:
Available-for-Sale:
U.S. Treasury and federal agency securities 1,472,582 942,643
State and municipal securities 441,175 444,951
Other securities 74,071 69,687
Held-to-maturity:
State and municipal securities (fair value of $7,186) 7,262 --
------------- -------------
Total investment securities 1,995,090 1,457,281
Mortgage loans held for sale 132,627 160,743
Loans:
Commercial 2,931,023 3,111,208
Real estate construction 181,164 262,363
Real estate mortgage 408,038 545,834
Consumer 1,706,161 1,513,156
------------- -------------
Total loans 5,226,386 5,432,561
Less: Allowance for loan losses (125,955) (109,467)
------------- -------------
Net loans 5,100,431 5,323,094
Premises and equipment 112,089 117,704
Goodwill 54,785 54,785
Other intangible assets 17,688 19,862
Bank owned life insurance 79,929 78,434
Other assets 108,461 66,935
------------- -------------
TOTAL ASSETS $ 7,784,364 $ 7,522,034
============= =============
LIABILITIES
Noninterest-bearing deposits $ 878,536 $ 900,674
Interest-bearing deposits 4,603,657 5,036,239
------------- -------------
Total deposits 5,482,193 5,936,913
Federal funds purchased and securities sold
under agreements to repurchase 610,865 223,289
Other short-term borrowings 41,564 79,062
Other liabilities 74,993 32,988
Long-term debt 940,605 599,313
------------- -------------
Total liabilities 7,150,220 6,871,565
SHAREHOLDERS' EQUITY
Preferred stock - no par value -- --
Common stock - no par value 100,425 112,253
Retained earnings 506,318 495,570
Other accumulated comprehensive net income 27,401 42,646
------------- -------------
Total shareholders' equity 634,144 650,469
------------- -------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 7,784,364 $ 7,522,034
============= =============
See notes to consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
CITIZENS BANKING CORPORATION AND SUBSIDIARIES
Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands, except per share amounts) 2003 2002 2003 2002
- --------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Interest and fees on loans $ 80,371 $ 95,924 $ 247,394 $ 292,912
Interest and dividends on investment securities:
Taxable 14,254 14,150 45,795 41,121
Tax-exempt 5,059 5,319 15,288 16,038
Money market investments 3 165 102 755
---------- ---------- ---------- ----------
Total interest income 99,687 115,558 308,579 350,826
---------- ---------- ---------- ----------
INTEREST EXPENSE
Deposits 18,851 31,725 66,410 99,160
Short-term borrowings 1,463 1,007 3,497 2,876
Long-term debt 8,219 7,644 23,092 23,240
---------- ---------- ---------- ----------
Total interest expense 28,533 40,376 92,999 125,276
---------- ---------- ---------- ----------
NET INTEREST INCOME 71,154 75,182 215,580 225,550
Provision for loan losses 10,300 89,250 54,942 103,900
---------- ---------- ---------- ----------
Net interest income (loss) after provision for loan losses 60,854 (14,068) 160,638 121,650
---------- ---------- ---------- ----------
NONINTEREST INCOME
Service charges on deposit accounts 7,703 6,620 21,842 19,767
Trust fees 4,368 4,372 12,912 14,260
Mortgage and other loan income 5,404 2,928 15,967 9,825
Brokerage and investment fees 2,333 2,337 6,015 7,020
Bankcard fees 761 672 2,310 5,359
Investment securities gains (losses) 42 45 101 (12)
Gain on sale of merchant business -- -- -- 5,400
Gain on securitized mortgages -- -- -- 2,436
Other 4,443 2,760 14,041 11,020
---------- ---------- ---------- ----------
Total noninterest income 25,054 19,734 73,188 75,075
---------- ---------- ---------- ----------
NONINTEREST EXPENSE
Salaries and employee benefits 31,036 32,218 92,548 96,262
Equipment 4,060 5,167 12,098 14,981
Occupancy 4,328 4,307 13,337 13,506
Professional services 4,946 3,524 12,613 9,713
Data processing services 3,225 3,066 9,599 9,441
Postage and delivery 1,739 1,860 5,100 5,375
Advertising and public relations 1,395 1,848 4,067 5,535
Telephone 1,169 1,268 3,479 4,103
Stationery and supplies 911 907 2,679 3,021
Bankcard expenses 79 134 261 3,787
Special charge (370) 13,807 (691) 13,807
Prepayment penalty on FHLB advances -- 3,300 -- 3,300
Contribution to charitable trust -- 2,000 -- 2,000
Other 7,082 6,139 17,452 17,426
---------- ---------- ---------- ----------
Total noninterest expense 59,600 79,545 172,542 202,257
---------- ---------- ---------- ----------
INCOME (LOSS) BEFORE INCOME TAXES 26,308 (73,879) 61,284 (5,532)
Income tax provision (benefit) 6,703 (27,950) 13,407 (9,045)
---------- ---------- ---------- ----------
NET INCOME (LOSS) $ 19,605 $ (45,929) $ 47,877 $ 3,513
========== ========== ========== ==========
NET INCOME (LOSS) PER SHARE:
Basic $ 0.45 $ (1.03) $ 1.10 $ 0.08
Diluted 0.45 (1.03) 1.10 0.08
CASH DIVIDENDS DECLARED PER SHARE 0.285 0.285 0.855 0.845
See notes to consolidated financial statements.
4
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
CITIZENS BANKING CORPORATION AND SUBSIDIARIES
Other
Accumulated
Common Retained Comprehensive
(in thousands except per share amounts) Stock Earnings Net Income Total
- -----------------------------------------------------------------------------------------------------------------------
BALANCE - SEPTEMBER 30, 2002 $ 135,833 $ 486,762 $ 45,658 $ 668,253
Comprehensive income:
Net income 21,525 21,525
Other comprehensive income:
Net unrealized loss on securities available-for-sale,
net of tax effect of $(2,343) (4,352)
Less: Reclassification adjustment for net gains included
in net income, net of tax effect of $4 (8)
Minimum pension liability 1,348 (3,012)
--------- ----------
Total comprehensive income 18,513
Exercise of stock options, net of shares purchased 131 131
Shares acquired for retirement (23,776) (23,776)
Net change in deferred compensation, net of tax effect 65 65
Cash dividends - $0.285 per share (12,717) (12,717)
---------- ---------- --------- ----------
BALANCE - DECEMBER 31, 2002 $ 112,253 $ 495,570 $ 42,646 $ 650,469
Comprehensive income:
Net income 15,058 15,058
Other comprehensive income:
Net unrealized loss on securities available-for-sale,
net of tax effect of $(2,007) (3,728)
Less: Reclassification adjustment for net gains included
in net income, net of tax effect of $17 (31) (3,759)
--------- ----------
Total comprehensive income 11,299
Exercise of stock options, net of shares purchased 1,991 1,991
Shares acquired for retirement (11,177) (11,177)
Net change in deferred compensation, net of tax effect 47 47
Stock issued for compensation 200 200
Cash dividends - $0.285 per share (12,455) (12,455)
---------- ---------- --------- ----------
BALANCE - MARCH 31, 2003 $ 103,314 $ 498,173 $ 38,887 $ 640,374
Comprehensive income:
Net income 13,214 13,214
Other comprehensive income:
Net unrealized loss on securities available-for-sale,
net of tax effect of $(258) (479)
Less: Reclassification adjustment for net gains included
in net income, net of tax effect of $4 (7) (486)
--------- ----------
Total comprehensive income 12,728
Exercise of stock options, net of shares purchased 1,428 1,428
Shares acquired for retirement (3,051) (3,051)
Net change in deferred compensation, net of tax effect 32 32
Cash dividends - $0.285 per share (12,343) (12,343)
---------- ---------- --------- ----------
BALANCE - JUNE 30, 2003 $ 101,723 $ 499,044 $ 38,401 $ 639,168
Comprehensive income:
Net income 19,605 19,605
Other comprehensive income:
Net unrealized loss on securities available-for-sale,
net of tax effect of $(5,974) (11,095)
Less: Reclassification adjustment for net gains included
in net income, net of tax effect of $15 (27)
Net unrealized gain on cash flow hedges 122 (11,000)
--------- ----------
Total comprehensive income 8,605
Exercise of stock options, net of shares purchased 622 622
Shares acquired for retirement (1,951) (1,951)
Net change in deferred compensation, net of tax effect 31 31
Cash dividends - $0.285 per share (12,331) (12,331)
---------- ---------- --------- ----------
BALANCE - SEPTEMBER 30, 2003 $ 100,425 $ 506,318 $ 27,401 $ 634,144
========== ========== ========= ==========
See notes to consolidated financial statements.
5
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
CITIZENS BANKING CORPORATION AND SUBSIDIARIES
Nine Months Ended
September 30,
(in thousands) 2003 2002
- -------------------------------------------------------------- -----------------------------
OPERATING ACTIVITIES:
Net income $ 47,877 $ 3,513
Adjustments to reconcile net income to net cash provided by
operating activities:
Provision for loan losses 54,942 103,900
Depreciation 10,590 12,617
Amortization of intangibles 2,174 2,174
Net amortization on investment securities 7,270 1,125
Investment securities gains (101) (2,424)
Loans originated for sale (1,103,644) (613,359)
Proceeds from loan sales 1,141,965 647,197
Net gain from loan sales (10,205) (4,683)
Other 9,015 9,052
------------- -------------
Net cash provided by operating activities 159,883 159,112
INVESTING ACTIVITIES:
Net decrease in money market investments 68,964 1,848
Securities available-for-sale:
Proceeds from sales 1,438 69,334
Proceeds from maturities 633,417 217,158
Purchases (1,196,213) (449,602)
Purchases of securities held-to-maturity (7,262) --
Purchase of bank owned life insurance -- (78,000)
Net decrease in loans 167,721 167,899
Net increase in premises and equipment (4,975) (5,818)
------------- -------------
Net cash used in investing activities (336,910) (77,181)
FINANCING ACTIVITIES:
Net increase (decrease) in demand and savings deposits (82,218) 112,188
Net decrease in time deposits (372,502) (173,592)
Net increase in short-term borrowings 350,078 133,908
Proceeds from issuance of long-term debt 370,332 26,000
Principal reductions in long-term debt (30,364) (125,602)
Cash dividends paid (37,129) (37,942)
Proceeds from stock options exercised 4,041 6,431
Shares acquired for retirement (16,179) (26,520)
------------- -------------
Net cash provided by (used in) financing activities 186,059 (85,129)
------------- -------------
Net increase (decrease) in cash and due from banks 9,032 (3,198)
Cash and due from banks at beginning of period 171,864 224,416
------------- -------------
Cash and due from banks at end of period $ 180,896 $ 221,218
============= =============
See notes to consolidated financial statements.
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
CITIZENS BANKING CORPORATION AND SUBSIDIARIES
NOTE 1. BASIS OF PRESENTATION
The accompanying unaudited consolidated financial statements of Citizens Banking
Corporation ("Citizens") have been prepared in accordance with accounting
principles generally accepted in the United States ("GAAP") for interim
financial information and the instructions for Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
notes required by GAAP 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. Operating results for the
three and nine month periods ended September 30, 2003 are not necessarily
indicative of the results that may be expected for the year ended December 31,
2003. The balance sheet at December 31, 2002 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by GAAP for complete financial statements. For further
information, refer to the consolidated financial statements and footnotes
thereto included in Citizens' 2002 Annual Report on Form 10-K.
STOCK-BASED COMPENSATION: Citizens' stock-based compensation plans are accounted
for based on the intrinsic value method set forth in Accounting Principles Board
("APB") Opinion 25, Accounting for Stock Issued to Employees, and related
interpretations. Compensation expense for employee stock options is generally
not recognized if the exercise price of the option equals or exceeds the fair
value of the stock on the date of grant. Compensation expense for restricted
share awards is ratably recognized over the period of service, usually the
restricted period, based on the fair value of the stock on the date of grant.
The following table illustrates the effect on net income and earnings per share
if Citizens had applied the fair value recognition provisions of Statement of
Financial Accounting Standards ("SFAS") 123, Accounting for Stock-Based
Compensation, to its stock option awards.
- ------------------------------------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands, except per share amounts) 2003 2002 2003 2002
- ------------------------------------------------- --------------------------------------------------
Net income, as reported $ 19,605 $ (45,929) $ 47,877 $ 3,513
Less pro forma expense related to options granted (582) (679) (1,649) (1,798)
---------- ---------- ---------- ----------
Pro forma net income $ 19,023 $ (46,608) $ 46,228 $ 1,715
========== ========== ========== ==========
Net income per share:
Basic - as reported $ 0.45 $ (1.03) $ 1.10 $ 0.08
Basic - pro forma 0.44 (1.04) 1.07 0.04
Diluted - as reported 0.45 (1.03) 1.10 0.08
Diluted - pro forma 0.44 (1.04) 1.06 0.04
NOTE 2. RECENT ACCOUNTING PRONOUNCEMENTS
AMENDMENT OF SFAS 133 ON DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES: In April
2003, the Financial Accounting Standards Board ("FASB") issued Statement of
Financial Accounting Standards No. 149 ("SFAS 149") which amends and clarifies
financial accounting and reporting for derivative instruments and for hedging
activities under SFAS 133. The statement clarifies under what circumstances a
contract with an initial net investment meets the characteristics of a
derivative, clarifies when a derivative contains a financing component, amends
the definition of an "underlying" to conform it to language used in FASB
Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Other, and amends
certain other existing pronouncements. The provisions of SFAS 149 are effective
for contracts entered into or modified after June 30, 2003. These changes
required by SFAS 149 did not have a material impact on Citizens' results of
operations, financial position, or liquidity.
CONSOLIDATION OF VARIABLE INTEREST ENTITIES: In January 2003, the Financial
Accounting Standards Board ("FASB") issued FASB Interpretation No. 46 ("FIN
46"), Consolidation of Variable Interest Entities. The objective of this
interpretation is to provide guidance on how to identify a variable interest
entity ("VIE") and determine when the assets, liabilities, non-controlling
interests, and results of operations of a VIE need to be included in a company's
consolidated financial statements. A company that holds variable interests in an
entity will need to consolidate the entity if the company's interest in the VIE
is such that the company will absorb a majority of the VIE's expected losses
and/or receive a majority of the entity's expected residual returns, if they
occur. FIN 46 also requires additional disclosures by primary beneficiaries and
other significant
7
variable interest holders. The provisions of this interpretation, as applied to
VIE's created after January 31, 2003, became effective upon issuance in January
2003. Citizens must apply the provisions of FIN 46 to existing variable
interests in a VIE no later than December 31, 2003. Citizens adopted the
provisions of FIN 46 for new VIE's effective January 1, 2003. Based on Citizens'
current understanding of FIN 46, the adoption of this interpretation for
pre-existing VIE's will not materially impact Citizens' financial position,
results of operations or cash flows.
NOTE 3. SPECIAL CHARGE
In the third quarter of 2002, Citizens recorded a special charge of $13.8
million ($9.0 million after-tax) that included restructuring and impairment
costs associated with the reorganization of our consumer, business and wealth
management lines of business. The reorganization resulted from a detailed review
of our consumer banking, business banking and wealth management areas by key
members of management with assistance from industry consultants. This review
revealed opportunities for process change, staff reassignment, reporting
structure changes, branch closures, expense reduction and business growth. As a
result of the reorganization, Citizens displaced 134 employees. Displaced
employees were offered severance packages and outplacement assistance.
Additionally, twelve banking offices were closed in the fourth quarter of 2002
and six additional offices were closed during the second quarter of 2003.
The following provides details on the special charge and the related remaining
liability as of September 30, 2003.
Original 2002 Reserve 2003 Reserve
Reserve/ ---------- Balance ------------------------ Balance
Special Net December 31, Cash Noncash September 30,
(in thousands) Charge Activity(1) 2002 Payments Reductions(2) 2003
- ----------------------------------------------------------------------------------------------------------------------------------
Employee benefits and severance $ 8,072 $(3,791) $ 4,281 $(3,187) $ (378) $ 716
Professional fees 2,369 (1,961) 408 (83) (316) 9
Facilities and lease impairment 2,358 (2,036) 322 (34) -- 288
Contract termination fees and write-off of
obsolete equipment, software and supplies 1,008 (826) 182 (51) (131) --
------- ------- ------- ------- ------- -------
Total $13,807 $(8,614) $ 5,193 $(3,355) $ (825) $ 1,013
======= ======= ======= ======= ======= =======
(1) Includes cash payments of $6,134,000 and a reversal of $404,600 for items
included in the original charge that are no longer expected to be paid --
primarily employee benefits and severance and professional fees.
(2) Includes a reversal of $691,000 for employee benefits, severance,
professional fees and obsolete supplies included in the original charge
that are no longer expected to be paid.
NOTE 4. OTHER INTANGIBLE ASSETS
Citizens' other intangible assets as of September 30, 2003, December 31, 2002
and September 30, 2002 are shown in the table below.
SEPTEMBER 30, December 31, September 30,
(in thousands) 2003 2002 2002
- ---------------------------------------------------------------------------------
Core deposit intangibles $28,989 $28,989 $28,989
Accumulated amortization 11,334 9,160 8,435
------- ------- -------
Net core deposit intangibles 17,655 19,829 20,554
Minimum pension liability 33 33 3,304
------- ------- -------
Total other intangibles $17,688 $19,862 $23,858
======= ======= =======
The estimated annual amortization expense for core deposit intangibles for each
of the next five years is $2.9 million.
NOTE 5. LINES OF BUSINESS INFORMATION
Citizens is managed along the following business lines: Business Banking,
Consumer Banking, Wealth Management, and Other. In 2003, Citizens allocated its
core deposit intangible and the related amortization to the Business Banking and
Consumer Banking business lines. The core deposit intangible and the related
amortization was previously recorded in the
8
Other business line. Prior period information has been restated to reflect this
change. In the third quarter of 2003, Citizens also reallocated the investment
security portfolio held in our mortgage company from Consumer Banking to
Treasury, which is a component of Other. The affect on net income for the prior
periods presented was not material to the segments and they were not restated.
Selected line of business segment information, as adjusted, for the three- and
nine-month periods ended September 30, 2003 and 2002 is provided below. There
are no significant intersegment revenues.
Business Consumer Wealth
(in thousands) Banking Banking Management Other Total
- ------------------------------------------------------------------------------------------------------------------------
EARNINGS SUMMARY - THREE MONTHS ENDED SEPTEMBER 30, 2003
Net interest income (taxable equivalent) $ 29,193 $ 41,436 $ 32 $ 3,784 $ 74,445
Provision for loan losses 3,913 6,763 -- (376) 10,300
-------- -------- -------- -------- --------
Net interest income after provision 25,280 34,673 32 4,160 64,145
Noninterest income 3,504 14,793 5,712 1,045 25,054
Noninterest expense 15,412 32,541 5,577 6,070 59,600
-------- -------- -------- -------- --------
Income before income taxes 13,372 16,925 167 (865) 29,599
Income tax (benefit) expense (taxable equivalent) 4,662 5,931 56 (655) 9,994
-------- -------- -------- -------- --------
Net income $ 8,710 $ 10,994 $ 111 $ (210) $ 19,605
======== ======== ======== ======== ========
Average Assets (in millions ) $ 2,960 $ 2,454 $ 8 $ 2,390 $ 7,812
======== ======== ======== ======== ========
EARNINGS SUMMARY - THREE MONTHS ENDED SEPTEMBER 30, 2002
Net interest income (taxable equivalent) $ 35,346 $ 36,949 $ 6 $ 6,471 $ 78,772
Provision for loan losses 86,041 3,523 -- (314) 89,250
-------- -------- -------- -------- --------
Net interest income after provision (50,695) 33,426 6 6,785 (10,478)
Noninterest income 4,097 10,997 5,689 (1,049) 19,734
Noninterest expense 17,467 31,375 4,475 26,228 79,545
-------- -------- -------- -------- --------
Income before income taxes (64,065) 13,048 1,220 (20,492) (70,289)
Income tax expense (taxable equivalent) (22,422) 4,577 427 (6,942) (24,360)
-------- -------- -------- -------- --------
Net income $(41,643) $ 8,471 $ 793 $(13,550) $(45,929)
======== ======== ======== ======== ========
Average Assets (in millions ) $ 3,422 $ 2,696 $ 4 $ 1,494 $ 7,616
======== ======== ======== ======== ========
Business Consumer Wealth
(in thousands) Banking Banking Management Other Total
- ------------------------------------------------------------------------------------------------------------------------
EARNINGS SUMMARY - NINE MONTHS ENDED SEPTEMBER 30, 2003
Net interest income (taxable equivalent) $ 95,855 $114,247 $ 100 $ 15,498 $225,700
Provision for loan losses 41,997 13,492 -- (547) 54,942
-------- -------- -------- -------- --------
Net interest income after provision 53,858 100,755 100 16,045 170,758
Noninterest income 11,866 41,397 16,637 3,288 73,188
Noninterest expense 45,580 99,694 15,580 11,688 172,542
-------- -------- -------- -------- --------
Income before income taxes 20,144 42,458 1,157 7,645 71,404
Income tax expense (taxable equivalent) 7,174 14,860 399 1,094 23,527
-------- -------- -------- -------- --------
Net income $ 12,970 $ 27,598 $ 758 $ 6,551 $ 47,877
======== ======== ======== ======== ========
Average Assets (in millions ) $ 3,057 $ 2,394 $ 8 $ 2,234 $ 7,693
======== ======== ======== ======== ========
EARNINGS SUMMARY - NINE MONTHS ENDED SEPTEMBER 30, 2002
Net interest income (taxable equivalent) $105,025 $114,566 $ 245 $ 16,557 $236,393
Provision for loan losses 96,477 8,998 -- (1,575) 103,900
-------- -------- -------- -------- --------
Net interest income after provision 8,548 105,568 245 18,132 132,493
Noninterest income 12,824 42,614 17,948 1,689 75,075
Noninterest expense 51,974 102,980 13,130 34,173 202,257
-------- -------- -------- -------- --------
Income before income taxes (30,602) 45,202 5,063 (14,352) 5,311
Income tax expense (taxable equivalent) (10,708) 15,822 1,772 (5,088) 1,798
-------- -------- -------- -------- --------
Net income $(19,894) $ 29,380 $ 3,291 $ (9,264) $ 3,513
======== ======== ======== ======== ========
Average Assets (in millions ) $ 3,405 $ 2,735 $ 5 $ 1,426 $ 7,571
======== ======== ======== ======== ========
9
NOTE 6. LONG-TERM DEBT
The components of long-term debt as of September 30, 2003, December 31, 2002 and
September 30, 2002 are presented below.
SEPTEMBER 30, December 31, September 30,
(in thousands) 2003 2002 2002
- -------------------------------------------------------------------------------------------------------
Federal Home Loan Bank advances (1) $ 788,810 $ 599,139 $ 529,279
Subordinated debt:
Notes maturing February 2013(2) 125,882 -- --
Deferrable interest debenture maturing June 2033(3) 25,774 -- --
Other borrowed funds 139 174 218
---------- ---------- ----------
Total long-term debt $ 940,605 $ 599,313 $ 529,497
========== ========== ==========
(1) At September 30, 2003, rates on FHLB advances are fixed and variable
ranging from 1.12% to 7.10% maturing in 2003 through 2021. In 2002 rates on
FHLB advances were fixed and variable ranging from 1.82% to 7.10% maturing
in 2002 through 2021. The majority of the fixed rate FHLB advances are
convertible to a floating rate at the option of the Federal Home Loan Bank.
(2) On January 27, 2003, Citizens issued $125 million of 5.75% subordinated
notes maturing February 1, 2013. Citizens also entered into an interest
rate swap to hedge the interest rate risk on the subordinated debt. The
carrying value of the subordinated notes has been adjusted to reflect the
gain or loss attributable to the risk hedged. Issuance costs of $1.3
million were capitalized and are included in other assets on the balance
sheet. The issuance costs are being amortized over 10 years as a component
of interest expense. The subordinated debt qualifies under the risk-based
capital guidelines as Tier 2 supplementary capital for regulatory purposes.
(3) On June 26, 2003, Citizens issued $25 million of floating rate, 30 year
trust preferred securities through an unconsolidated special purpose trust
to unrelated institutional investors. The gross proceeds from issuance were
used to purchase a floating rate junior subordinated deferrable interest
debenture (the "Debenture") issued by Citizens, which is the sole asset of
the trust. The Debenture matures in thirty years and bears interest at an
annual rate equal to the three-month LIBOR plus 3.10%, payable quarterly
beginning in September, 2003. Interest is adjusted on a quarterly basis
provided that prior to May 2008, the interest rate shall not exceed 11.75%.
The Debenture is an unsecured obligation of Citizens and is junior in the
right of payment to all future senior indebtedness of Citizens. Citizens
has guaranteed that interest payments on the Debenture made to the trust
will be distributed by the trust to the holders of the trust preferred
securities. Issuance costs of $490,000 were incurred related to the
issuance. These costs have been capitalized and are included in other
assets on the balance sheet. The issuance costs are being amortized over
five years as a component of interest expense. The trust preferred
securities of the special purpose trust are callable after five years at
par and must be redeemed in 30 years after issuance. For regulatory
purposes, these trust preferred securities qualify under the risk-based
capital guidelines as Tier 1 capital.
NOTE 7. DERIVATIVES AND HEDGING ACTIVITIES
SFAS 133, "Accounting for Derivative Instruments and Hedging Activities," as
amended by SFAS 138 and SFAS 149, "Accounting for Certain Derivative Instruments
and Certain Hedging Activities," (collectively referred to as "SFAS 133")
establish accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities. All derivatives, whether designated in hedging relationships
or not, are required to be recorded on the balance sheet at fair value.
Citizens designates its derivatives based upon criteria established by SFAS 133.
For a derivative designated as a fair value hedge, the derivative is recorded at
fair value on the consolidated balance sheet. Any difference between the fair
value change of the hedge versus the fair value change of the hedged item is
considered to be the "ineffective" portion of the hedge. The ineffectiveness of
the hedge is recorded in current earnings. For a derivative designated as a cash
flow hedge, the effective portion of the derivative's gain or loss is initially
reported as a component of accumulated other comprehensive income (loss) and
subsequently reclassified into earnings when the hedged exposure affects
earnings.
Citizens may use derivative instruments to hedge the variability in interest
payments or protect the value of certain assets and liabilities recorded in its
balance sheet from changes in interest rates. Citizens uses interest rate
contracts such as interest rate swaps to manage its interest rate risk. These
contracts are designated as hedges of specific assets or liabilities. The net
interest receivable or payable on swaps is accrued and recognized as an
adjustment to the interest income or expense of the hedged asset or liability.
The following table summarizes the derivative financial instruments held or
issued by Citizens.
10
DERIVATIVE FINANCIAL INSTRUMENTS:
SEPTEMBER 30, 2003
-----------------------------------------------
NOTIONAL RECEIVE PAY FAIR
(dollars in thousands) AMOUNT RATE RATE VALUE
- --------------------------------------------------------------------------------------------------------------
Received fixed swaps $165,000 4.66% 1.96% $ 1,820
Interest rate lock commitments 29,940 -- -- 700
Forward mortgage loan contracts 110,000 -- -- (652)
-------- --------
TOTAL $304,940 $ 1,868
======== ========
DERIVATIVE CLASSIFICATIONS AND HEDGING RELATIONSHIPS:
SEPTEMBER 30, 2003
-----------------------------------------------
NOTIONAL FAIR VALUE
(dollars in thousands) AMOUNT GAIN LOSS
- -------------------------------------------------------------------------- --------------------
Derivatives Designated as Cash Flow Hedges:
Hedging commercial loans $ 25,000 $ 398 $ --
Derivatives Designated as Fair Value Hedges:
Hedging time deposits 15,000 122 --
Hedging long-term debt 125,000 1,300 --
-------- --------- --------
TOTAL $165,000 $ 1,820 $ --
======== ========= ========
NOTE 8. EARNINGS PER SHARE
Net income per share is computed based on the weighted-average number of shares
outstanding, including the dilutive effect of stock options, as follows:
Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands, except per share amounts) 2003 2002 2003 2002
- ----------------------------------------------------------------------------------------------------
NUMERATOR:
Basic and dilutive earnings per share -- net income
available to common shareholders $ 19,605 $(45,929) $ 47,877 $ 3,513
======== ======== ======== ========
DENOMINATOR:
Basic earnings per share -- weighted average shares 43,227 44,610 43,326 44,819
Effect of dilutive securities -- potential conversion
of employee stock options 274 -- 248 476
-------- -------- -------- --------
Diluted earnings per share -- adjusted weighted-average
shares and assumed conversions 43,501 44,610 43,574 45,295
======== ======== ======== ========
BASIC EARNINGS PER SHARE $ 0.45 $ (1.03) $ 1.10 $ 0.08
======== ======== ======== ========
DILUTED EARNINGS PER SHARE $ 0.45 $ (1.03) $ 1.10 $ 0.08
======== ======== ======== ========
During the third quarter of 2003, employees exercised stock options to acquire
34,852 shares at an average exercise price of $17.83 per share.
11
NOTE 9. OBLIGATIONS UNDER STANDBY LETTERS OF CREDIT AND OTHER CONTINGENT
GUARANTEES
In the normal course of business Citizens provides financial and performance
standby letters of credit to its clients. Financial standby letters of credit
guarantee future payment of client financial obligations to third parties. They
are issued primarily for services provided or to facilitate the shipment of
goods. Performance standby letters of credit are irrevocable guarantees to make
payment in the event a specified third party fails to perform under a
nonfinancial contractual obligation. Standby letters of credit arrangements
generally expire within one year and have essentially the same level of credit
risk as extending loans to clients and are subject to Citizens' normal credit
policies. Inasmuch as these arrangements generally have fixed expiration dates
or other termination clauses, most expire unfunded and do not necessarily
represent future liquidity requirements. Collateral is obtained based on
management's assessment of the client and may include receivables, inventories,
real property and equipment.
Amounts available to clients under standby letters of credit follow:
SEPTEMBER 30, December 31,
(in thousands) 2003 2002
- -------------------------------------------------------------------------------------------------
CONTINGENT GUARANTEES:
Financial standby letters of credit $ 36,803 $ 28,783
Performance standby letters of credit 6,080 7,613
NOTE 10. ACCUMULATED OTHER COMPREHENSIVE INCOME
The components of other accumulated comprehensive income, net of tax, for the
three and nine month periods ended September 30, 2003 and 2002 are presented
below.
Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands) 2003 2002 2003 2002
- ----------------------------------------------------------------------------------------------------------------------------
Balance at beginning of period $ 38,401 $ 33,545 $ 42,646 $ 20,553
Net unrealized gain (loss) on securities for the quarter, net of tax
effect of $(5,974) in 2003 and $6,538 in 2002. (11,095) 12,142
Less: Reclassification adjustment for net gains included in net
income for the quarter, net of tax effect of $15 in 2003 and $16 in
2002 (27) (29)
Net unrealized gain (loss) on securities for the period, net of tax
effect of $(8,269) in 2003 and $14,366 in 2002 (15,302) 26,680
Less: Reclassification adjustment for net gains included in net
income for the period, net of tax effect of $36 in 2003 and $849 in
2002 (65) (1,575)
Net unrealized gain on cash flow hedges 122 122
---------- ---------- -------- ----------
Accumulated other comprehensive income, net of tax $ 27,401 $ 45,658 $ 27,401 $ 45,658
========== ========== ======== ==========
12
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FIVE-QUARTER SUMMARY OF SELECTED FINANCIAL INFORMATION
CITIZENS BANKING CORPORATION AND SUBSIDIARIES
FOR THE QUARTER ENDED
-----------------------------------------------------------------------
SEPTEMBER 30, JUNE 30, MARCH 31, DECEMBER 31, SEPTEMBER 30,
2003 2003 2003 2002 2002
-----------------------------------------------------------------------
SUMMARY OF OPERATIONS (THOUSANDS)
Interest income $ 99,687 $ 104,683 $ 104,209 $ 112,558 $ 115,558
Net interest income 71,154 72,920 71,506 76,232 75,182
Provision for loan losses 10,300 25,650 18,992 16,300 89,250
Noninterest income 25,054 24,847 23,287 26,701 19,734
Noninterest expense 59,600 56,361 56,581 57,126 79,545 (1)
Income tax provision (benefit) 6,703 2,542 4,162 7,982 (27,950)
Net income (loss) 19,605 13,214 15,058 21,525 (45,929)
Cash dividends 12,331 12,343 12,455 12,717 12,719
-----------------------------------------------------------------------
PER COMMON SHARE DATA
Basic net income (loss) $ 0.45 $ 0.30 $ 0.35 $ 0.49 $ (1.03)
Diluted net income (loss) 0.45 0.30 0.34 0.48 (1.03)
Cash dividends 0.285 0.285 0.285 0.285 0.285
Market value (end of period) 26.41 27.01 23.62 24.78 24.17
Book value (end of period) 14.67 14.77 14.79 14.88 14.97
-----------------------------------------------------------------------
AT PERIOD END (MILLIONS)
Assets $ 7,784 $ 7,786 $ 7,765 $ 7,522 $ 7,614
Portfolio Loans (2) 5,226 5,287 5,303 5,433 5,524
Deposits 5,482 5,660 5,812 5,937 5,904
Shareholders' equity 634 639 640 650 668
-----------------------------------------------------------------------
AVERAGE FOR THE QUARTER (MILLIONS)
Assets $ 7,812 $ 7,809 $ 7,454 $ 7,564 $ 7,616
Portfolio Loans (2) 5,183 5,253 5,343 5,470 5,577
Deposits 5,610 5,723 5,853 5,922 5,951
Shareholders' equity 620 639 643 654 711
-----------------------------------------------------------------------
RATIOS (ANNUALIZED)
Return on average assets 1.00% 0.68% 0.82% 1.13% (2.39)%
Return on average shareholders' equity 12.55 8.29 9.50 13.06 (25.63)
Net interest margin (FTE) 4.03 4.17 4.33 4.49 4.40
Efficiency ratio 59.90 55.74 57.58 53.61 80.75
Net loans charged off to average loans 0.80 0.92 1.20 0.80 4.70
Average equity to average assets 7.94 8.18 8.63 8.65 9.34
Allowance for loan losses as a percent of loans 2.41 2.38 2.12 2.02 1.89
Nonperforming assets to loans plus ORAA (end of period) 1.74 1.82 1.76 1.76 1.95
Nonperforming assets to total assets (end of period) 1.17 1.24 1.20 1.27 1.42
Leverage ratio 7.25 7.20 7.21 7.18 7.26
Tier 1 capital ratio 9.64 9.55 9.15 9.18 9.27
Total capital ratio 13.07 13.10 12.59 10.43 10.52
(1) Includes special charge of $13.8 million -- see Note 3 to the consolidated
financial statements included in this report.
(2) Balances exclude mortgage loans held for sale.
13
INTRODUCTION
The following commentary presents management's discussion and analysis of
Citizens Banking Corporation's financial condition and results of operations for
the three and nine month periods ended September 30, 2003 and should be read in
conjunction with the unaudited consolidated financial statements and notes
included elsewhere in this report and the audited consolidated financial
statements and notes contained in our 2002 Annual Report on Form 10-K. Unless
the context indicates otherwise, all references in the discussion to "Citizens,"
the "Company," "our," "us" and "we" refer to Citizens Banking Corporation and
its subsidiaries.
FORWARD -LOOKING STATEMENTS
Discussions in this quarterly report that are not statements of historical fact
(including statements that include terms such as "believe", "expect", and
"anticipate") are forward-looking statements that involve risks and
uncertainties, and our actual future results could materially differ from those
discussed. Factors that could cause or contribute to such differences include,
but are not limited to, adverse changes in our loan portfolios (including losses
due to fraud and economic factors) and the resulting credit risk-related losses
and expenses, our future lending and collections experience and the potential
inadequacy of our loan loss reserves, interest rate fluctuations and other
adverse changes in economic or financial market conditions, the potential
inability to hedge certain risks economically, adverse changes in competition
and pricing environments, our potential failure to maintain or improve loan
quality levels and origination volume, our potential inability to continue to
attract core deposits, the potential lack of market acceptance of our products
and services, adverse changes in our relationship with major customers,
unanticipated technological changes that require major capital expenditures,
adverse changes in applicable laws and regulatory requirements, unanticipated
environmental liabilities or costs, our potential inability to complete our
restructuring, the effects of terrorist attacks and potential attacks, our
success in managing the risks involved in the foregoing, and other risks and
uncertainties detailed in this report and from time to time in our other filings
with the Securities and Exchange Commission.
Other factors not currently anticipated by management may also materially and
adversely affect our results of operations. We do not undertake, and expressly
disclaim any obligation, to update or alter our forward-looking statements
whether as a result of new information, future events or otherwise, except as
required by applicable law.
CRITICAL ACCOUNTING POLICIES
Citizens' consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States and follow general
practices within the industries in which it operates. Application of these
principles requires management to make estimates, assumptions, and judgments
that affect the amounts reported in the financial statements and accompanying
notes. These estimates, assumptions and judgments are based on information
available as of the date of the financial statements; accordingly, as this
information changes, the financial statements could reflect different estimates,
assumptions and judgments. Certain policies inherently have a greater reliance
on the use of estimates, assumptions, and judgments and as such, have a greater
possibility of producing results that could be materially different than
originally reported. Based on the valuation techniques used and the sensitivity
of financial statement amounts to the methods, assumptions and estimates
underlying those amounts, management has identified the determination of the
allowance for loan losses and the benefit obligation and net periodic pension
expense for our employee pension and postretirement benefit plans to be the
accounting areas that require the most subjective or complex judgments, and,
therefore, the most subject to revision as new information becomes available.
Our significant accounting policies are more fully described in Item 7 of our
2002 Annual Report on Form 10-K and in Note 1 to the audited consolidated
financial statements contained in that report. There have been no material
changes to those policies or the estimates made pursuant to those policies
during the most recent quarter.
RESULTS OF OPERATIONS
EARNINGS SUMMARY
Citizens earned net income of $19,605,000, or $0.45, per diluted share for the
three months ended September 30, 2003, compared with a net loss of
$(45,929,000), or $(1.03) per diluted share, for the same quarter of 2002.
Returns on average assets and average equity for the quarter were 1.00% and
12.55%, respectively, compared with negative returns of (2.39)% and (25.63)%,
respectively, in 2002. For the nine months ended September 30, 2003, net income
was $47,877,000 or $1.10 per diluted share, compared to $3,513,000 or $0.08 per
diluted share for the same period of 2002. Returns on average assets and average
equity during the first nine months of 2003 were 0.83% and 10.10%, respectively,
compared with 0.06% and 0.67%, respectively, in 2002.
14
The improvement in net income for the three and nine months ended September 30,
2003 compared to the same periods in 2002 resulted primarily from lower loan
loss provision and noninterest expense partially offset by lower net interest
income. Noninterest income improved for the quarter but was down for the nine
months ended September 30, 2003. Gains recorded in the second quarter of 2002 of
$5.4 million from the sale of our merchant services business and $2.4 million
from the sale of securitized mortgages contributed to the decline in noninterest
income for the nine months ended September 30, 2003.
The provision for losses declined to $10.3 million in the third quarter of 2003
from $89.3 million in the third quarter of 2002. For the nine months ended
September 30, 2003, the provision for loan losses was $54.9 million compared
with $103.9 million for the same period in 2002. The large loan loss provision
for the third quarter of 2002 was primarily in response to an unusually high
amount of commercial credits that deteriorated to charge-off status during the
quarter, as well as increases in nonperforming and impaired commercial credits.
Higher loss factors, based on more recent loan loss experience, applied to the
formula portion of the allowance also increased the third quarter 2002
provision. The lower loan loss provision in 2003 reflects a decline in
nonperforming assets, lower net charge-offs and fewer risk rating downgrades
within the commercial loan portfolio.
Changes in net interest income, noninterest income and noninterest expense were
also impacted by a third quarter 2002 special charge of $13.8 million ($9.0
million after-tax) to restructure Citizens' consumer, business and wealth
management lines of business and other charges of $9.4 million ($6.1 million
after-tax) in the same quarter for various items we considered unusual in
nature. Net interest income was charged $0.7 million, noninterest income was
charged $1.6 million and noninterest expense was charged $20.9 million for these
charges.
NET INTEREST INCOME AND NET INTEREST MARGIN
The primary source of our revenue is net interest income. Net interest income is
the difference between interest income on earning assets, such as loans and
securities, and interest expense on liabilities, including interest-bearing
deposits and borrowings, used to fund those assets. The amount of net interest
income is affected by fluctuations in the amount and composition of earning
assets and funding sources and in the yields earned and rates paid,
respectively, on these assets and liabilities. The level of net interest income
relative to our interest bearing liabilities and our earning assets can be
measured through two statistics - interest spread and net interest margin. The
interest spread represents the difference between yields on earning assets and
the rates paid for interest-bearing liabilities. The net interest margin is
expressed as the percentage of net interest income to average earning assets.
Both the interest spread and net interest margin are presented on a
tax-equivalent basis. Because noninterest-bearing funding sources, such as
demand deposits and shareholders' equity, also support earning assets, the net
interest margin exceeds the interest spread.
Net interest income decreased $4.0 million in the third quarter of 2003 compared
to the third quarter of 2002, as a lower net interest margin more than offset
the effects of an increase in average earning assets. Average earning assets
increased $221.6 million in the third quarter compared with the same quarter a
year ago as growth in the investment portfolio of $502.0 million more than
offset declines in loan balances and money market investments. This growth was
due to our strategy, beginning late in the first quarter of 2003, to expand our
investment securities portfolio to offset the effects of weak loan demand and
the prospect of net interest margin pressure from continued low interest rates,
while moving us to a more neutral interest rate risk position. For the first
nine months of 2003, net interest income declined $10.0 million from the same
period a year ago due to a 28 basis point decline in net interest margin
partially offset by an increase of $100.9 million in average earning assets.
Net interest margin in the third quarter of 2003 declined to 4.03% from 4.40% in
the third quarter of 2002. Net interest margin for the first nine months of 2003
declined to 4.15% from 4.43% for the same period in 2002. These declines are
attributable to the asset sensitive position held prior to the second quarter of
2003, accelerated prepayments in both the fixed rate commercial loan portfolio
and the mortgage related securities portfolio, plus a shift in the mix of
earning assets from loans to lower yielding securities.
The low rates available for reinvestment of fixed rate asset maturities and
prepayments, and the lack of material loan growth are expected to continue to
put pressure on our net interest income and net interest margin. As a result, we
expect our margin to decline in the fourth quarter of 2003, but to a lesser
extent than in the second and third quarters.
15
The table below shows the effect of changes in average balances ("volume") and
market rates of interest ("rate") on interest income, interest expense and net
interest income for major categories of earning assets and interest-bearing
liabilities.
ANALYSIS OF CHANGES IN INTEREST INCOME AND INTEREST EXPENSE
Three Months Ended September 30, Nine Months Ended September 30,
--------------------------------------- ---------------------------------------
Increase (Decrease) Increase (Decrease)
Due to Change in Due to Change in
2003 COMPARED WITH 2002 Net ------------------------ Net ------------------------
(in thousands) Change (1) Rate (2) Volume (2) Change (1) Rate (2) Volume (2)
- -----------------------------------------------------------------------------------------------------------------------------------
INTEREST INCOME
Money market investments $ (162) $ (74) $ (88) $ (653) $ (233) $ (420)
Investment securities:
Taxable 104 (5,682) 5,786 4,674 (10,737) 15,411
Tax-exempt (260) (66) (194) (750) (98) (652)
Mortgage loans held for sale 1,374 (817) 2,191 1,435 (2,088) 3,523
Loans:
Commercial (9,966) (5,819) (4,147) (24,864) (17,172) (7,692)
Real estate (4,372) (1,109) (3,263) (13,529) (4,146) (9,383)
Direct consumer (1,656) (2,564) 908 (5,032) (6,622) 1,590
Indirect consumer (933) (1,619) 686 (3,528) (3,700) 172
-------- -------- ------- -------- -------- --------
Total (15,871) (17,750) 1,879 (42,247) (44,796) 2,549
-------- -------- ------- -------- -------- --------
INTEREST EXPENSE
Deposits:
Demand (2,277) (2,941) 664 (4,157) (5,572) 1,415
Savings (2,288) (2,142) (146) (4,681) (4,759) 78
Time (8,309) (4,423) (3,886) (23,912) (15,092) (8,820)
Short-term borrowings 456 (456) 912 621 (941) 1,562
Long-term debt 575 (2,680) 3,255 (148) (5,994) 5,846
-------- -------- ------- -------- -------- --------
Total (11,843) (12,642) 799 (32,277) (32,358) 81
-------- -------- ------- -------- -------- --------
NET INTEREST INCOME $ (4,028) $ (5,108) $ 1,080 $ (9,970) $(12,438) $ 2,468
======== ======== ======= ======== ======== ========
(1) Changes are based on actual interest income and do not reflect taxable
equivalent adjustments.
(2) Changes not solely due to changes in volume or rates have been allocated in
proportion to the absolute dollar amounts of the change in each.
The decrease in net interest income reflected unfavorable rate-related variances
partially offset by favorable volume-related variances. The net unfavorable
rate-related variance reflects the asset-sensitive interest rate risk position
held prior to the second quarter of 2003 coupled with the Federal Reserve's
actions in the fourth quarter of 2002 to lower short-term interest rates by 50
basis points, a shift in the mix of earning assets toward lower yielding
securities and higher prepayment levels on fixed rate loans and investments.
Yields on commercial loans and consumer home equity loans were impacted as many
of these loans are tied to the prime interest rate, which declined in step with
the decline in short-term interest rates. Lower interest rates have also led to
a decrease in funding costs which have further benefited from a shift in mix
from higher cost time deposits to lower cost demand deposits. The net favorable
volume variance reflected our previously mentioned strategy to expand the
investment portfolio, growth in home equity and indirect consumer lending, and
mortgage loans awaiting sale in the secondary market. Partially offsetting these
increases were declines in real estate and commercial loans. Real estate loans
declined due to high prepayment activity, sale of most new mortgage loan
production into the secondary market, and securitization in 2002 of $28.6
million of mortgage loan originations and $114.3 million of seasoned portfolio
mortgage loans through the Federal National Mortgage Association ("FNMA") and
the Federal Home Loan Mortgage Corporation ("FHLMC"). During the first nine
months of 2003, 83.4% of total mortgage loans originated were designated for
sale into the secondary market.
16
An analysis of net interest income, interest spread and net interest margin with
average balances and related interest rates for the three and nine months ended
September 30, 2003 and 2002 is presented below.
AVERAGE BALANCES/NET INTEREST INCOME/AVERAGE RATES
2003 2002
--------------------------------------- --------------------------------
Three Months Ended September 30 AVERAGE AVERAGE AVERAGE AVERAGE
(in thousands) BALANCE INTEREST(1) RATE(2) BALANCE INTEREST(1) RATE(2)
- ------------------------------------------------------------------------------------------------------------------------------------
EARNING ASSETS
Money market investments:
Federal funds sold $ 1,509 $ 1 0.38% $ 33,802 $ 140 1.61%
Other 2,418 2 0.25 7,736 25 1.29
Investment securities(3):
Taxable 1,526,583 14,254 3.73 1,009,300 14,150 5.61
Tax-exempt 401,302 5,059 7.76 416,550 5,319 7.86
Mortgage loans held for sale 234,793 3,090 5.26 82,804 1,716 8.29
Loans:
Commercial 3,049,878 42,110 5.54 3,368,262 52,076 6.21
Real estate mortgage 481,337 7,626 6.34 681,658 11,998 7.03
Direct consumer 937,133 14,648 6.27 848,198 16,304 7.63
Indirect consumer 714,302 12,897 7.24 679,362 13,830 8.17
----------- ----------- ---------- --------
Total earning assets(3) 7,349,255 99,687 5.58 7,127,672 115,558 6.65
NONEARNING ASSETS
Cash and due from banks 183,214 182,153
Bank premises and equipment 112,812 123,920
Investment security fair value adjustment 28,909 65,960
Other nonearning assets 262,373 198,045
Allowance for loan losses (124,964) (82,244)
----------- ----------
Total assets $ 7,811,599 $7,615,506
----------- ----------
INTEREST-BEARING LIABILITIES
Deposits:
Interest-bearing demand $ 1,334,765 $ 2,483 0.75 $1,151,589 $ 4,760 1.64
Savings deposits 1,332,519 1,839 0.55 1,374,149 4,127 1.19
Time deposits 2,054,257 14,529 2.84 2,539,356 22,838 3.57
Short-term borrowings 561,427 1,463 1.03 249,531 1,007 1.60
Long-term debt 937,941 8,219 3.47 615,124 7,644 4.93
----------- ----------- ---------- --------
Total interest-bearing liabilities 6,220,909 28,533 1.83 5,929,749 40,376 2.70
----------- --------
NONINTEREST-BEARING LIABILITIES AND SHAREHOLDERS'
EQUITY
Noninterest-bearing demand 888,440 886,387
Other liabilities 82,150 88,392
Shareholders' equity 620,100 710,978
----------- ----------
Total liabilities and shareholders' equity $ 7,811,599 $7,615,506
----------- ----------
INTEREST SPREAD $ 71,154 3.75% $ 75,182 3.95%
=========== ========
Contribution of net noninterest bearing sources of funds 0.28 0.45
---- ----
NET INTEREST INCOME AS A PERCENT OF EARNING ASSETS 4.03% 4.40%
(1) Interest income shown on actual basis and does not include taxable
equivalent adjustments.
(2) Average rates are presented on an annual basis and include taxable
equivalent adjustments to interest income of $3,291,000 and $3,590,000 for
the three months ended September 30, 2003 and 2002, respectively, based on
a tax rate of 35%.
(3) For presentation in this table, average balances and the corresponding
average rates for investment securities are based upon historical cost,
adjusted for amortization of premiums and accretion of discounts.
17
AVERAGE BALANCES/NET INTEREST INCOME/AVERAGE RATES
2003 2002
-------------------------------------- ------------------------------------
Nine Months Ended September 30 AVERAGE AVERAGE AVERAGE AVERAGE
(in thousands) BALANCE INTEREST(1) RATE(2) BALANCE INTEREST(1) RATE(2)
- ---------------------------------------- --------- ------------ ------- -------- ----------- --------
EARNING ASSETS
Money market investments:
Federal funds sold $ 12,083 $ 95 1.03% $ 41,942 $ 526 1.65%
Other 2,054 7 0.49 26,901 229 1.12
Investment securities(3):
Taxable 1,359,305 45,795 4.49 943,410 41,121 5.81
Tax-exempt 401,022 15,288 7.82 418,108 16,038 7.87
Mortgage loans held for sale 185,891 7,727 5.54 109,458 6,292 7.66
Loans:
Commercial 3,155,940 133,073 5.64 3,350,474 157,937 6.31
Real estate mortgage 538,880 25,442 6.30 729,941 38,971 7.11
Direct consumer 895,155 43,899 6.56 832,054 48,931 7.86
Indirect consumer 668,772 37,253 7.45 665,952 40,781 8.19
---------- ----------- ---------- -----------
Total earning assets(3) 7,219,102 308,579 5.86 7,118,240 350,826 6.79
NONEARNING ASSETS
Cash and due from banks 172,681 180,701
Bank premises and equipment 114,419 126,393
Investment security fair value adjustment 51,598 48,796
Other nonearning assets 254,554 178,132
Allowance for loan losses (119,411) (81,146)
---------- ----------
Total assets $7,692,943 $7,571,116
========== ==========
INTEREST-BEARING LIABILITIES
Deposits:
Interest-bearing demand $1,312,898 $ 9,263 0.94 $1,112,259 $ 13,420 1.61
Savings deposits 1,352,398 7,408 0.73 1,364,617 12,089 1.18
Time deposits 2,192,473 49,739 3.03 2,584,035 73,651 3.81
Short-term borrowings 418,967 3,497 1.10 231,807 2,876 1.66
Long-term debt 835,990 23,092 3.65 624,349 23,240 4.98
---------- ----------- ---------- -----------
Total interest-bearing liabilities 6,112,726 92,999 2.02 5,917,067 125,276 2.83
----------- -----------
NONINTEREST-BEARING LIABILITIES AND SHAREHOLDERS'
EQUITY
Noninterest-bearing demand 870,039 864,238
Other liabilities 76,073 85,273
Shareholders' equity 634,105 704,538
---------- ----------
Total liabilities and shareholders' equity $7,692,943 $7,571,116
========== ==========
INTEREST SPREAD $ 215,580 3.84% $ 225,550 3.96%
=========== ===========
Contribution of net noninterest bearing sources of
funds 0.31 0.47
---- ----
NET INTEREST INCOME AS A PERCENT OF EARNING ASSETS 4.15% 4.43%
- --------------------------
(1) Interest income shown on actual basis and does not include taxable
equivalent adjustments.
(2) Average rates are presented on an annual basis and include taxable
equivalent adjustments to interest income of $10,120,000 and $10,843,000 for
the nine months ended September 30, 2003 and 2002, respectively, based on
a tax rate of 35%.
(3) For presentation in this table, average balances and the corresponding
average rates for investment securities are based upon historical cost,
adjusted for amortization of premiums and accretion of discounts.
18
NONINTEREST INCOME
Noninterest income for the third quarter of 2003 was $25.1 million, an increase
of $5.3 million or 27.0% from the third quarter of 2002. Noninterest income for
the nine months ended September 30, 2003 was $73.2 million, down $1.9 million or
2.5% from the first nine months of 2002. The increase for the quarter reflected
higher service charges on deposit accounts and mortgage banking revenue. Also
contributing to the increase was a charge of $1.6 million recorded in the third
quarter of 2002, which included market valuation adjustments of $662,000 to an
equity investment and $650,000 to life insurance cash surrender values, and
write-offs of $200,000 for obsolete assets and $75,000 for cash management fees
accrued but not collectible. The year-to-date decline in 2003 was largely due to
gains recorded in 2002 of $5.4 million from the sale of Citizens' merchant
services business and $2.4 million from the sale of securitized mortgages
partially offset by the aforementioned one-time charge of $1.6 million. The
other components of noninterest income increased $4.4 million as higher service
charges on deposits, mortgage banking revenue and income from bank owned life
insurance more than offset lower trust, brokerage and investment fees and
bankcard fees. An analysis of the sources of noninterest income during the three
and nine months ended September 30, 2003 and 2002 is summarized in the table
below.
NONINTEREST INCOME
Three Months Ended Nine Months Ended
September 30, September 30, $ Change in 2003 % Change in 2003
------------------ ----------------- ---------------- ----------------
(in thousands) 2003 2002 2003 2002 3 Mos 9 Mos 3 Mos 9 Mos
- ------------------------------------- ------- -------- --------- ------- ----- ----- ----- -----
Service charges on deposit accounts $ 7,703 $ 6,620 $ 21,842 $19,767 $ 1,083 $ 2,075 16.4% 10.5%
Trust fees 4,368 4,372 12,912 14,260 (4) (1,348) (0.1) (9.5)
Mortgage and other loan income 5,404 2,928 15,967 9,825 2,476 6,142 84.6 62.5
Brokerage and investment fees 2,333 2,337 6,015 7,020 (4) (1,005) (0.2) (14.3)
Bankcard fees 761 672 2,310 5,359 89 (3,049) 13.2 (56.9)
Gain on sale of merchant business -- -- -- 5,400 -- (5,400) 0.0 (100.0)
Gain on sale of securitized mortgages -- -- -- 2,436 -- (2,436) 0.0 (100.0)
Investment securities gains (losses) 42 45 101 (12) (3) 113 (6.7) (941.7)
Other, net 4,443 2,760 14,041 11,020 1,683 3,021 61.0 27.4
------- -------- -------- ------- -------- --------
Total noninterest income $25,054 $ 19,734 $ 73,188 $75,075 $ 5,320 $ (1,887) 27.0 (2.5)
======= ======== ======== ======= ======== ========
Service charges on deposit accounts were up for both the three and nine-month
periods ended September 30, 2003 compared to the same periods in 2002. Last
year, with the assistance of banking industry consultants, we began an extensive
review of our consumer bank business line. As a result of the review, we
implemented a number of recommendations that have resulted in, among other
things, additional overdraft fees, a new overdraft monitoring system and fewer
waived fees. The increases in service charges were due to these changes.
Trust fees were essentially unchanged for the quarter but decreased for the
first nine months of 2003 compared to the same periods in 2002. These fees are
based primarily on the market value of the average assets under administration.
For the nine months ended September 30, 2003, the decline in trust fees was due
to lower financial markets and, to a lesser extent, client attrition. Attrition
was down in the third quarter, but outpaced new business generation for the nine
month period. We expect attrition to continue to decline as we expand our
product offerings and provide upgraded systems and technology. Total trust
assets under administration were $2.61 billion at September 30, 2003, an
increase of $123.0 million from September 30, 2002, and a decline of $13.0
million from June 30, 2003. On average, trust assets under administration were
down $275 million in the first nine months of 2003 compared to the same period
in 2002.
Mortgage and other loan income was up due to higher mortgage loan origination
volume in 2003. A strong mortgage origination market, spurred by low mortgage
interest rates, helped push total mortgage originations to $444 million in the
third quarter and $1.284 billion year-to-date, compared with $350 million in the
third quarter of 2002 and $801 million in the first nine months of 2002. The
majority of all new mortgage loan originations along with the related servicing
were sold in the secondary market resulting in higher revenue.
Brokerage and investment fees were unchanged for the quarter but declined for
the nine months ended September 30, 2003 compared to the same periods of 2002.
The decline for the first nine months of 2003 reflects slower retail sales of
fixed annuity products.
Bankcard fees, which include revenue generated from personal and business debit
and credit cards as well as merchant services, were up slightly for the quarter
but declined for the nine month period ended September 30, 2003 compared to the
same periods in 2002. The decline for the first nine months of 2003 resulted
from the sale of our merchant services business in the second quarter of 2002.
19
Other noninterest income increased $1.7 million for the quarter and $3.0 million
for the nine months ended September 30, 2003, compared to the same periods of
2002. The increases in both periods were principally due to the aforementioned
charge of $1.6 million recorded in the third quarter of 2002 and increases in
life insurance income and title insurance fees. Higher life insurance income
reflects the purchase of $78.0 million of separate account bank owned life
insurance in the third quarter of 2002. Title insurance fees increased due to
higher mortgage origination volume.
Based on the current economic and interest rate environment, noninterest income
is expected to decline somewhat in the fourth quarter of 2003 from third quarter
levels due to lower mortgage income as mortgage origination and sale volume is
expected to decline in the fourth quarter.
NONINTEREST EXPENSE
Noninterest expense for the third quarter was $59.6 million compared with $79.5
million for the third quarter of 2002, a decrease of $19.9 million or 25.1%. For
the nine months ended September 30, 2003, total noninterest expense decreased
$29.7 million or 14.7% to $172.5 million compared to the same period in 2002.
The declines reflect a special charge of $13.8 million and other charges of $7.1
million recorded in the third quarter of 2002 for restructuring and other
initiatives as well as decreases in most other major components of noninterest
expense offset, in part, by increased professional services, and system
implementation costs and other expense reflected below in other, net. An
analysis of the components of noninterest expense during the three and nine
months ended September 30, 2003 and 2002 is summarized in the table below.
NONINTEREST EXPENSE
Three Months Ended Nine Months Ended
September 30, September 30, $ Change in 2003 % Change in 2003
-------------------- --------------------- ------------------------ ------------------
(in thousands) 2003 2002 2003 2002 3 Mos 9 Mos 3 Mos 9 Mos
- -----------------------------------------------------------------------------------------------------------------------------------
Salaries and employee benefits $ 31,036 $ 32,218 $ 92,548 $ 96,262 $ (1,182) $ (3,714) (3.7)% (3.9)%
Equipment 4,060 5,167 12,098 14,981 (1,107) (2,883) (21.4) (19.2)
Occupancy 4,328 4,307 13,337 13,506 21 (169) 0.5 (1.3)
Professional services 4,946 3,524 12,613 9,713 1,422 2,900 40.4 29.9
Data processing services 3,225 3,066 9,599 9,441 159 158 5.2 1.7
Postage and delivery 1,739 1,860 5,100 5,375 (121) (275) (6.5) (5.1)
Advertising and public relations 1,395 1,848 4,067 5,535 (453) (1,468) (24.5) (26.5)
Telephone 1,169 1,268 3,479 4,103 (99) (624) (7.8) (15.2)
Stationery and supplies 911 907 2,679 3,021 4 (342) 0.4 (11.3)
Bankcard expenses 79 134 261 3,787 (55) (3,526) (41.0) (93.1)
Special charge (370) 13,807 (691) 13,807 (14,177) (14,498) (102.7) (105.0)
Prepayment penalty on
FHLB advances -- 3,300 -- 3,300 (3,300) (3,300) (100.0) (100.0)
Contribution to charitable trust -- 2,000 -- 2,000 (2,000) (2,000) (100.0) (100.0)
Other, net 7,082 6,139 17,452 17,426 943 26 15.4 0.1
-------- -------- --------- -------- -------- --------
Total noninterest expense $ 59,600 $ 79,545 $ 172,542 $202,257 $(19,945) $(29,715) (25.1) (14.7)
======== ======== ========= ======== ======== ========
Salaries and employee benefits were down due to lower staffing levels resulting
from the restructuring initiatives announced during the third quarter of 2002
and normal attrition. Higher incentive-based compensation associated with
mortgage loan origination and sales activity and increased medical costs
partially offset the decline. We had 2,353 full time equivalent employees at
September 30, 2003, down from 2,650 at September 30, 2002.
Equipment expenses decreased due to lower depreciation and improved pricing from
new or renegotiated maintenance contracts. A $0.4 million charge in the third
quarter of 2002 for additional depreciation on equipment to be retired early
also contributed to the decrease. The increase in professional services
reflected $0.6 million incurred for the collateral field audit initiative begun
in March of 2003, higher legal costs related to loan collection efforts,
increased executive recruiting and relocation costs, implementation costs for
Citizens' new INEA Performance Management software and additional costs
associated with engagement of banking industry consultants who assisted in the
restructuring. The decrease in advertising and public relations expense resulted
from less media-intensive marketing campaigns as we adopted a more focused
marketing strategy, seeking higher exposure at lower costs. Bankcard expense
declined due to the sale of our merchant services business in the second quarter
of 2002.
In the third quarter of 2002, we recorded a special charge of $13.8 million for
restructuring initiatives within its three major lines of business (consumer
banking, business banking and wealth management) to be able to compete more
effectively, reduce layers of management, be more customer oriented, and be
better positioned to grow core deposits and loans. At the
20
same time, Citizens also charged to noninterest expense $7.1 million of other
significant items considered unusual in nature. These charges included a $3.3
million prepayment penalty on high cost FHLB debt, a $2.0 million contribution
to Citizens' charitable trust, $0.4 million of additional equipment depreciation
described previously and $1.4 million included in other noninterest expense as
described below.
Other noninterest expense increased $0.9 million, or 15.4% for the quarter and
was virtually unchanged for the nine months ended September 30, 2003 compared to
the same periods in 2002. The increase in the third quarter of 2003 compared to
same quarter in 2002 was primarily due to a loss of $0.5 million on the sale of
other real estate ("ORE"), higher state taxes of $0.6 million due to our third
quarter 2002 net loss and higher loan charge-offs in the third quarter of 2002,
and $0.6 million associated with the implementation of new strategic alliances
between our trust bank subsidiary, Citizens Bank Wealth Management N.A., and
three third party vendors, SEI Investments, EnvestnetPMC and EPIC Advisors, Inc.
Partially offsetting these increases were $1.4 million of other charges recorded
in the third quarter of 2002, which included an ORE market valuation adjustment
of $1.0 million and other charges of $0.4 million. For the nine months ended
September 30, 2003 compared to the same period in 2002, higher ORE expenses of
$1.2 million, state taxes of $0.3 million, and trust bank implementation costs
of $0.8 million were essentially offset by the $1.4 million of other charges in
the third quarter of 2002, a contract termination fee of $0.6 million in the
first half of 2002 as servicing for our debit card portfolio was brought back
in-house, and fewer fraud and other losses recorded in 2003.
Noninterest expense is expected to remain relatively flat in the fourth quarter
of 2003 compared to third quarter 2003 levels as additional marketing expenses
targeting selected markets and deposit products are expected to be offset by
lower mortgage-related compensation.
INCOME TAXES
Income tax provision was $6.7 million in the third quarter of 2003 compared with
an income tax benefit of $28.0 million during the same period in 2002. For the
nine months ended September 30, 2003, income tax provision was $13.4 million
compared with an income tax benefit of $9.0 million for the same period last
year. The income tax benefits in both the three and nine months ended September
30, 2002 resulted from a pretax operating loss due to a high loan loss
provision, the special charge and other charges recorded in the third quarter of
2002. The effective tax rate, computed by dividing the provision for income
taxes by income before taxes, was 25.5% for the third quarter of 2003 and 21.9%
for the first nine months of 2003. The effective tax rates for the same periods
of 2002 of 37.8% and 163.5%, respectively, are essentially meaningless because
of the net losses recorded.
LINES OF BUSINESS REPORTING
We monitor our financial performance using an internal profitability measurement
system, which provides line of business results and key performance measures.
Our business line results are divided into four major business segments:
Business Banking, Consumer Banking, Wealth Management and Other. For additional
information about each line of business, see Note 19 to the consolidated
financial statements of our 2002 Annual Report on Form 10-K and Note 5 to the
consolidated financial statements of this report. A summary of net income (loss)
by each business line is presented below.
Three Months Ended Nine Months Ended
September 30, September 30,
(in thousands) 2003 2002 2003 2002
- -----------------------------------------------------------------------
Business Banking $ 8,710 $(41,643) $12,970 $(19,894)
Consumer Banking 10,994 8,471 27,598 29,380
Wealth Management 111 793 758 3,291
Other (210) (13,550) 6,551 (9,264)
-------- -------- ------- --------
Net income $ 19,605 $(45,929) $47,877 $ 3,513
======== ======== ======= ========
BUSINESS BANKING
The increases in net income in both the three and nine month periods ended
September 30, 2003 were primarily attributed to decreases in the provision for
loan losses and to a lesser extent noninterest expense. The significant declines
in the loan loss provision in both the three and nine month periods were due to
lower net charge-offs, fewer commercial loan risk rating downgrades and
improving non-performing asset levels. Commercial loan net charge-offs totaled
$7.8 million and $29.6 million in the third quarter and year-to-date periods of
2003, respectively, compared with $62.0 million and $71.3 million in the same
periods of 2002. Net interest income declined in both the three and nine month
periods ended September 30, 2003
21
as a result of lower average loan balances, particularly in Michigan and
Wisconsin, due to the sluggish economy, on-going fixed rate loan refinancing and
pay-downs, and earlier identification and reduction of exposure on credits with
the potential to deteriorate. The decline in net interest income is also
attributable to a decrease in commercial loan yields due to the lower prime rate
as a result of the Federal Reserve's action to reduce short term interest rates.
Noninterest income declined due to lower deposit service charges and cash
management fees. Noninterest expense decreased due to lower compensation and
other costs as a result of the third quarter 2002 line of business
restructuring.
CONSUMER BANKING
The increase in net income for the three months ended September 30, 2003 was due
to an increase in net interest income and noninterest income partially offset by
higher provision for loan losses, noninterest expense and income taxes. Net
interest income increased due to a lower cost of funds and higher loan volumes
from growth in home equity and indirect consumer loans. Noninterest income
increased due to higher mortgage income and service charges on deposits. The
increase in the provision for loan losses reflected a higher loss allocation for
our wholesale mortgage business. Noninterest expense was up due to higher
incentive-based salary expense related to the high volume of mortgage
originations.
The decrease in net income for the first nine months of 2003 was caused by an
increase in provision for loan losses and a decrease in noninterest income,
partially offset by lower noninterest expense and income taxes. The higher
provision for loan losses in the nine month period ended September 30, 2003
reflected a higher loss allocation for our wholesale mortgage business and
higher charge-offs in the first quarter of 2003 due to a discount on the sale of
nonperforming residential mortgage loans. The decrease in noninterest income in
2003 was due to a gain of $5.4 million recorded in the second quarter of 2002
from the sale of our merchant services business and lower bankcard fees as a
result of the sale, partially offset by higher mortgage banking revenue and
deposit service charges. Noninterest expense was down due to lower bankcard
expense as a result of the sale of the merchant services business and lower
compensation and equipment expenses due to the third quarter 2002 business line
restructuring.
WEALTH MANAGEMENT
The decline in net income for the three month period ended September 30, 2003
was due to an increase in noninterest expense related to severance of $0.2
million and implementation costs of $0.6 million associated with our strategic
alliances with SEI Investments, EnvestnetPMC, Inc, and EPIC Advisors, Inc. In
the third quarter of 2003, our trust bank, Citizens Bank Wealth Management,
N.A., through an arrangement with EPIC Advisors, Inc., announced plans to
increase and grow its retirement plan business by offering its clients advanced
state-of-the-art online employee account access, online retirement plan design
and consulting options, and access to industry experts. Additionally, in the
second quarter of 2003, Citizens Bank Wealth Management, N.A. formed strategic
alliances with SEI Investments and EnvestnetPMC, Inc. These alliances will
enable us to offer our wealth management clients a broader range of mutual fund
family choices, access to separately managed accounts with specialized portfolio
managers, state of the art research capabilities, and sophisticated client
profiling and portfolio modeling tools.
The decline in net income for the nine month period ended September 30, 2003 was
caused by a decrease in noninterest income and an increase in noninterest
expense. Noninterest income declined as a result of lower trust and brokerage
and investment fees. The decline in trust fees was due to lower average trust
assets resulting from the decline in the financial markets during the latter
half of 2002 and the first quarter of 2003 and, to a lesser extent, attrition.
The decline in brokerage and investment fees reflects slower retail sales of
fixed annuity products. Noninterest expense increased due to implementation
costs associated with the restructuring and the strategic alliances and a net
loss of $0.3 million in settlement of a lawsuit.
OTHER
The net loss in the three month period and the net income in the nine month
period ended September 30, 2003 represent significant improvements compared with
the net losses recorded in the three and nine month periods ended September 30,
2002. The net losses recorded in the prior year periods resulted from the
special charge to restructure Citizens' three major lines of business and other
charges totaling a combined $21.5 million attributed to Other in the third
quarter of 2002. Noninterest income improved in both the three and nine month
periods ended September 30, 2003 due to the other charges of $1.3 million
recorded in the third quarter of 2002. Noninterest expense declined in both the
three and nine month periods ended 2003 due to the special and other charges of
$19.5 million recorded in the third quarter of 2002 and cost savings as a result
of the third quarter 2002 restructuring. Lower net interest income in both the
three and nine month periods ended September 30, 2003 partially offset the
reduction in noninterest expense and the increase in noninterest income. The
decline in net interest income is attributable to accelerated purchase premium
amortization on mortgage related securities purchased prior to 2003, partially
offset by additional interest income on investment securities as a result of the
expansion of the securities portfolio which began in March 2003 and $0.7 million
of other charges in the third quarter of 2002.
22
FINANCIAL CONDITION
Proper management of the volume and composition of our earning assets and
funding sources is essential for ensuring strong and consistent earnings
performance, maintaining adequate liquidity and limiting exposure to risks
caused by changing market conditions. Our investment securities portfolio is
structured to provide a source of liquidity principally through the maturity of
the securities held in the portfolio and to generate an income stream with
relatively low levels of principal risk. Loans comprise the largest component of
earning assets and are some of our highest yielding assets. Client deposits are
the primary source of funding for earning assets while short-term debt and other
managed sources of funds are used as market conditions and liquidity needs
change.
We had total assets of $7.784 billion as of September 30, 2003, an increase of
$262 million, or 3.5%, from $7.522 billion as of December 31, 2002. Investment
security balances increased $537.8 million or 36.9% from year end 2002 as
Citizens began to expand its investment securities portfolio near the end of the
first quarter of 2003 to offset the effects of weak loan demand and the prospect
of net interest margin pressure from continued low interest rates. Loans
declined $234.3 million or 4.2% compared with December 31, 2002. The decline in
loans from year-end 2002 reflected a decrease in commercial and mortgage loans,
partially offset by an increase in consumer loans. Increases in short-term
borrowings and FHLB advances have funded the expansion of the investment
portfolio. Average earning assets comprised 93.8% of average total assets during
the first nine months of 2003 compared with 94.0% in the first nine months of
2002.
INVESTMENT SECURITIES AND MONEY MARKET INVESTMENTS
Total average investments, including money market investments, comprised 24.6%
of average earning assets during the first nine months of 2003, compared with
20.1% for the same period of 2002. Average investment securities for the nine
months ended September 30, 2003 were up $398.8 million from the first nine
months of 2002 average levels. The increase was primarily due to retention of
securities created from mortgage loan securitizations in the second half of 2002
and purchases of securities since December 31, 2002. In March 2003, Citizens
implemented an investment portfolio expansion plan to help offset the effect on
net interest income of weak loan demand. In accordance with the plan, we
purchased approximately $500 million of mortgage backed securities and
collateralized mortgage obligations with average lives of three to five years
and an average duration of two to four years, resulting in interest spreads of
up to 250 basis points over funding sources. The purchases were funded with cash
flow from loan repayments, runoff of investments and short-and medium-term
borrowings.
Average money market investments for the first nine months of 2003 were down
$54.7 million from the first nine months of 2002. We held higher levels of money
market investments during most of 2002 in anticipation of purchasing bank-owned
life insurance. We completed a $78 million purchase of bank-owned life insurance
in the third quarter of 2002.
MORTGAGE LOANS HELD FOR SALE
Mortgage loans held for sale were $ 132.6 million at September 30, 2003, down
$28.1 million from year-end 2002 but up $11.3 million from September 30, 2002.
These balances generally track the level of originations as we are selling most
of our new residential mortgage loan production into the secondary market due to
the low interest rate environment. A strong mortgage origination market, spurred
by low mortgage interest rates, helped push total mortgage originations to $444
million and $1.284 billion for the three and nine month periods ended September
30, 2003, respectively, compared with $350 million and $801 million,
respectively, for the same periods in 2002. Average mortgage loans held for sale
during the nine months of 2003 comprised 2.6% of average earning assets compared
with 1.5% during the same period in 2002. Mortgages held for sale are accounted
for on the lower of cost or market basis.
PORTFOLIO LOANS
We extend credit primarily within the local markets of our banking subsidiaries
located in Michigan, Wisconsin, Iowa and Illinois. We generally lend to
consumers and small to mid-sized businesses and, consistent with our emphasis on
relationship banking, most of these credits represent core, multi-relationship
customers who also maintain deposit relationships and use other banking services
such as cash management. Our loan portfolio is diversified by borrower and
industry with no concentration within a single industry that exceeds 10% of the
total loan balance outstanding. We do not have any loans to foreign debtors and
do not purchase nationally syndicated loans or participate in highly leveraged
transactions. We seek to limit our credit risk by establishing guidelines to
review the aggregate outstanding commitments and loans to particular borrowers,
industries, and geographic areas. We obtain collateral based on the nature of
the credit and our credit assessment of the customer.
Total portfolio loans at September 30, 2003 were down $206.2 million, or 3.8%,
from December 31, 2002. The decline in total portfolio loans was caused
primarily by lower demand for commercial loans in the current sluggish economy,
tightening
23
of our credit standards, and a decline in mortgage loans, partially offset by
an increase in consumer loans. Commercial loan balances at September 30, 2003
declined $180.2 million from December 31, 2002, due to lower demand caused by
the sluggish economy, increased activity in fixed-rate loan refinancing,
prepayments and other paydowns, and proactive identification and reduction of
exposure on credits with the potential to deteriorate. Mortgage loans declined
$138 million due to the continued sale of most new mortgage loan production into
the secondary market and record high refinancing activity causing prepayment of
existing portfolio loans in the historically low interest rate environment.
Consumer loans, other than mortgage loans, increased $193 million or 12.8% from
December 31, 2002 as growth in home equity loans more than offset a decline in
other direct consumer loans. Home equity loans increased 23.1% from year-end
2002 and comprised $127 million of the $193 million increase in consumer loans.
Two home equity line of credit campaigns contributed to this growth. The spring
campaign contributed most of the growth, while the summer campaign contributed
commitments of $54 million and $26 million of new balances at September 30,
2003. The campaigns have yielded over 4,500 new accounts with commitments of
over $260 million and aggregate balances in excess of $131 million. Average
total portfolio loans declined by $395 million, or 7.1%, for the third quarter
of 2003 compared to the same period in 2002.
Total loans are expected to decline slightly during the remainder of 2003 as
growth in consumer loans is anticipated to be more than offset by continued
declines in commercial and mortgage loans. Growth in consumer loans is expected
to continue to come primarily from home equity products but will be partially
offset by a decline in new indirect loans largely due to the seasonal slow down
of marine and RV sales. Mortgage loans are anticipated to decline due to
expected prepayments on portfolio loans and due to the sale of our current
mortgage originations into the secondary market. Commercial loans are expected
to decline slowly throughout the year due to lower demand and the continued
implementation of our credit improvement initiatives.
At September 30, 2003 and 2002, $65.6 million and $224.9 million, respectively,
of residential real estate loans originated and subsequently sold in the
secondary market were being serviced by Citizens. Capitalized servicing rights
relating to the serviced loans were fully amortized in June 2003 and were $0.8
million at September 30, 2002.
CREDIT RISK MANAGEMENT
Extending credit to businesses and consumers exposes us to credit risk. Credit
risk is the risk that the principal balance of a loan and any related interest
will not be collected due to the inability or unwillingness of the borrower to
repay the loan. Credit risk is mitigated through portfolio diversification that
limits exposure to any single industry or customer. Similarly, credit risk is
also mitigated through the establishment of a comprehensive system of internal
controls, which includes standard lending policies and procedures, underwriting
criteria, collateral safeguards, and surveillance and evaluation by an
independent internal loan review staff of the quality, trends, collectibility
and collateral protection within the loan portfolio. Lending policies and
procedures are reviewed and modified on an ongoing basis as conditions change
and new credit products are offered. Our commercial and commercial real estate
credit administration policies include a loan rating system and an analysis by
the internal loan review staff of loans over a fixed amount and of a sampling of
loans under such amount. Furthermore, account officers are vested with the
responsibility of monitoring their customer relationships and act as the first
line of defense in determining changes in the loan ratings on credits for which
they are responsible. Loans that have migrated within the loan rating system to
a level that requires remediation are actively reviewed by senior management at
regularly scheduled quarterly meetings with the credit administration staff and
the account officers. At these meetings, action plans are developed to either
remediate any emerging problem loans or develop a specific plan for removing
such loans from the portfolio within a short time frame.
The collateral field audits initiated in late March are essentially complete.
Based upon results of these audits, there have been no additional reserves or
charge-offs although a small number of commercial customers have been requested
to seek alternative financing because they were unwilling or unable to
accommodate Citizens' reporting requests. We intend to continue regular audits
of receivable and inventory collateral as standard practice going forward.
PROVISION AND ALLOWANCE FOR LOAN LOSSES
The provision for loan losses represents a charge against income and a
corresponding increase in the allowance for loan losses. Credit losses are
charged and recoveries are credited to the allowance for loan losses. The amount
of the provision for loan losses is based on our review of the historical credit
loss experience and such factors that, in our judgment, deserve consideration
under existing economic conditions in estimating probable credit losses. While
we consider the allowance for loan losses to be adequate based on information
currently available, future adjustments to the allowance may be necessary due to
changes in economic conditions, delinquencies or loss rates. See "-- Critical
Accounting Policies."
24
A summary of loan loss experience during the three and nine months ended
September 30, 2003 and 2002 is provided below.
ANALYSIS OF ALLOWANCE FOR LOAN LOSSES
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------- -------------------------
(in thousands) 2003 2002 2003 2002
- -----------------------------------------------------------------------------------------------------------------------
Allowance for loan losses - beginning of period $ 125,992 $ 80,447 $ 109,467 $ 80,299
Provision for loan losses 10,300 89,250 54,942 103,900
Charge-offs:
Commercial 9,539 56,042 31,249 65,734
Commercial real estate 1,531 5,452 6,807 5,452
Small business 348 1,596 885 1,941
----------- ------------ ---------- ----------
Total commercial 11,418 63,090 38,941 73,127
Real estate mortgage 213 229 914 282
Consumer - Direct 1,628 2,478 5,166 5,982
Consumer - Indirect 1,941 2,035 6,604 6,136
----------- ------------ ---------- ----------
Total charge-offs 15,200 67,832 51,625 85,527
----------- ------------ ---------- ----------
Recoveries:
Commercial 2,882 1,004 7,029 1,750
Commercial real estate 595 11 1,683 11
Small business 139 50 594 106
----------- ------------ ---------- ----------
Total commercial 3,616 1,065 9,306 1,867
Real estate mortgage 27 11 36 11
Consumer - Direct 504 463 1,422 1,292
Consumer - Indirect 716 754 2,407 2,316
----------- ------------ ---------- ----------
Total recoveries 4,863 2,293 13,171 5,486
----------- ------------ ---------- ----------
Net charge-offs 10,337 65,539 38,454 80,041
----------- ------------ ---------- ----------
Allowance for loan losses - end of period $ 125,955 $ 104,158 $ 125,955 $ 104,158
=========== ===========- ========== ==========
Portfolio loans outstanding at period end (1) $ 5,226,386 $ 5,524,023 $5,226,386 $5,524,023
Average portfolio loans outstanding during period (1) 5,182,650 5,577,480 5,258,747 5,578,421
Allowance for loan losses as a percentage of portfolio loans 2.41% 1.89% 2.41% 1.89%
Ratio of net charge-offs during period to average 0.80 4.70 0.97 1.91
portfolio loans (annualized)
Loan loss coverage (allowance as a multiple of 3.0X 0.4X 2.5X 1.0X
net charge-offs, annualized)
(1) Balances exclude mortgage loans held for sale.
The provision for losses declined to $10.3 million in the third quarter of 2003
compared to $89.3 million in the third quarter of 2002. The lower loan loss
provision resulted from a decline in nonperforming assets, lower net charge-offs
and fewer risk rating downgrades within the commercial loan portfolio.
Additionally, in the third quarter of 2002 we recorded an incremental loan loss
provision primarily in response to an unusually high amount of commercial
credits that deteriorated to charge-off status, a significant migration of loans
to higher risk ratings as well as increases in nonperforming and impaired
commercial credits during the quarter. Higher loss factors applied to the
formula portion of the allowance also affected the third quarter 2002 provision,
which increased $23 million due to this change.
Net loans charged-off in the third quarter of 2003 totaled $10.3 million, or
0.80%, of average loans (annualized), compared with $65.5 million, or 4.70%, in
the third quarter of 2002. The decrease in net charge-offs occurred primarily in
the commercial loan portfolio. Commercial net charge-offs were $7.8 million in
the third quarter of 2003, down $54.2 million from the third quarter of 2002 and
$1.5 million from the second quarter of 2003. Of the unusually high level of
commercial charge-offs in the third quarter 2002, 60% consisted of seven
credits. These seven credits were from a variety of industries, including
automotive manufacturing and packaging, heavy construction, health supplement
products and real estate development. Commercial charge-offs in the third
quarter of 2003 included two credits totaling $5.0 million or 64% of the
commercial loan amount. These two credits were in the electric power
distribution and grocery industries. In the second quarter of 2003, we recorded
provision expense in excess of charge-offs as a result of an in-depth risk
rating review, which included a review of higher risk "pass" rated credits to
conform the risk ratings of these loans and the continued application of
previous
25
enhancements to our internal risk rating process. Based on these enhanced credit
processes and credit administration procedures, we now expect, barring any
unforeseen downturn in the economy, net charge-offs and loan loss provisions in
the fourth quarter to be less than $11 million each.
The allowance for credit losses represents our estimate of probable losses
inherent in the loan portfolio. The allowance is based on ongoing quarterly
assessments and is maintained at a level management considers to be adequate to
absorb probable loan losses identified with specific customer relationships and
for probable losses believed to be inherent in the loan portfolio that have not
been specifically identified. Our evaluation process is inherently subjective as
it requires estimates that may be susceptible to significant change and have the
potential to materially affect net income. Default frequency, internal risk
ratings, expected future cash collections, loss recovery rates, and general
economic factors, among other things, are considered in this evaluation, as are
the size and diversity of individual large credits. While we have implemented
enhancements to our loan loss allocation model and risk rating process, we have
not substantively changed our overall approach in the determination of the
allowance for loan losses in 2003 from 2002. Our methodology for measuring the
adequacy of the allowance relies on several key elements, which include specific
allowances for identified problem loans, a formula-based risk-allocated
allowance for the remainder of the portfolio and an unallocated allowance. This
methodology is discussed at length in our 2002 Annual Report on Form 10-K.
The allowance for loan losses was $126.0 million at September 30, 2003, an
increase of $16.5 million compared to December 31, 2002. The higher allowance at
September 30, 2003 reflects an increase in the formula based risk-allocated
reserves. At September 30, 2003, the allowance allocated to specific commercial
and commercial real estate credits was $11.3 million, down from $18.7 million at
December 31, 2002. The decrease reflects fewer criticized and classified credits
subject to specific allocation, as many of these credits have been fully or
partially charged off. Criticized and classified credits (i.e., those internally
risk rated 7 - special mention, 8 - substandard or 9 - doubtful) subject to
specific reserves decreased to $54.0 million at September 30, 2003 from $90.4
million at December 31, 2002.
The total formula risk-allocated allowance was $107.4 million at September 30,
2003, up from $83.4 million at December 31, 2002. The amount allocated to
commercial and commercial real estate loans, including construction loans,
increased to $86.4 million at September 30, 2003 from $65.5 million at December
31, 2002. The increase reflected a higher level of criticized and classified
loans and migration of loans to higher risk ratings as well as our assessment of
current economic conditions within our local markets. The risk-allocated
allowance for residential real estate loans increased to $4.8 million at
September 30, 2003, from $2.3 million at December 31, 2002, reflecting a higher
loss allocation for our wholesale mortgage business partially offset by fewer
non-accrual loans and a smaller portfolio. Lower nonaccrual loan levels were
due, in part, to the sale in January 2003 of $2.1 million of nonperforming
residential mortgage loans from the F&M banks and the sale of $2.8 million of
nonperforming residential loans in March 2003. Even with the discounts taken for
these sales, historical loss ratios in the residential mortgage portfolio remain
very low. The risk-allocated allowance for consumer loans increased to $16.2
million at September 30, 2003 from $15.6 million at December 31, 2002. The
increase in the allowance was due to growth in the consumer portfolio.
The unallocated allowance was $7.3 million at September 30, 2003, essentially
unchanged from December 31, 2002. The unallocated portion of the allowance is
maintained to capture the uncertainty that factors affecting the determination
of probable losses inherent in the loan portfolio may exist which have not yet
manifested themselves in our specific allowances or in the historical loss
factors used to determine the formula allowances, such as geographic expansion,
the possible imprecision of internal risk-ratings within the portfolios,
continued weak general economic and business conditions and changes in the
composition of our portfolio.
26
NONPERFORMING ASSETS
Nonperforming assets are comprised of nonaccrual loans, loans with restructured
terms and other repossessed assets, primarily other real estate. Although these
assets have more than a normal risk of loss, they will not necessarily result in
a higher level of losses in the future. The table below provides a summary of
nonperforming assets as of September 30, 2003, December 31, 2002 and September
30, 2002.
NONPERFORMING ASSETS
September 30, December 31, September 30,
(in thousands) 2003 2002 2002
- -----------------------------------------------------------------------------------------------------------------------
Nonperforming Loans
Nonaccrual Commercial:
Commercial $51,158 $50,231 $ 48,374
Commercial real estate 17,379 19,301 28,488
Small business 1,648 813 588
------- ------- --------
Total commercial 70,185 70,345 77,450
Nonaccrual Consumer:
Direct 3,291 3,704 3,512
Indirect 1,625 1,803 1,657
------- ------- --------
Total consumer 4,916 5,507 5,169
Nonaccrual Mortgage 8,177 10,865 16,113
------- ------- --------
Total nonaccrual loans 83,278 86,717 98,732
Loans 90 days past due and still accruing 601 860 1,260
------- ------- --------
Total nonperforming loans 83,879 87,577 99,992
Other Repossessed Assets Acquired (ORAA) 7,350 8,094 8,025
------- ------- --------
Total nonperforming assets $91,229 $95,671 $108,017
======= ======= ========
Nonperforming assets as a percent of portfolio loans plus ORAA (1) 1.74% 1.76% 1.95%
Nonperforming assets as a percent of total assets 1.17 1.27 1.42
Allowance for loan loss as a percent of nonperforming loans 150.16 125.00 104.17
Allowance for loan loss as a percent of nonperforming assets 138.06 114.42 96.43
(1) Portfolio loans exclude mortgage loans held for sale
The level of nonperforming commercial loans at September 30, 2003 was
essentially unchanged from December 31, 2002, but was down $7.3 million from
September 30, 2002. The decline in nonperforming commercial loans since the
third quarter of 2002, reflects aggressive collection efforts and, to a lesser
extent, charge-offs in the fourth quarter of 2002, which reduced nonperforming
credits to the current level. Changes in nonperforming loans are reflected in
the allowance for loan losses through specific and risk allocated allowances. As
of September 30, 2003, the total allocated allowance for nonaccrual commercial
loans was approximately $14 million, unchanged from December 31, 2002.
Nonperforming loans in both the residential mortgage and consumer loan
portfolios were down at September 30, 2003 from December 31, 2002. The lower
level of nonperforming residential real estate loans primarily reflects the
previously mentioned sales of nonperforming residential mortgage loans, which
totaled $4.9 million during the first quarter of 2003. In the consumer
portfolio, a change in asset mix, which included strong growth in home equity
loans, has helped reduce nonperforming levels.
The level and composition of nonperforming assets are affected by economic
conditions in our local markets. Nonperforming assets, charge-offs and
provisions for loan losses tend to decline in a strong economy and increase in a
weak economy, potentially impacting our results. In addition to loans classified
as nonperforming, we carefully monitor other credits that are current in terms
of principal and interest payments but which we believe may deteriorate in
quality if economic conditions change. As of September 30, 2003, such loans
amounted to $212.6 million, or 4.1% of total portfolio loans, compared with
$134.6 million, or 2.5%, of total portfolio loans as of December 31, 2002. These
loans are primarily commercial and commercial real estate loans made in the
normal course of business and do not represent a concentration in any one
industry or geographic location.
27
Certain of our nonperforming loans included in the nonperforming loan table
above are considered to be impaired. Total loans considered impaired and their
related reserve balances at September 30, 2003 and 2002 as well as their effect
on net income for the third quarter of 2003 and 2002 follows:
IMPAIRED LOAN INFORMATION
Valuation Reserve
-----------------
(in thousands) 2003 2002 2003 2002
- ---------------------------------------------------------------------------------------------
Balances - September 30
Impaired loans with valuation reserve $31,887 $32,203 $8,438 $6,552
Impaired loans with no valuation reserve 47,303 57,191 -- --
------- ------- ------ ------
Total impaired loans $79,190 $89,394 $8,438 $6,552
======= ======= ====== ======
Impaired loans on nonaccrual basis $70,185 $77,450 $3,659 $3,618
Impaired loans on accrual basis 9,005 11,944 4,779 2,934
------- ------- ------ ------
Total impaired loans $79,190 $89,394 $8,438 $6,552
======= ======= ====== ======
Average balance for the quarter $87,786 $94,101
Interest income recognized for the quarter 226 446
Cash collected applied to outstanding principal 876 2,044
DEPOSITS
Average deposits declined $197 million, or 3.3%, in the first nine months of
2003 compared to the same period in 2002. Total deposits decreased $455 million
or 7.7% to $5.482 billion at September 30, 2003 compared with $5.937 billion at
December 31, 2002. The decline in deposits occurred largely within time
deposits, and to a lesser extent, savings deposits as clients sought higher
yielding investment alternatives in the low interest rate environment. In the
third quarter of 2003, Citizens completed a successful marketing campaign
promoting its "Perfect Fit" checking account products to increase growth in core
interest bearing and non-interest bearing checking accounts. During the 12 week
"Perfect Fit" campaign, over 10,600 new accounts were opened representing nearly
$61 million in new deposit balances.
We gather deposits primarily within our local markets and have not
traditionally relied on brokered or out of market purchased deposits for any
significant portion of our funding. At September 30, 2003, we had approximately
$134 million in brokered deposits, essentially unchanged from December 31, 2002.
We will continue to evaluate the use of alternative funding sources such as
brokered deposits as funding needs change. In addition to brokered deposits, we
had approximately $490 million of time deposits greater than $100,000, down $54
million from December 31, 2002. Time deposits greater than $100,000 consist of
commercial, consumer and public fund deposits derived almost exclusively from
our local markets. We continue to promote relationship driven core deposit
growth and stability through focused marketing efforts and competitive pricing
strategies.
BORROWED FUNDS
Short-term borrowings are comprised primarily of federal funds purchased,
securities sold under agreements to repurchase, FHLB advances and Treasury Tax
and Loan borrowings. As of September 30, 2003, short-term borrowed funds totaled
$652.4 million, an increase of $350.0 million or 115.7% compared to December 31,
2002. For the nine months ending September 30, 2003, average short-term borrowed
funds totaled $419.0 million, an increase of $187.2 million, or 80.7% from the
same period of 2002. The increases provided funding to support expansion of the
investment portfolio, which commenced in the first quarter of 2003, and to a
lesser extent offset a modest decrease in average deposits.
Long-term debt consists almost entirely of advances from the Federal Home Loan
Bank ("FHLB") to Citizens' subsidiary banks, and subordinated notes issued by
Citizens. Long-term debt totaled $940.6 million at September 30, 2003, up $341.3
million or 56.9% from December 31, 2002. Average long-term debt totaled $836.0
million for the first nine months of 2003, an increase of $211.7 million or
33.9% compared with the same period in 2002. The increases were driven by the
issuance of $125 million of subordinated debt in the first quarter of 2003, $25
million of junior subordinated debentures in the second quarter of 2003, and
increases in FHLB advances. See Note 6 of the Consolidated Financial Statements
elsewhere in this report for a description of the two subordinated debt
issuances. The growth in FHLB borrowings since December 31, 2002 was primarily
in the two to three year maturity range, with remaining amounts in the one and
five year maturity, and were used to fund the growth in the investment
portfolio.
28
CAPITAL RESOURCES
Citizens continues to maintain a strong capital position, which supports our
current needs and provides a sound foundation to support further expansion. Our
regulatory capital ratios are consistently at or above the "well capitalized"
standards and all of our bank subsidiaries have sufficient capital to maintain a
well capitalized designation. Our capital ratios as of September 30, 2003,
December 31, 2002 and September 30, 2002 are presented below.
CAPITAL RATIOS
Regulatory
Minimum For
"Well SEPTEMBER 30, December 31, September 30,
Capitalized" 2003 2002 2002
- ------------------------------------------------------------------------------
Risk based capital:
Tier I 6.0% 9.6% 9.2% 9.3%
Total capital 10.0 13.1 10.4 10.5
Tier I leverage 5.0 7.3 7.2 7.3
Shareholders' equity at September 30, 2003 was $634.1 million, compared with
$650.5 million at December 31, 2002 and $668.3 million as of September 30, 2002.
Book value per common share at September 30, 2003, December 31, 2002 and
September 30, 2002 was $14.67, $14.88 and $14.97, respectively. We declared and
paid cash dividends of $0.285 per share in the third quarter of 2003, the same
as declared and paid in the third quarter of 2002. Shareholders' equity
decreased as cash dividends and the capital requirements of our share repurchase
program exceeded net income.
In October 2001, our board of directors approved a plan to repurchase up to
3,000,000 shares of our common stock from time to time in the market. During the
third quarter of 2003, we purchased a total of 75,000 shares for $2.0 million.
As of September 30, 2003, a total of 2,578,200 shares of common stock had been
repurchased under the plan at an average price of $28.13. In October of 2003,
Citizens' board of directors approved a new plan to repurchase an additional
3,000,000 shares of common stock. These shares are in addition to the 421,800
shares still available under the plan approved in October 2001. The purchase of
our shares is subject to limitations that may be imposed by applicable
securities laws and regulations and the rules of the Nasdaq Stock Market. The
timing of the purchases and the number of shares to be bought at any one time
depend on market conditions and our capital requirements. There can be no
assurance that we will repurchase the remaining shares authorized to be
repurchased, or that any additional repurchases will be authorized by our board
of directors.
LIQUIDITY AND DEBT CAPACITY
We monitor our liquidity position so that funds will be available at a
reasonable cost to meet financial commitments, to finance business expansion and
to take advantage of unforeseen opportunities. Our subsidiary banks derive
liquidity primarily through core deposit growth, maturity of money market
investments, and maturity and sale of investment securities and loans.
Additionally, our subsidiary banks have access to market borrowing sources on an
unsecured, as well as a collateralized basis, for both short-term and long-term
purposes including, but not limited to, the Federal Reserve and Federal Home
Loan Banks where the subsidiary banks are members. Another source of liquidity
is the ability of our parent company to borrow funds on both a short-term and
long-term basis.
In the first quarter of 2003, as discussed above, we issued $125 million of
subordinated debt maturing on February 1, 2013. A portion of the proceeds from
this offering were used to repay amounts outstanding under our short-term
revolving credit facility. The remainder of the net proceeds was used or is
available for general corporate purposes. The subordinated debt requires
semi-annual interest payments beginning in August 2003 and qualifies as a
component of our capital, bolstering our overall capital ratios. The higher
capital ratios are viewed favorably by regulators and credit rating agencies. In
June 2003, we also issued approximately $25 million of floating rate, 30 year
trust preferred securities through a special purpose trust with an initial
interest rate of 4.16%. Interest only payments are due quarterly beginning
September 1, 2003 and payment in full of the principal is due in June 2033. Our
rights and obligations in connection with these securities are described --in
Note 6 of the Consolidated Financial Statements elsewhere in this report.
Citizens' parent company also has a short-term revolving credit facility with
two unaffiliated banks and has used this facility for various corporate purposes
from time to time. In August 2003, the parent company refinanced this facility,
reducing the borrowing limit from $75 million to $50 million and extending the
maturity to August 2004. The credit agreement also requires Citizens to maintain
certain financial covenants related to asset quality and capital levels. There
were no borrowings outstanding under this credit facility as of September 30,
2003.
29
Downgrades in the first quarter of 2003 by FitchRatings and Standard & Poor's
Rating Service of our long-term credit rating to BBB from BBB+ due to asset
quality deterioration and increased nonperforming assets have not and are not
expected to materially affect our liquidity position. Our short-term credit
rating remained unchanged at F2 and A-2, respectively. Separately, in the second
quarter of 2003, Moody's Investors Service affirmed our outstanding ratings of
Baa-1 (long term) and P-2 (short term), after their review for a possible
downgrade. We believe that our capital position provides enough financial
flexibility to deal with a degree of additional credit deterioration, if such
were to occur.
We manage the liquidity of our subsidiary banks to meet client cash flow needs
while maintaining funds available for loan and investment opportunities. We
manage the liquidity of our parent company to pay dividends to shareholders,
service debt, invest in subsidiaries and to satisfy other operating
requirements. The primary sources of liquidity for the parent company are
dividends and returns on investment in its subsidiaries. Each of our banking
subsidiaries is subject to dividend limits under the laws of the state in which
it is chartered and, as member banks of the Federal Reserve System, is subject
to the dividend limits of the Federal Reserve Board. The Federal Reserve Board
allows a member bank to make dividends or other capital distributions in an
amount not exceeding the current calendar year's net income, plus retained net
income of the preceding two years. Distributions in excess of this limit require
prior approval of the Federal Reserve Board. At September 30, 2003, the banking
subsidiaries could distribute to Citizens approximately $26 million in dividends
without regulatory approval.
We also have contingent letter of credit commitments that may impact liquidity.
Since many of these commitments historically have expired without being drawn
upon, the total amount of these commitments does not necessarily represent our
future cash requirements in connection with them. Further information on these
commitments is presented in Note 9 to the Consolidated Financial Statements in
this report.
INTEREST RATE RISK
Interest rate risk arises when the repricing structures of our assets and
liabilities differ significantly. Interest rate risk can result from a mismatch
in the timing of the repricing of assets and liabilities, option risk which can
alter the expected timing of repricing of certain assets or liabilities, or
basis risk. Basis risk occurs when assets and liabilities reprice at the same
time but based on different market rates, and when those market rates change by
different amounts. Many assets and liabilities contain embedded options which
allow customers, and entities associated with our investments and wholesale
funding, the opportunity to prepay loans or securities prior to maturity, or to
withdraw or reprice deposits or other funding instruments prior to maturity. Our
Asset / Liability Committee (ALCO) monitors asset, liability, and
off-balance-sheet portfolios to ensure comprehensive management of interest rate
risk. The Asset / Liability management process includes monitoring contractual
and expected repricing of assets and liabilities as well as forecasting earnings
under different interest rate scenarios and balance sheet structures with the
objective of insulating net interest income from large swings attributable to
changes in market interest rates. Our static interest rate sensitivity, commonly
referred to as repricing "GAP," as of September 30, 2003 and 2002 is illustrated
in the table on the following page.
As shown, as of September 30, 2003 rate sensitive assets repricing within one
year exceeded rate sensitive liabilities repricing within one year by $642.1
million, compared to $786.5 million as of September 30, 2002. These results
suggest an interest rate risk position which is not significantly mismatched;
however, embedded options can change the repricing characteristics of assets,
liabilities, and off-balance sheet hedges thereby changing the repricing
position from that outlined above. Further, basis risk is not captured by
repricing gap analysis. Because of these limitations, we use income simulation
modeling to evaluate the impact of market interest rate changes on the company's
net interest income.
We performed simulations as of September 30, 2003 to evaluate the impact of
market rate changes on net interest income over the following 12 months assuming
limited changes to balance sheet levels over that time period. Net interest
income is expected to decline modestly over the period if rates remain at
September 30, 2003 levels. See "-- Net Interest Income and Net Interest Margin."
If market interest rates were to increase immediately by 100 or 200 basis points
(a parallel and immediate shift along the yield curve) net interest income is
expected to be within 1% of what it would be if rates were to remain at
September 30, 2003 levels. An immediate 50 basis point parallel decline in
market rates is expected to reduce net interest income over the following 12
months by less than 1% of what it would be if rates remain constant over the
entire time period at September 30, 2003 levels. Net interest income is not only
affected by the level and direction of interest rates, but also by the shape of
the yield curve, pricing spreads in relation to market rates, balance sheet
growth, the mix of different types of assets or liabilities, and the timing of
changes in these variables. A flattening of the curve would exacerbate the
negative impact on net interest income. Scenarios different from those outlined
above, whether different by only timing, level, or a combination of factors,
could produce different results.
30
INTEREST RATE SENSITIVITY
TOTAL
1-90 91-180 181-365 WITHIN 1-5 Over
(dollars in millions) Days Days Days 1 YEAR Years 5 Years Total
- -----------------------------------------------------------------------------------------------------------------------------------
SEPTEMBER 30, 2003
RATE SENSITIVE ASSETS (1)
Portfolio loans (2) $ 2,605.1 $ 323.1 $ 559.7 $3,487.9 $1,522.8 $ 215.7 $ 5,226.4
Mortgage loans held for sale 132.6 -- -- 132.6 -- -- 132.6
Investment securities 178.4 72.4 112.5 363.3 951.7 680.1 1,995.1
Short-term investments 2.4 -- -- 2.4 -- -- 2.4
--------- --------- --------- -------- -------- -------- ---------
Total $ 2,918.5 $ 395.5 $ 672.2 $3,986.2 $2,474.5 $ 895.8 $ 7,356.5
========= ========= ========= ======== ======== ======== =========
RATE SENSITIVE LIABILITIES
Deposits(3) $ 1,098.1 $ 447.9 $ 1,070.2 $2,616.2 $1,752.9 $ 234.6 $ 4,603.7
Other interest bearing liabilities 596.6 106.2 25.1 727.9 475.5 389.6 1,593.0
--------- --------- --------- -------- -------- -------- ---------
Total $ 1,694.7 $ 554.1 $ 1,095.3 $3,344.1 $2,228.4 $ 624.2 $ 6,196.7
========= ========= ========= ======== ======== ======== =========
Period GAP (4) $ 1,223.8 $ (158.6) $ (423.1) $ 642.1 $ 246.1 $ 271.6 $ 1,159.8
Cumulative GAP 1,223.8 1,065.2 642.1 888.2 1,159.8
Cumulative GAP to Total Assets 15.72% 13.68% 8.25% 8.25% 11.41% 14.90% 14.90%
Multiple of Rate Sensitive Assets to Liabilities 1.72 0.71 0.61 1.19 1.11 1.44 1.19
SEPTEMBER 30, 2002
RATE SENSITIVE ASSETS (1)
Portfolio loans(2) $ 2,616.4 $ 272.3 $ 484.8 $3,373.5 $1,859.9 $ 290.6 $ 5,524.0
Mortgage loans held for sale 121.3 -- -- 121.3 -- -- 121.3
Investment securities 117.4 56.7 136.5 310.6 706.2 483.9 1,500.7
Short-term investments 2.5 -- -- 2.5 -- -- 2.5
--------- --------- --------- -------- -------- -------- ---------
Total $ 2,857.6 $ 329.0 $ 621.3 $3,807.9 $2,566.1 $ 774.5 $ 7,148.5
========= ========= ========= ======== ======== ======== =========
RATE SENSITIVE LIABILITIES
Deposits(3) 782.9 $ 564.0 $ 1,075.8 $2,422.7 $2,265.4 $ 327.0 $ 5,015.1
Other interest bearing liabilities 573.5 -- 25.2 598.7 95.9 283.2 977.8
--------- --------- --------- -------- -------- -------- ---------
Total $ 1,356.4 $ 564.0 $ 1,101.0 $3,021.4 $2,361.3 $ 610.2 $ 5,992.9
========= ========= ========= ======== ======== ======== =========
Period GAP (4) $ 1,501.2 $ (235.0) $ (479.7) $ 786.5 $ 204.8 $ 164.3 $ 1,155.6
Cumulative GAP 1,501.2 1,266.2 786.5 991.3 1,155.6
Cumulative GAP to Total Assets 19.72% 16.63% 10.33% 10.33% 13.02% 15.18% 15.18%
Multiple of Rate Sensitive Assets to Liabilities 2.11 0.58 0.56 1.26 1.09 1.27 1.19
(1) Incorporates prepayment projections for certain assets which may shorten
the time frame for repricing or maturity compared to contractual runoff.
(2) Balances exclude mortgage loans held for sale.
(3) Includes interest bearing savings and demand deposits of $906 million and
$789 million in 2003 and 2002, respectively, in the less than one year
category, and $1.005 billion and $1.745 billion, respectively in the over
one year category, based on historical trends for these noncontractual
maturity deposit types, which reflects industry standards.
(4) GAP is the excess of rate sensitive assets (liabilities).
We may, from time-to-time, use derivative contracts to help manage or hedge our
exposure to interest rate risk and to market value risk in conjunction with our
mortgage banking operations. We currently use interest rate swaps, mortgage loan
commitments and forward mortgage loan sales. Interest rate swaps are contracts
with a third party (the "counter-party") to exchange interest payment streams
based upon an assumed principal amount (the "notional amount"). The notional
amount is not advanced from the counter-party. Swap contracts are carried at
fair value on the consolidated balance sheet with the fair value representing
the net present value of expected future cash receipts or payments based on
market interest rates as of the balance sheet date. The fair values of the
contracts change daily as market interest rates change. Further discussion of
derivative instruments is included in Note 1 to the Consolidated Financial
Statements in our 2002 Annual Report on Form 10-K and in Note 7 to the
Consolidated Financial Statements presented in this report.
Holding residential mortgage loans for sale and committing to fund residential
mortgage loan applications at specific rates exposes Citizens to market value
risk caused by changes in interest rates during the period from rate commitment
issuance
31
until sale. To minimize this risk, we enter into mandatory forward commitments
to sell residential mortgage loans at the time a rate commitment is issued.
These mandatory forward commitments are considered derivatives under SFAS 133.
These forward commitments qualify and have been designated as fair value hedges
of our portfolio of loans held for sale and our new mortgage loan commitments.
Our practice to hedge our market value risk with mandatory forward commitments
has been effective and has not generated any material gains or losses. As of
September 30, 2003, we had forward commitments to sell mortgage loans of $110
million.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There has been no material change in the information concerning quantitative and
qualitative disclosures about market risk contained in Item 7A of Citizens' 2002
Annual Report on Form 10-K, except as set forth in Item 2. Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Interest Rate Risk.
ITEM 4. CONTROLS AND PROCEDURES
As of the end of the period covered by this report, the Company carried out an
evaluation, under the supervision and with the participation of its management,
including its Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of the Company's disclosure controls
and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934.
Based upon that evaluation, the Company's Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures are
effective to cause the material information required to be disclosed by the
Company in the reports that it files or submits under the Securities Exchange
Act of 1934 to be recorded, processed, summarized and reported within the time
periods specified in the Commission's rules and forms. There have been no
significant changes in the Company's internal controls or in other factors which
could significantly affect internal controls subsequent to the date the Company
carried out its evaluation.
32
PART II - OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a)
of the Securities Exchange Act
31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a)
of the Securities Exchange Act
32.1 Certification pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b)
of the Securities Exchange Act
(b) Reports on Form 8-K
A report on Form 8-K, dated July 11, 2003, was filed disclosing information
under Items 7, 9 and 12 on July 11, 2003, announcing Citizens' results of
operations for the three month period ended June 30, 2003. The information
was considered furnished, rather than filed. No financial statements were
filed with this report.
33
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CITIZENS BANKING CORPORATION
Date November 10, 2003 By /s/ Charles D. Christy
---------------------------------
Charles D. Christy
Chief Financial Officer
(Principal Financial Officer and
duly authorized officer)
/s/ Daniel E. Bekemeier
---------------------------------
Daniel E. Bekemeier
Controller
(Principal Accounting Officer)
34
10-Q EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION
- ----------- --------------------------------------------------------------------------------------------------
31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act
31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act
32.1 Certification pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(b) of the Securities Exchange Act
35