UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

Commission file number 001-31708

CAPITOL BANCORP LTD.

Capitol Bancorp Center
200 Washington Square North, Lansing, Michigan
(Address of principal executive offices)
48933
(Zip Code)
(517) 487-6555
(Registrant’s telephone number)

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

     Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( )

     Indicate by a check mark whether the registrant is an accelerated filer (as defined in Rule 12b of the Act). Yes (X) 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:

     Common stock, No par value: 14,282,363 shares outstanding as of April 15, 2004.

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INDEX

PART I. FINANCIAL INFORMATION

Forward-Looking Statements

Certain of the statements contained in this document, including Capitol’s consolidated financial statements, Management’s Discussion and Analysis of Financial Condition and Results of Operations and in documents incorporated into this document by reference that are not historical facts, including, without limitation, statements of future expectations, projections of results of operations and financial condition, statements of future economic performance and other forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, are subject to known and unknown risks, uncertainties and other factors which may cause the actual future results, performance or achievements of Capitol and/or its subsidiaries and other operating units to differ materially from those contemplated in such forward-looking statements. The words “intend”, “expect”, “project”, “estimate”, “predict”, “anticipate”, “should”, “believe”, and similar expressions also are intended to identify forward-looking statements. Important factors which may cause actual results to differ from those contemplated in such forward-looking statements include, but are not limited to: (i) the results of Capitol’s efforts to implement its business strategy, (ii) changes in interest rates, (iii) legislation or regulatory requirements adversely impacting Capitol’s banking business and/or expansion strategy, (iv) adverse changes in business conditions or inflation, (v) general economic conditions, either nationally or regionally, which are less favorable than expected and that result in, among other things, a deterioration in credit quality and/or loan performance and collectability, (vi) competitive pressures among financial institutions, (vii) changes in securities markets, (viii) actions of competitors of Capitol’s banks and Capitol’s ability to respond to such actions, (ix) the cost of capital, which may depend in part on Capitol’s asset quality, prospects and outlook, (x) changes in governmental regulation, tax rates and similar matters, and (xi) other risks detailed in Capitol’s other filings with the Securities and Exchange Commission. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual outcomes may vary materially from those indicated. All subsequent written or oral forward-looking statements attributable to Capitol or persons acting on its behalf are expressly qualified in their entirety by the foregoing factors. Investors and other interested parties are cautioned not to place undue reliance on such statements, which speak as of the date of such statements. Capitol undertakes no obligation to release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of unanticipated events.

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PART I, ITEM I

CAPITOL BANCORP LTD.

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CAPITOL BANCORP LTD.

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CAPITOL BANCORP LTD.

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CAPITOL BANCORP LTD.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD.

Note A – Basis of Presentation

     The accompanying unaudited condensed consolidated financial statements of Capitol Bancorp Ltd. (“Capitol”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q. Accordingly, they do not include all information and footnotes necessary for a fair presentation of consolidated financial position, results of operations and cash flows in conformity with generally accepted accounting principles.

     The statements do, however, include all adjustments of a normal recurring nature (in accordance with Rule 10-01(b)(8) of Regulation S-X) which Capitol considers necessary for a fair presentation of the interim periods.

     The results of operations for the period ended March 31, 2004 are not necessarily indicative of the results to be expected for the year ending December 31, 2004.

     The consolidated balance sheet as of December 31, 2003 was derived from audited consolidated financial statements as of that date. Certain 2003 amounts have been reclassified to conform to the 2004 presentation.

Note B – Implementation of New Accounting Standard

     FASB Interpretation No. 46, Consolidation of Variable Interest Entities, (as revised December 2003—FIN 46(R)), clarifies when some entities previously not consolidated under prior accounting guidance, should be. In some instances, it also requires certain previously consolidated entities to be deconsolidated. FIN 46(R) is effective for periods ending after December 15, 2003 for special purpose entities and for periods ending after March 15, 2004 for other types of variable interest entities that are not defined as special purpose entities. Implementation of this new guidance required Capitol to deconsolidate its trusts which issued trust-preferred securities that are classified as debt obligations on Capitol’s consolidated balance sheet effective March 31, 2004.

     Although those trusts are no longer consolidated, the underlying subordinated debentures are reported as debt obligations on Capitol’s consolidated balance sheet. It is, however, unclear what effect, if any, such deconsolidation will have on the regulatory-capital treatment of those securities.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD. - Continued

Note C – Stock Options

     Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, establishes an alternative fair value method of accounting for stock options whereby compensation expense would be recognized based on the computed fair value of the options on the grant date. By not electing this alternative, certain pro forma disclosures of the expense recognition provisions of Statement No. 123 are required, which are as follows:

     Stock option activity for the interim 2004 period is summarized as follows:

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD. - Continued

Note C – Stock Options – Continued

     As of March 31, 2004, stock options outstanding had a weighted average remaining contractual life of 5 years. The following table summarizes stock options outstanding segregated by exercise price range:

Note D – Net Income Per Share

     The computations of basic and diluted earnings per share were as follows:

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD. - Continued

Note E – Bank Development Activities

     Bank development efforts are currently under consideration at March 31, 2004 in several states including pre-development exploratory discussions, lease and employment negotiations and preparation of preliminary regulatory applications for formation and/or acquisition of community banks. During March 2004, Capitol completed the capitalization of Capitol Development Bancorp Limited II (CDBL II); CDBL II is substantially similar in structure and purpose to CDBLI which was formed in late 2003. At March 31, 2004, an application was pending for the formation of a de novo bank in Point Loma (San Diego County), California.

Note F – Pending Share Exchange Proposal

     As of March 31, 2004, a potential share exchange transaction was in the proposal stage regarding the minority interest of Sunrise Bank of San Diego which, if completed, would result in Capitol issuing approximately 175,000 additional shares of common stock and the majority-owned subsidiary becoming wholly-owned. Such proposed share exchange is subject to the separate approval of the minority shareholders of the bank and other contingencies.

Note G – Subsequent Acquisition of Bank

     Effective April 1, 2004, Capitol acquired First Carolina State Bank (First Carolina) located in Rocky Mount, North Carolina, in a purchase transaction with total consideration approximating $10 million. Approximately half of the consideration was paid in cash and the remainder through issuance of approximately 183,000 previously unissued shares of Capitol’s common stock. At March 31, 2004, First Carolina’s total assets approximated $61.7 million. Capitol’s acquisition of First Carolina will be accounted for under the purchase method of accounting and its results of operations will be included in Capitol’s consolidated financial statements for periods after the effective date of the acquisition.

Note H – Impact of New Accounting Standards

     AICPA Statement of Position 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3), addresses the accounting for differences between contractual cash flows and cash flows expected to be collected from the initial investment in loans acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes such loans acquired in purchase business combinations and does not apply to loans originated by the entity. The SOP prohibits carrying over or creation of valuation allowances in the initial accounting for loans acquired in a transfer. It is effective for loans acquired in fiscal years beginning after December 15, 2004. The effects of this new guidance on Capitol’s consolidated financial statements will depend on future acquisition activity, thus, its impact is not readily determinable.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CAPITOL BANCORP LTD. - Continued

Note H – Impact of New Accounting Standards – Continued

     On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a proposed statement, Share-Based Payment, that addresses the accounting for share-based payment transactions (for example, stock options and awards of restricted stock) in which an employer receives employee-services in exchange for equity securities of the company or liabilities that are based on the fair value of the company’s equity securities. This proposal, if finalized as proposed, would eliminate use of APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require such transactions be accounted for using a fair-value-based method and recording compensation expense rather than optional pro forma disclosure of what expense amounts might be. The proposal, if approved, would substantially amend FASB Statement No. 123, Accounting for Stock-Based Compensation. Because of the timing of the proposal and the uncertainty of whether it will be adopted substantially as proposed, management has not completed its review of the proposal or assessed its potential impact on Capitol.

     A variety of proposed or otherwise potential accounting standards are currently under study by standard-setting organizations and various regulatory agencies. Because of the tentative and preliminary nature of these proposed standards, management has not determined whether implementation of such proposed standards would be material to Capitol’s consolidated financial statements.

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PART I, ITEM 2

     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Financial Condition

     Total assets approximated $2.9 billion at March 31, 2004, an increase of $131 million from the December 31, 2003 level of $2.7 billion. The balance sheet includes Capitol and its consolidated subsidiaries:

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     Portfolio loans increased during the three-month 2004 period by approximately $100 million, compared to net loan growth of about $60 million during the corresponding period of 2003. The first three months of the year tends to be a slower period for loan growth; the 2004 loan growth was significantly higher than expected. The majority of portfolio loan growth occurred in commercial loans, consistent with the banks’ emphasis on commercial lending activities.

     The allowance for loan losses at March 31, 2004 approximated $33 million or 1.41% of total portfolio loans, a slight increase from the year-end 2003 ratio of 1.40%.

     The allowance for loan losses is maintained at a level believed adequate by management to absorb potential losses inherent in the loan portfolio at the balance sheet date. Management’s determination of the adequacy of the allowance is based on evaluation of the portfolio (including potential impairment of individual loans and concentrations of credit), past loss experience, current economic conditions, volume, amount and composition of the loan portfolio, loan commitments outstanding and other factors. The allowance is increased by provisions charged to operations and reduced by net charge-offs. The table below summarizes portfolio loan balances and activity in the allowance for loan losses for the interim periods (in thousands):

     Net charge-offs of loans in the interim 2004 period increased approximately $1 million, compared to the corresponding 2003 period. The increase was mainly due to losses associated with loans secured by business equipment and accounts receivable, of which $500,000 related to the one loan for which a special $1 million provision for loan losses was also recorded during the period.

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     The amounts of the allowance for loan losses allocated in the following table (in thousands) are based on management’s estimate of losses inherent in the portfolio at the balance-sheet date, include all loans for which, based on Capitol’s loan rating system, management has concerns, and should not be interpreted as an indication of future charge-offs.

     Nonperforming loans (i.e., loans which are 90 days or more past due and loans on nonaccrual status) and other nonperforming assets are summarized below (in thousands):

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     Nonperforming loans decreased 17.5% or $4.7 million during the three-month period ended March 31, 2004, in large part, due to the resolution of one $2 million credit (without loss), during the period. Nonperforming loans at March 31, 2004 were less than 1% of total portfolio loans, a significant improvement from earlier recent reporting periods. Of the nonperforming loans at March 31, 2004, about 71% are real estate secured. Those loans, when originated, had appropriate loan-to-value ratios and, accordingly, have loss exposure which is expected to be minimal; however, underlying real estate values depend upon current economic conditions and liquidation strategies. Most other nonperforming loans are generally secured by other business assets. Nonperforming loans at March 31, 2004 are in various stages of resolution for which management believes such loans are adequately collateralized or otherwise appropriately considered in its determination of the adequacy of the allowance for loan losses.

     In addition to the identification of nonperforming loans involving borrowers with payment performance difficulties (i.e., nonaccrual loans and loans past-due 90 days or more), management utilizes an internal loan review process to identify other potential problem loans which may warrant additional monitoring or other attention. This loan review process is a continuous activity which periodically updates internal loan ratings. At inception, all loans are individually assigned a rating which grades the credits on a risk basis, based on the type and discounted value of collateral, financial strength of the borrower and guarantors and other factors such as nature of the borrower’s business climate, local economic conditions and other subjective factors. The loan rating process is fluid and subjective.

     Potential problem loans include loans which are generally performing as agreed; however, because of loan review’s and/or lending staff’s risk assessment, increased monitoring is deemed appropriate. In addition, some loans are assigned a more adverse classification, with specific performance issues or other risk factors requiring close management and development of specific remedial action plans.

     At March 31, 2004, potential problem loans (including the previously mentioned nonperforming loans) approximated $120 million, or about 5% of total consolidated portfolio loans. These potential problem loans do not necessarily have significant loss exposure (nor are they necessarily deemed ‘impaired’), but rather are classified by management in this manner to aid in loan administration and risk management. Management believes such loans to be adequately considered in its evaluation of the adequacy of the allowance for loan losses. Management believes, however, that current general economic conditions may result in higher levels of future loan losses, in comparison to previous years, as evidenced by higher loan losses in the interim 2004 period.

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     The following comparative analysis summarizes each bank’s total portfolio loans, allowance for loan losses, nonperforming loans and ratio of the allowance as a percentage of portfolio loans (dollars in thousands):

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Results of Operations

     Net income for the three months ended March 31, 2004 was $4.4 million, a decrease of $897,000 or 17% over the same period in 2003. Diluted earnings per share for the three-month 2004 period were $0.30 compared to $0.44 for the prior year period.

     Three particular items had a significant impact on first quarter earnings:

• Loan growth – As the Corporation’s banks grow their loan portfolios, they typically record additional loan loss reserves – an expense. As mentioned earlier, the first quarter of the year is the slowest period for loan growth. In 2004, consolidated first quarter loan growth was about $100 million. That compares to about $60 million in the same period of 2003. This significant early 2004 loan growth resulted in higher than planned provisions for loan losses.

• A special loan loss provision for one loan – In the first quarter of 2004 a special loan loss provision of $1 million was recorded related to a $1.5 million commercial loan, secured by receivables, and a long-term customer relationship going back to 1994. The loan has been in ‘nonperforming’ status since mid-2003. As additional information became available in the first quarter from both the borrower’s corporate and personal bankruptcy proceedings, management determined that the special loss provision was appropriate.

• Exiting investments in mutual funds – Some of Capitol’s banks had, as of December 31, 2003, invested their excess liquidity of about $57 million in short-term adjustable-rate mortgage mutual funds. At December 31, 2003, these securities were classified as available for sale and had an unrealized loss of about $470,000. These funds continued to be adversely impacted by volatility in the bond markets in the first quarter of 2004 and management determined that, from a risk-management perspective, Capitol’s investment policies should be revised to prohibit investments in mutual funds and, accordingly, all such funds were liquidated in April. The loss on those investments was accrued at March 31, 2004 and included in first quarter 2004 results.

     Net interest income for the first three months of 2004 totaled $30.2 million, a 12% increase compared to $27 million in 2003. This increase is attributable to the banks’ growth in size and a relatively stable interest rate environment. During this 2004 period, however, net interest margin decreased, in part, due to the added carrying costs of trust-preferred securities.

     Noninterest income for the three months ended March 31, 2004 was $4.1 million, a decrease of $391,000, or 9%, over the same period in 2003. Fees from origination of non-portfolio residential mortgage loans totaled $1.3 million for the first quarter of 2004, as compared to $2.2 million for the comparable period in 2003, decreasing as mortgage interest rates have recently risen, caused by a decrease in residential mortgage loan volume. Trust fee income accounts for the three-month 2004 period increased by 69%, compared to 2003, due to growth in the number and size of trust accounts.

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     The provision for loan losses for the three-month period in 2004 was $3.5 million, as compared to $1.9 million for the same period in 2003. As previously mentioned, significant loan growth and a special loan loss provision relating to one loan in the 2004 period accounted for the majority of the increase in the provision, compared to the 2003 period. The provisions for loan losses are based upon management’s analysis of the adequacy of the allowance for loan losses, as previously discussed.

     Noninterest expense totaled $24 million for the three-month period, as compared to $21.2 million for the comparable period in 2003. The increase in noninterest expense is associated with growth in the size of the banks and increases in general operating costs. Increases in both occupancy and salaries and employee benefits relate primarily to the growth in the size of banks within the consolidated group and the addition of one bank in late 2003.

     Operating results (dollars in thousands) were as follows: