**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

**ý****                                ****QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended March 31, 2005**

 

**OR**

 

**o****                                ****TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thetransition period from                   to                   **

 

**Commissionfile number 0-5127**

 

**MERCANTILE BANKSHARES CORPORATION**

(Exact name of registrant asspecified in its charter)

 
| **Maryland**                                                     | ** ** | **52-0898572**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State or  other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.) |

 

#### **2 Hopkins Plaza**

**Baltimore,Maryland 21201**

(Address of principal executiveoffices) (Zip Code)

 

**(410) 237-5900**

(Registrant’s telephone number,including area code)

 

**NONE**

(Former name, former addressand 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) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Exchange Act Rule 12b-2).  Yes ý  No o

 

As of April 29, 2005, 79,491,610 shares of registrant’s Common Stock, $2 par value per share,were outstanding.

 

 

----

 

# **PART I – FINANCIAL INFORMATION**

# ** **

**Item 1. Financial Statements (Unaudited)**

 

**MERCANTILEBANKSHARES CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

 
| **(Dollars  in thousands, except per share data)**                                                                                                                                                                                                               | ** ** | **March 31,  2005** | ** **     | **December 31,  2004** | ** ** | **March 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|----------------|-----------------------------|------------|--------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                       |       |                     |           |                        |       |                     |       |
| Cash and due from banks                                                                                                                                                                                                                                          | ** ** | **$**                    | **304,969**    |                        | $          | 244,875                  |       | $ | 296,077 |   |
| Interest-bearing deposits in other banks                                                                                                                                                                                                                         | ** ** | **158**                  |           | 158                         |       | 158                      |       |
| Federal funds sold                                                                                                                                                                                                                                               | ** ** | **26,901**               |           | 101                         |       | 353,893                  |       |
| Total cash and cash equivalents                                                                                                                                                                                                                                  | ** ** | **332,028**              |           | 245,134                     |       | 650,128                  |       |
| Investment securities available-for-sale (Note 4)                                                                                                                                                                                                                | ** ** | **2,807,721**            |           | 2,908,694                   |       | 3,006,218                |       |
| Investment securities held-to-maturity (Note 4) fair value of $20,371  (2005), $21,094 (December 2004) and $28,436 (March 2004)                                                                                                                        | ** ** | **19,704**               |           | 20,176                      |       | 26,555                   |       |
| Total investment securities                                                                                                                                                                                                                                      | ** ** | **2,827,425**            |           | 2,928,870                   |       | 3,032,773                |       |
| Loans held-for-sale                                                                                                                                                                                                                                              | ** ** | **24,341**               |           | 11,000                      |       | 38,741                   |       |
| Loans:                                                                                                                                                                                                                                                           |       |                     |           |                        |       |                     |       |
| Commercial                                                                                                                                                                                                                                                       | ** ** | **2,797,435**            |           | 2,813,325                   |       | 2,566,692                |       |
| Commercial real estate                                                                                                                                                                                                                                           | ** ** | **3,180,853**            |           | 3,122,701                   |       | 2,836,846                |       |
| Construction                                                                                                                                                                                                                                                     | ** ** | **1,347,365**            |           | 1,268,350                   |       | 1,105,346                |       |
| Residential real estate                                                                                                                                                                                                                                          | ** ** | **1,543,778**            |           | 1,486,106                   |       | 1,387,647                |       |
| Consumer                                                                                                                                                                                                                                                         | ** ** | **1,487,040**            |           | 1,484,583                   |       | 1,473,491                |       |
| Lease financing                                                                                                                                                                                                                                                  | ** ** | **56,751**               |           | 53,368                      |       | 64,398                   |       |
| Total loans                                                                                                                                                                                                                                                      | ** ** | **10,413,222**           |           | 10,228,433                  |       | 9,434,420                |       |
| Less: allowance for loan losses                                                                                                                                                                                                                                  | ** ** | **(149,017**             | )              | (149,002                    | )          | (156,635                 | )          |
| Loans, net                                                                                                                                                                                                                                                       | ** ** | **10,264,205**           |           | 10,079,431                  |       | 9,277,785                |       |
| Bank premises and equipment, less accumulated depreciation of $144,515  (2005), $142,384 (December 2004) and $154,468 (March 2004)                                                                                                                     | ** ** | **141,135**              |           | 139,946                     |       | 141,482                  |       |
| Other real estate owned, net                                                                                                                                                                                                                                     | ** ** | **145**                  |           | 212                         |       | 134                      |       |
| Goodwill                                                                                                                                                                                                                                                         | ** ** | **507,791**              |           | 507,791                     |       | 522,226                  |       |
| Other intangible assets, net (Note 7)                                                                                                                                                                                                                            | ** ** | **46,122**               |           | 48,226                      |       | 54,223                   |       |
| Other assets                                                                                                                                                                                                                                                     | ** ** | **484,641**              |           | 465,080                     |       | 424,890                  |       |
| Total assets                                                                                                                                                                                                                                                     | ** ** | **$**                    | **14,627,833** |                        | $          | 14,425,690               |       | $ | 14,142,382 |   |
| **LIABILITIES**                                                                                                                                                                                                                                                  |       |                     |           |                        |       |                     |       |
| Deposits:                                                                                                                                                                                                                                                        |       |                     |           |                        |       |                     |       |
| Noninterest-bearing deposits                                                                                                                                                                                                                                     | ** ** | **$**                    | **3,098,666**  |                        | $          | 3,049,031                |       | $ | 2,769,189 |   |
| Interest-bearing deposits                                                                                                                                                                                                                                        | ** ** | **7,872,610**            |           | 7,750,168                   |       | 7,774,398                |       |
| Total deposits                                                                                                                                                                                                                                                   | ** ** | **10,971,276**           |           | 10,799,199                  |       | 10,543,587               |       |
| Short-term borrowings                                                                                                                                                                                                                                            | ** ** | **856,963**              |           | 887,857                     |       | 904,327                  |       |
| Accrued expenses and other liabilities                                                                                                                                                                                                                           | ** ** | **179,747**              |           | 129,996                     |       | 149,052                  |       |
| Long-term debt                                                                                                                                                                                                                                                   | ** ** | **681,331**              |           | 690,955                     |       | 657,411                  |       |
| Total liabilities                                                                                                                                                                                                                                                | ** ** | **12,689,317**           |           | 12,508,007                  |       | 12,254,377               |       |
| **COMMITMENTS and CONTINGENCIES** (Note 6)                                                                                                                                                                                                                       |       |                     |           |                        |       |                     |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                    |       |                     |           |                        |       |                     |       |
| Preferred stock, no par value; authorized 2,000,000 shares; issued  and outstanding - None                                                                                                                                                                       |       |                     |           |                        |       |                     |       |
| Common stock, $2 par value; authorized 130,000,000 shares; issued  shares - 79,485,853 (2005), 79,300,506 (December 2004) and 79,974,797 (March 2004);  restricted shares - 168,930 (2005), 143,528 (December 2004) and 140,167 (March 2004) | ** ** | **158,972**              |           | 158,601                     |       | 159,950                  |       |
| Capital surplus                                                                                                                                                                                                                                                  | ** ** | **538,075**              |           | 530,705                     |       | 553,955                  |       |
| Retained earnings                                                                                                                                                                                                                                                | ** ** | **1,264,634**            |           | 1,231,102                   |       | 1,139,360                |       |
| Accumulated other comprehensive income (loss)                                                                                                                                                                                                                    | ** ** | **(23,165**              | )              | (2,725                      | )          | 34,740                   |       |
| Total shareholders’ equity                                                                                                                                                                                                                                  | ** ** | **1,938,516**            |           | 1,917,683                   |       | 1,888,005                |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                                                                  | ** ** | **$**                    | **14,627,833** |                        | $          | 14,425,690               |       | $ | 14,142,382 |   |

 

See notes to consolidated financial statements

 

2

----

 

**MERCANTILEBANKSHARES CORPORATION**

**STATEMENTSOF CONSOLIDATED INCOME**

 
| ** **                                              | ** ** | **For the 3  months ended  March 31,** | ** **  |
|---------------------------------------------------------|------------|---------------------------------------------|-------------|
| **(Dollars  in thousands, except per share data)**      | ** ** | **2005**                                    | ** **  | **2004** | ** ** |
| **INTEREST INCOME**                                     |       |                                        |        |   |   |
| Interest and fees on loans                              | ** ** | **$**                                       | **152,544** |   | $ | 129,129 |   |
| Interest and dividends on investment securities:        |       |                                        |        |   |   |
| Taxable interest income                                 | ** ** | **24,992**                                  |        | 27,401 |   |
| Tax-exempt interest income                              | ** ** | **721**                                     |        | 877 |   |
| Other investment income                                 | ** ** | **644**                                     |        | 333 |   |
| Total interest and dividends on investment securities   | ** ** | **26,357**                                  |        | 28,611 |   |
| Other interest income                                   | ** ** | **344**                                     |        | 106 |   |
| Total interest income                                   | ** ** | **179,245**                                 |        | 157,846 |   |
| **INTEREST EXPENSE**                                    |       |                                        |        |   |   |
| Interest on deposits                                    | ** ** | **25,305**                                  |        | 20,767 |   |
| Interest on short-term borrowings                       | ** ** | **4,042**                                   |        | 1,419 |   |
| Interest on long-term debt                              | ** ** | **6,815**                                   |        | 5,255 |   |
| Total interest expense                                  | ** ** | **36,162**                                  |        | 27,441 |   |
| **NET INTEREST INCOME**                                 | ** ** | **143,083**                                 |        | 130,405 |   |
| Provision for loan losses                               | ** ** | **756**                                     |        | 2,426 |   |
| **NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES** | ** ** | **142,327**                                 |        | 127,979 |   |
| **NONINTEREST INCOME**                                  |       |                                        |        |   |   |
| Investment and wealth management                        | ** ** | **24,057**                                  |        | 21,983 |   |
| Service charges on deposit accounts                     | ** ** | **10,426**                                  |        | 10,692 |   |
| Mortgage banking-related fees                           | ** ** | **2,283**                                   |        | 2,940 |   |
| Investment securities gains and (losses), net           | ** ** | **414**                                     |        | (55 | ) |
| Nonmarketable investments                               | ** ** | **5,271**                                   |        | 4,204 |   |
| Other income                                            | ** ** | **15,418**                                  |        | 13,390 |   |
| Total noninterest income                                | ** ** | **57,869**                                  |        | 53,154 |   |
| **NONINTEREST EXPENSES**                                |       |                                        |        |   |   |
| Salaries                                                | ** ** | **46,554**                                  |        | 44,788 |   |
| Employee benefits                                       | ** ** | **11,897**                                  |        | 12,513 |   |
| Net occupancy expense of bank premises                  | ** ** | **6,922**                                   |        | 6,060 |   |
| Furniture and equipment expenses                        | ** ** | **7,279**                                   |        | 7,364 |   |
| Communications and supplies                             | ** ** | **4,040**                                   |        | 4,304 |   |
| Other expenses                                          | ** ** | **23,461**                                  |        | 18,357 |   |
| Total noninterest expenses                              | ** ** | **100,153**                                 |        | 93,386 |   |
| Income before income taxes                              | ** ** | **100,043**                                 |        | 87,747 |   |
| Applicable income taxes                                 | ** ** | **37,416**                                  |        | 32,050 |   |
| **NET INCOME**                                          | ** ** | **$**                                       | **62,627**  |   | $ | 55,697 |   |
| **NET INCOME PER SHARE OF COMMON STOCK** (Note 3):      |       |                                        |        |   |   |
| Basic                                                   | ** ** | **$**                                       | **0.79**    |   | $ | 0.70 |   |
| Diluted                                                 | ** ** | **$**                                       | **0.78**    |   | $ | 0.69 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                     | ** ** | **$**                                       | **0.35**    |   | $ | 0.33 |   |

 

See notes to consolidated financial statements

 

3

----

 

**MERCANTILEBANKSHARES CORPORATION**

**STATEMENTSOF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY**

 

**For the 3 months ended March 31,2005 and 2004**

 
| **(Dollars  in thousands, except per share data)**                                                            | ** ** | **Total** | ** **    | **Common  Stock** | ** ** | **Capital  Surplus** | ** ** | **Retained  Earnings** | ** **  | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------|---------------|-------------------|------------|----------------------|------------|------------------------|-------------|------------------------------------------------------|------------|
| BALANCE, DECEMBER 31, 2003                                                                               |       | $         | 1,841,441     |              | $          | 159,545              |       | $                      | 548,664     |                                                 | $          | 1,110,748 |   | $ | 22,484 |   |
|                                                                                                          |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Net income                                                                                                    |       | 55,697    |          |              |       |                 |       | 55,697                 |        |                                                 |       |
| Unrealized gains (losses) on securities available-for-sale, net of reclassification  adjustment, net of taxes |       | 12,256    |          |              |       |                 |       |                   |        | 12,256                                               |       |
| Comprehensive income                                                                                          |       | 67,953    |          |              |       |                 |       |                   |        |                                                 |       |
| Cash dividends paid:                                                                                          |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Common stock ($.33 per share)                                                                                 |       | (26,335   | )             |              |       |                 |       | (26,335                | )           |                                                 |       |
| Issuance of 31,674 shares for dividend reinvestment and stock  purchase plan                                  |       | 1,298     |          | 63                |       | 1,235                |       |                   |        |                                                 |       |
| Issuance of 5,873 shares for employee stock purchase dividend  reinvestment plan                              |       | 257       |          | 12                |       | 245                  |       |                   |        |                                                 |       |
| Issuance of 138,251 shares for employee stock option plan                                                     |       | 2,431     |          | 277               |       | 2,154                |       |                   |        |                                                 |       |
| Restricted stock awards                                                                                       |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Issuance of 26,294 shares                                                                                     |       | 1,199     |          | 53                |       | 1,146                |       |                   |        |                                                 |       |
| Deferred compensation                                                                                         |       | (1,263    | )             |              |       |                 |       | (1,263                 | )           |                                                 |       |
| Amortization                                                                                                  |       | 513       |          |              |       |                 |       | 513                    |        |                                                 |       |
| Vested stock options                                                                                          |       | 511       |          | —            |       | 511                  |       | —                 |        | —                                               |       |
| BALANCE, MARCH 31, 2004                                                                                  |       | $         | 1,888,005     |              | $          | 159,950              |       | $                      | 553,955     |                                                 | $          | 1,139,360 |   | $ | 34,740 |   |
|                                                                                                          |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| BALANCE, DECEMBER 31, 2004                                                                               |       | $         | 1,917,683     |              | $          | 158,601              |       | $                      | 530,705     |                                                 | $          | 1,231,102 |   | $ | (2,725 | ) |
|                                                                                                          |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Net income                                                                                                    |       | 62,627    |          |              |       |                 |       | 62,627                 |        |                                                 |       |
| Unrealized gains (losses) on securities available-for-sale, net of  reclassification adjustment, net of taxes |       | (20,440   | )             |              |       |                 |       |                   |        | (20,440                                              | )          |
| Comprehensive income                                                                                          |       | 42,187    |          |              |       |                 |       |                   |        |                                                 |       |
| Cash dividends paid:                                                                                          |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Common stock ($.35 per share)                                                                                 |       | (27,750   | )             |              |       |                 |       | (27,750                | )           |                                                 |       |
| Issuance of 26,355 shares for dividend reinvestment and stock  purchase plan                                  |       | 1,278     |          | 53                |       | 1,225                |       |                   |        |                                                 |       |
| Issuance of 5,441 shares for employee stock purchase dividend  reinvestment plan                              |       | 273       |          | 11                |       | 262                  |       |                   |        |                                                 |       |
| Issuance of 115,703 shares for employee stock option plan                                                     |       | 1,519     |          | 231               |       | 1,288                |       |                   |        |                                                 |       |
| Directors’ deferred compensation plan:                                                                   |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Issuance of 884 shares                                                                                        |       | —    |          | 2                 |       | (2                   | )          |                   |        |                                                 |       |
| Contribution                                                                                                  |       | 202       |          |              |       | 202                  |       |                   |        |                                                 |       |
| Dividend                                                                                                      |       | —    |          |              |       | 60                   |       | (60                    | )           |                                                 |       |
| Restricted stock awards                                                                                       |       |      |          |              |       |                 |       |                   |        |                                                 |       |
| Issuance of 36,964 shares                                                                                     |       | 1,890     |          | 74                |       | 1,816                |       |                   |        |                                                 |       |
| Deferred compensation                                                                                         |       | (1,938    | )             |              |       |                 |       | (1,938                 | )           |                                                 |       |
| Amortization                                                                                                  |       | 653       |          |              |       |                 |       | 653                    |        |                                                 |       |
| Vested stock options                                                                                          |       | 2,519     |          | —            |       | 2,519                |       | —                 |        | —                                               |       |
| **BALANCE, MARCH 31, 2005**                                                                              | ** ** | **$**     | **1,938,516** | ** **        | **$**      | **158,972**          | ** ** | **$**                  | **538,075** | ** **                                           | **$**      | **1,264,634** | ** ** | **$** | **(23,165** | **)** |

 

See notes to consolidated financial statements

 

4

----

 

**MERCANTILEBANKSHARES CORPORATION**

#### **STATEMENTS OF CONSOLIDATED CASH FLOWS**

 
| **Increase  (decrease) in cash and cash equivalents**                              | ** ** | **For the 3  months ended March 31,** | ** **  |
|------------------------------------------------------------------------------------|------------|--------------------------------------------|-------------|
| **(Dollars  in thousands)**                                                        | ** ** | **2005**                                   | ** **  | **2004** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                          |       |                                       |        |   |   |
| Net income                                                                         | ** ** | **$**                                      | **62,627**  |   | $ | 55,697 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                                       |        |   |   |
| Provision for loan losses                                                          | ** ** | **756**                                    |        | 2,426 |   |
| Depreciation                                                                       | ** ** | **3,714**                                  |        | 3,900 |   |
| Amortization of other intangible assets                                            | ** ** | **2,072**                                  |        | 2,032 |   |
| Investment securities (gains) / losses                                             | ** ** | **(414**                                   | )           | 55 |   |
| Income of investments in private equity funds                                      | ** ** | **(2,181**                                 | )           | (141 | ) |
| Write-downs of other real estate owned                                             | ** ** | **1**                                      |        | — |   |
| Gains on sales of other real estate owned                                          | ** ** | **(125**                                   | )           | (13 | ) |
| Gains on sales of premises                                                         | ** ** | **(1,147**                                 | )           | (564 | ) |
| Net (increase) decrease in assets:                                                 |       |                                       |        |   |   |
| Interest receivable                                                                | ** ** | **(5,796**                                 | )           | (1,939 | ) |
| Other receivables                                                                  | ** ** | **363**                                    |        | 2,991 |   |
| Bank-owned life insurance                                                          | ** ** | **(951**                                   | )           | (794 | ) |
| Other assets                                                                       | ** ** | **(6,615**                                 | )           | (11,126 | ) |
| Loans held-for-sale                                                                | ** ** | **(13,341**                                | )           | (23,816 | ) |
| Net increase (decrease) in liabilities:                                            |       |                                       |        |   |   |
| Interest payable                                                                   | ** ** | **8,268**                                  |        | 6,052 |   |
| Accrued expenses                                                                   | ** ** | **19,969**                                 |        | (25,110 | ) |
| Taxes payable                                                                      | ** ** | **24,441**                                 |        | 37,273 |   |
| Net cash provided by operating activities                                          | ** ** | **91,641**                                 |        | 46,923 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                          |       |                                       |        |   |   |
| Proceeds from maturities of investment securities held-to-maturity                 | ** ** | **472**                                    |        | 1,658 |   |
| Proceeds from maturities of investment securities available-for-sale               | ** ** | **219,959**                                |        | 297,156 |   |
| Proceeds from sales of investment securities available-for-sale                    | ** ** | **15,997**                                 |        | 8 |   |
| Purchases of investment securities held-to-maturity                                | ** ** | **—**                                 |        | (4,765 | ) |
| Purchases of investment securities available-for-sale                              | ** ** | **(167,201**                               | )           | (244,497 | ) |
| Net increase in customer loans                                                     | ** ** | **(185,665**                               | )           | (163,394 | ) |
| Proceeds from sales of other real estate owned                                     | ** ** | **191**                                    |        | 75 |   |
| Capital expenditures                                                               | ** ** | **(5,619**                                 | )           | (702 | ) |
| Proceeds from sales of premises                                                    | ** ** | **2,075**                                  |        | 1,169 |   |
| Purchases of private equity funds                                                  | ** ** | **(1,458**                                 | )           | (183 | ) |
| Net cash used in investing activities                                              | ** ** | **(121,249**                               | )           | (113,475 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                          |       |                                       |        |   |   |
| Net increase in noninterest-bearing deposits                                       | ** ** | **49,635**                                 |        | 18,468 |   |
| Net increase in checking plus interest and savings accounts                        | ** ** | **38,811**                                 |        | 268,332 |   |
| Net increase (decrease) in certificates of deposit                                 | ** ** | **83,631**                                 |        | (5,766 | ) |
| Net (decrease) increase in short-term borrowings                                   | ** ** | **(30,894**                                | )           | 95,306 |   |
| Repayment of long-term debt                                                        | ** ** | **(1**                                     | )           | (12 | ) |
| Proceeds from issuance of shares                                                   | ** ** | **3,070**                                  |        | 3,986 |   |
| Dividends paid                                                                     | ** ** | **(27,750**                                | )           | (26,335 | ) |
| Net cash provided by financing activities                                          | ** ** | **116,502**                                |        | 353,979 |   |
| Net increase in cash and cash equivalents                                          | ** ** | **86,894**                                 |        | 287,427 |   |
| Cash and cash equivalents at beginning of period                                   | ** ** | **245,134**                                |        | 362,701 |   |
| Cash and cash equivalents at end of period                                         | ** ** | **$**                                      | **332,028** |   | $ | 650,128 |   |
| **SUPPLEMENTAL INFORMATION**                                                       |       |                                       |        |   |   |
| Cash payments for interest                                                         | ** ** | **$**                                      | **27,894**  |   | $ | 21,389 |   |
| Cash payments for income taxes                                                     | ** ** | **13,226**                                 |        | 2,579 |   |

 

See notes to consolidated financial statements

 

5

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**MERCANTILEBANKSHARES CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

1. Basis ofPresentation

 

Theconsolidated financial statements, which include the accounts of MercantileBankshares Corporation (“Bankshares”) (Nasdaq: MRBK) and all of its affiliates,are prepared in conformity with accounting principles generally accepted in theUnited States of America and follow general practice within the bankingindustry.  In the opinion of management,the consolidated financial statements include all adjustments necessary for afair presentation of the interim period. These adjustments are of a normal nature and include adjustments toeliminate all significant intercompany transactions.  In view of the changing conditions in thenational economy, the effect of actions taken by regulatory authorities andnormal seasonal factors, the results for the interim period are not necessarilyindicative of annual performance.  Forcomparability, certain prior period amounts have been reclassified to conformwith current period presentation.

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and contingent assets and liabilities in the financial statements,and the disclosure of revenue and expenses during the reporting period.  These assumptions are based on informationavailable as of the date of the financial statements and could differ fromactual results.  See Annual Report on Form 10-Kfor more detail.

 

2. BusinessCombinations / Restructuring

 

Thefollowing provides information concerning acquisitions and restructurings. Acquisitionsare accounted for as purchases with the results of their operations subsequentto the acquisition date to be included in Bankshares’ Statements ofConsolidated Income.

 

In2004, Bankshares initiated a significant reorganization within its CommunityBanking network.  In a move designed tocreate banks of sufficient size and depth to compete more effectively today andin the future, Bankshares combined 11 affiliate banks to create four neworganizations, all with a more prominent Mercantile identity. Thisreorganization has enabled Bankshares to operate more effectively andefficiently in the face of increased competitive and regulatory pressures.  Fewer, larger banks allow better leverage ofour branch network, reduce administrative and operational redundancies andincrease the breadth and depth of expertise within our Community Banks. Allbanks that were combined are geographically contiguous, share increasinglycommon market dynamics and offer the opportunity to create scale efficiencies.In 2004, Bankshares accrued approximately $2.3 million in restructuring chargesdue to this reorganization. The majority of these costs were in severancecharges. At March 31, 2005, $1.4 million remains to be paid.

 

On January 25,2005, Bankshares, Mercantile-Safe Deposit and Trust Company, a wholly ownedsubsidiary of Bankshares and a Maryland Bank (“MSD&T”), and Community Bankof Northern Virginia, a Virginia Bank (“CBNV”) entered into an Agreement andPlan of Merger. At December 31, 2004, CBNV had $880 million in assets,$654 million in gross loans and $649 million in deposits. The merger, which issubject to CBNV shareholder approval and certain bank regulatory approvals,among other conditions, is expected to be completed by the end of the secondquarter of 2005. CBNV will hold a special meeting of shareholders of CBNV on May 16,2005, to approve the merger. For the quarter ended March 31, 2005,Bankshares expensed merger-related costs totaling $0.3 million. These costswere included in noninterest expenses.

 

At theeffective time and as a result of the Merger, each outstanding share of CBNV’scommon stock (the “Bank Shares”) will be converted into the right to receiveeither (i) $20.375 in cash without interest (the “Cash Election Price”),or (ii) .4005 of Bankshares’ common stock (the “Exchange Ratio,” andtogether with the cash Election Price, the “Merger Consideration”). Eachshareholder of CBNV will be entitled to elect the number of its Bank Shares tobe exchanged for the Cash Election Price or to make no election, subject to aproration which will provide that the aggregate Merger Consideration exchangedfor Bank Shares outstanding at the closing of the Merger will be allocated as40% cash and 60% Bankshares’ common stock. The Merger is anticipated to be taxfree to the shareholders of CBNV, as to the portion of the Merger Considerationreceived as Bankshares common stock. Outstanding CBNV stock options will beconverted into stock options of Bankshares.

 

6

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3. Earnings PerShare

 

Basic earnings pershare (“EPS”) are computed by dividing income available to common shareholdersby weighted average common shares outstanding. Diluted EPS are computed using the same components as basic EPS with thedenominator adjusted for the dilutive effect of stock options, restricted stockawards and vested directors’ deferred compensation plan shares.  The following tables provide reconciliationbetween the computation of basic EPS and diluted EPS for the three months endedMarch 31, 2005 and 2004, respectively.

 
| ** **                                               | ** ** | **For the 3  months ended March 31,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|
| **2005 (In thousands, except per  share data)**          | ** ** | **Net  Income**                            | ** ** | **Weighted  Average  Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                | ** ** | **$**                                      | **62,627** | ** ** | **79,228** | ** ** | **$** | **0.79** | ** ** |
| Dilutive effect of:                                      | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options and restricted stock awards                | ** ** | ** **                                 | ** ** | **479** | ** ** | ** ** | ** ** |
| Vested directors’ deferred compensation plan shares | ** ** | ** **                                 | ** ** | **168** | ** ** | ** ** | ** ** |
| Diluted EPS                                              | ** ** | **$**                                      | **62,627** | ** ** | **79,875** | ** ** | **$** | **0.78** | ** ** |
|                                                     | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                               | ** ** | **For the 3  months ended March 31,** | ** ** |
| **2004 (In thousands, except per  share data)**          | ** ** | **Net  Income**                            | ** ** | **Weighted  Average  Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                |       | $                                          | 55,697     |   | 79,725 |   | $ | 0.70 |   |
| Dilutive effect of:                                      |       |                                       |       |   |   |   |   |
| Stock options and restricted stock awards                |       |                                       |       | 533 |   |   |   |
| Diluted EPS                                              |       | $                                          | 55,697     |   | 80,258 |   | $ | 0.69 |   |

 

Antidilutiveoptions and awards excluded from the computation of diluted earnings per sharewere 116,565 and 298,319 for the three months ended March 31, 2005 and2004, respectively.

 

# **4.Investment Securities**

# ** **

Atboth periods presented, securities with an amortized cost of $1.1 billion werepledged as collateral for certain deposits as required.

 

The amortized costand fair value of investment securities at March 31, 2005 and December 31,2004 are shown below:

 
| ** **                                | ** ** | **March 31, 2005** | ** **    | **December 31, 2004**   | ** ** |
|-------------------------------------------|------------|-------------------------|---------------|------------------------------|------------|
| **(Dollars in thousands)**                | ** ** | **Amortized  Cost**     | ** **    | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| Investment securities  held-to-maturity   |       |                    |          |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| States and political  subdivisions        | ** ** | **$**                   | **19,704**    | ** **                   | **$**      | **683** | ** ** | **$** | **16** | ** ** | **$** | **20,371** |   | $ | 20,176 |   | $ | 921 |   | $ | 3 |   | $ | 21,094 |   |
|                                      |       |                    |          |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment securities  available-for-sale |       |                    |          |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury                             | ** ** | **$**                   | **521,307**   | ** **                   | **$**      | **1,511** | ** ** | **$** | **2,487** | ** ** | **$** | **520,331** |   | $ | 605,505 |   | $ | 4,534 |   | $ | 980 |   | $ | 609,059 |   |
| U.S. Government agencies                  | ** ** | **875,677**             | ** **    | **1,329**                    | ** ** | **11,246** | ** ** | **865,760** |   | 853,930 |   | 3,742 |   | 4,699 |   | 852,973 |   |
| Mortgage-backed securities                | ** ** | **1,326,104**           | ** **    | **1,322**                    | ** ** | **28,148** | ** ** | **1,299,278** |   | 1,326,056 |   | 4,372 |   | 13,127 |   | 1,317,301 |   |
| States and political  subdivisions        | ** ** | **60,405**              | ** **    | **433**                      | ** ** | **88** | ** ** | **60,750** |   | 61,984 |   | 917 |   | 31 |   | 62,870 |   |
| Other investments                         | ** ** | **60,969**              | ** **    | **851**                      | ** ** | **218** | ** ** | **61,602** |   | 65,323 |   | 1,294 |   | 126 |   | 66,491 |   |
| Total                                     | ** ** | **$**                   | **2,844,462** | ** **                   | **$**      | **5,446** | ** ** | **$** | **42,187** | ** ** | **$** | **2,807,721** |   | $ | 2,912,798 |   | $ | 14,859 |   | $ | 18,963 |   | $ | 2,908,694 |   |

 

At March 31,2005, there were $328.3 million of individual securities that had unrealizedlosses for a period greater than 12 months. At March 31, 2005, thesesecurities had an unrealized loss of $14.8 million of which 93.4% weremortgage-backed securities. Management has assessed the impairment of thesesecurities and determined that the impairment is temporary. All principal andinterest payments on available-for-sale debt securities in an unrealized lossposition for greater than 12 months are expected to be collected given the highcredit quality of the U.S. government agency debt securities and Banksharesability and intent to hold the securities until such time as the value recoversor they mature.

 

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# **5.Impaired Loans**

# ** **

When scheduled principal or interest payments are pastdue 90 days or more at quarter-end on any loan, the accrual of interest incomeis discontinued and subsequent receipts on these loans are recorded as areduction of principal, and interest income is recorded only once principalrecovery is reasonably assured. Previously accrued but uncollected interest onthese loans is charged against interest income. Generally, a loan may berestored to accruing status when all past due principal, interest and latecharges have been paid and the bank expects repayment of the remainingcontractual principal and interest on a timely basis.

 

Under Statements of Financial Accounting Standards(SFAS) Nos. 114 and 118, “Accounting by Creditors for Impairment of a Loan-anamendment of FASB Statements Nos. 5 and 15,” a loan is considered impaired,based on current information and events, if it is probable that Bankshares willnot collect all principal and interest payments according to the contractualterms of the loan agreement. The impairment of a loan is measured based on thepresent value of expected future cash flows discounted at the loan’s effectiveinterest rate, or the fair value of the collateral if the repayment is expectedto be provided predominantly by the underlying collateral. Informationwith respect to impaired loans and the related valuation allowance (if themeasure of the impaired loan is less than the recorded investment) at March 31,2005, December 31, 2004 and March 31, 2004 is shown below.  See Annual Report on Form 10-K formore detail.

 
| **(Dollars  in thousands)**                                                      | ** ** | **March 31,  2005** | ** **  | **December 31,  2004** | ** ** | **March 31,  2004** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------|-------------|-----------------------------|------------|--------------------------|------------|
| Impaired loans with a specific valuation allowance                               | ** ** | **$**                    | **17,188**  |                        | $          | 18,365                   |       | $ | 25,971 |   |
| All other impaired loans                                                         | ** ** | **11,592**               |        | 9,113                       |       | 16,508                   |       |
| Total impaired loans                                                             | ** ** | **$**                    | **28,780**  |                        | $          | 27,478                   |       | $ | 42,479 |   |
|                                                                             |       |                     |        |                        |       |                     |       |
| Specific allowance for loan losses applicable to impaired loans                  | ** ** | **$**                    | **10,437**  |                        | $          | 10,611                   |       | $ | 14,094 |   |
| General allowance for loan losses applicable to other than impaired  loans       | ** ** | **138,580**              |        | 138,391                     |       | 142,541                  |       |
| Total allowance for loan losses                                                  | ** ** | **$**                    | **149,017** |                        | $          | 149,002                  |       | $ | 156,635 |   |
|                                                                             |       |                     |        |                        |       |                     |       |
| Year-to-date interest income on impaired loans recorded on the cash  basis       | ** ** | **$**                    | **23**      |                        | $          | 379                      |       | $ | 103 |   |
| Year-to-date average recorded investment in impaired loans during the  period    | ** ** | **$**                    | **28,780**  |                        | $          | 39,025                   |       | $ | 42,479 |   |
| Quarter-to-date interest income on impaired loans recorded on the  cash basis    | ** ** | **$**                    | **23**      |                        | $          | 79                       |       | $ | 103 |   |
| Quarter-to-date average recorded investment in impaired loans during  the period | ** ** | **$**                    | **28,780**  |                        | $          | 35,583                   |       | $ | 42,479 |   |

 

Note: Impairedloans do not include large groups of smaller balance homogeneous loans that areevaluated collectively for impairment (e.g., residential mortgages and consumerinstallment loans).  The allowance forloan losses related to these loans is included in the general allowance forloan losses applicable to other than impaired loans.

 

6. Commitments andContingencies

 

Banksharesis a party to financial instruments that are not reflected in the balancesheet, which include commitments to extend credit and standby letters ofcredit. Various commitments to extend credit (lines of credit) are made in thenormal course of banking business. Letters of credit are issued for the benefitof customers by affiliated banks. These commitments are subject to loanunderwriting standards and geographic boundaries consistent with Bankshares’loans outstanding. Bankshares’ lending activities are concentrated in Maryland,Delaware and Virginia.

 

Commitmentsto extend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract. Commitments generallyhave fixed expiration dates or other termination clauses and may requirepayment of a fee. Since many of the commitments are expected to expire withoutbeing drawn upon, the total commitment amounts do not necessarily representfuture cash requirements. Total commitments to extend credit were $4.4 billionat March 31, 2005, $4.2 billion at December 31, 2004, and $3.6billion at March 31, 2004.

 

Lettersof credit are commitments issued to guarantee the performance of a customer toa third party. Outstanding letters of credit were $401.7 million at March 31,2005, $379.8 million at December 31, 2004 and $303.3 million at March 31,2004.  Fees received for issuing lettersof credit are deferred and amortized over the life of the commitment.  The unamortized fees on letters of credit at March 31,2005, December 31, 2004, and March 31, 2004 had a carrying value of$1.4 million, $1.3 million and $1.1 million, respectively.

 

Bankshares’mortgage banking subsidiary is a Fannie Mae Delegated Underwriting and Servicinglender, and has a loss sharing arrangement for loans originated on behalf ofand sold to Fannie Mae.  The unamortizedprincipal balance of the underlying loans

 

8

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totaled $220.9million, $190.7 million and $148.6 million at March 31, 2005, December 31,2004 and March 31, 2004, respectively. No loss reserve has been established for potential losses on loansoriginated and sold in the secondary market since there have been no lossesrecognized during the history of this arrangement and no losses were incurredat March 31, 2005.  The mortgagesubsidiary also has originated and sold loans with recourse in the event offoreclosure on the underlying real estate. The unamortized amount of principal balance of loans sold with recoursetotaled $1.6 million at March 31, 2005, $1.7 million at December 31,2004 and $2.2 million at March 31, 2004. These mortgages are generally in good standing, are well-collateralizedand no loss has ensued and no future loss is expected.

 

Bankshareshas committed to invest funds in third-party private equity investments. At March 31,2005, December 31, 2004 and March 31, 2004, $32.5 million, $28.9million and $20.9 million, respectively, remained unfunded.

 

In theordinary course of business, Bankshares and its subsidiaries are involved in anumber of pending and threatened legal actions and proceedings. In certain ofthese actions and proceedings, claims for substantial monetary damages areasserted against Bankshares and its subsidiaries. In view of the inherentdifficulty of predicting the outcome of such matters, Bankshares cannot statewhat the eventual outcome of pending matters will be. However, based on currentknowledge, management does not believe that liabilities, if any, arising frompending litigation matters, will have a material adverse effect on theconsolidated financial position or liquidity of Bankshares. If paymentassociated with a claim becomes probable and the cost can be reasonablyestimated, a contingent liability would be established based on informationcurrently available, advice of counsel and available insurance coverage.

 

Aspreviously disclosed, on July 12, 2004, former employee John Pileggi fileda lawsuit against Mercantile Bankshares Corporation (“Bankshares”),Mercantile-Safe Deposit and Trust Company (“MSD&T”) and Edward J. Kelly, III,Chairman and CEO of Bankshares alleging that the public statements made by thedefendants regarding the circumstances of Mr. Pileggi’s termination gaverise to claims of libel, invasion of privacy and false light. Mr. Pileggialso alleged breach of his employment contract and made a claim pursuant to achange-in-control agreement. The complaint sought actual and punitive damagesamounting to in excess of $240 million.

 

On September 27,2004, Bankshares filed a countersuit against Mr. Pileggi alleging thatduring his employment, Mr. Pileggi engaged in activities that constitutedfraud, breach of contract, and breach of his fiduciary duty. The countersuitsought compensatory and punitive damages amounting to $8.2 million.

 

On March 30,2005, Bankshares, MSD&T, Mr. Kelly and Mr. Pileggi agreed todismiss all claims and provide full releases from any future claims. Inaddition, Mercantile has agreed to pay Mr. Pileggi $1.3 million in respectof Mr. Pileggi’s employment contract and certain related benefits.Mercantile also has agreed, subject to certain conditions, to pay a portion ofthe legal fees incurred by Mr. Pileggi.

 

7. OtherIntangible Assets

 

Thefollowing table discloses the gross carrying amount and accumulatedamortization of intangible assets subject to amortization at March 31,2005 and December 31, 2004:

 
| ** **                 | ** ** | **March 31,  2005**    | ** ** | **December 31,  2004**   | ** ** |
|----------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Gross  carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** | **Gross  carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** |
| Core deposits              | ** ** | **$**                       | **49,881** | ** **                    | **$**      | **(16,380** | **)** | **$** | **33,501** |   | $ | 49,881 |   | $ | (15,014 | ) | $ | 34,867 |   |
| Mortgage servicing         | ** ** | **1,338**                   | ** ** | **(1,072**                    | **)**      | **266** |   | 1,370 |   | (1,013 | ) | 357 |   |
| Customer lists and other   | ** ** | **17,010**                  | ** ** | **(4,655**                    | **)**      | **12,355** |   | 17,010 |   | (4,008 | ) | 13,002 |   |
| Total                      | ** ** | **$**                       | **68,229** | ** **                    | **$**      | **(22,107** | **)** | **$** | **46,122** |   | $ | 68,261 |   | $ | (20,035 | ) | $ | 48,226 |   |

 

Identifiableintangible assets are amortized based on estimated lives of up to 15 years.Management reviews other intangible assets for impairment yearly, or wheneverevents or changes in circumstances indicate that their carrying amounts may notbe recoverable. For those intangible assets subject to amortization, impairmentis indicated if the sum of undiscounted estimated future net cash flows is lessthan the carrying amount of the asset. Impairment is recognized by writing downthe carrying value or adjusting the estimated life of the asset. Any impairmentrecognized in a valuation account is reflected in the income statement in thecorresponding period.

 

Thefollowing table shows the current period and estimated future amortizationexpense for amortized intangible assets. The projections of amortizationexpense shown for mortgage servicing rights are based on asset balances and theinterest rate environment as of March 31, 2005. Future amortizationexpense may be significantly different depending upon changes in the mortgageservicing portfolio, mortgage interest rates and market conditions.

 

9

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| **(Dollars  in thousands)**                            | ** ** | ** ** | ** ** | **Core  deposits** | ** ** | **Mortgage  servicing** | ** ** | **Customer  lists  and other** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|------------|------------|--------------------|------------|-------------------------|------------|--------------------------------|------------|-----------|------------|
| Three months ended March 31, 2005 (actual)        | ** ** | ** ** | ** ** | **$**              | **1,367**  | ** **              | **$**      | **54**                         | ** ** | **$**     | **651**    | ** ** | **$** | **2,072** | ** ** |
| Nine months ended December 31, 2005 (estimated)   |       |       |       | 4,100              |       | 74                      |       | 1,939                          |       | 6,113     |       |
| Twelve months ended December 31, 2005 (estimated) |       |       |       | 5,467              |       | 128                     |       | 2,590                          |       | 8,185     |       |
|                                                   |       |       |       |               |       |                    |       |                           |       |      |       |
| Estimate for year ended December 31,              |       | 2006       |       | 5,467              |       | 99                      |       | 2,343                          |       | 7,909     |       |
|                                                   |       | 2007       |       | 5,209              |       | 39                      |       | 2,149                          |       | 7,397     |       |
|                                                   |       | 2008       |       | 4,344              |       |                    |       | 1,966                          |       | 6,310     |       |
|                                                   |       | 2009       |       | 4,020              |       |                    |       | 1,028                          |       | 5,048     |       |
|                                                        |            |            |            |                    |            |                         |            |                                |            |           |            |  |  |  |  |

 

8. ComprehensiveIncome

 

Thefollowing table summarizes the market value change and related tax effect ofunrealized gains (losses) on securities available-for-sale for the quartersended March 31, 2005 and 2004, respectively.  The total comprehensive income is included inthe Statements of Changes in Consolidated Shareholders’ Equity.

 
| ** **                                                            | ** ** | **For the 3  months ended March 31,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **(Dollars  in thousands)**                                           | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Net income                                                            | ** ** | **$**                                      | **62,627** |   | $ | 55,697 |   |
| Other comprehensive income, net of taxes:                             |       |                                       |       |   |   |
| Unrealized holding (losses) gains arising during the period           | ** ** | **(20,190**                                | )          | 12,223 |   |
| Reclassification adjustment for (gains) losses included in net income | ** ** | **(250**                                   | )          | 33 |   |
| Total                                                                 | ** ** | **$**                                      | **42,187** |   | $ | 67,953 |   |

 

9. CapitalAdequacy

 

Banksharesand its bank affiliates are subject to various regulatory capital adequacyrequirements administered by federal and state banking agencies.  These requirements include maintainingcertain capital ratios above minimum levels. These capital ratios include tier I capital and total risk-based capitalas percentages of net risk-weighted assets and tier I capital as a percentageof adjusted average total assets (leverage ratio).  The minimum ratios for capital adequacy purposesare 4.00%, 8.00% and 4.00%, for the tier I capital, total capital and leverageratios, respectively.  To be categorizedas *well capitalized,* a bank must maintainminimum ratios of 6.00%, 10.00% and 5.00%, for its tier I capital, totalcapital and leverage ratios, respectively. As of March 31, 2005, Bankshares and each of its bank affiliatesexceeded all capital adequacy requirements to be considered well capitalized.

 

Capitalratios and the amounts used to calculate them are presented in the followingtable for Bankshares and Mercantile-Safe Deposit and Trust Company (MSD&T),the lead bank, as of March 31, 2005 and December 31, 2004.

 
| ** **                    | ** ** | **March 31,  2005** | ** **    | **December 31,  2004** | ** ** |
|-------------------------------|------------|--------------------------|---------------|-----------------------------|------------|
| **(Dollars  in thousands)**   | ** ** | **Bankshares**           | ** **    | **MSD&T**               | ** ** | **Bankshares** | ** ** | **MSD&T** | ** ** |
|                          |       |                     |          |                        |       |   |   |   |   |
| Tier I capital                | ** ** | **$**                    | **1,412,974** | ** **                  | **$**      | **419,288** |   | $ | 1,370,112 |   | $ | 411,587 |   |
| Total risk-based capital      | ** ** | **1,844,629**            | ** **    | **467,357**                 |       | 1,802,520 |   | 459,812 |   |
| Net risk-weighted assets      | ** ** | **11,323,077**           | ** **    | **3,839,217**               |       | 11,109,137 |   | 3,847,161 |   |
| Adjusted average total assets | ** ** | **13,873,772**           | ** **    | **4,669,943**               |       | 13,674,386 |   | 4,504,451 |   |
|                          |       |                     |          |                        |       |   |   |   |   |
| Tier I capital ratio          | ** ** | **12.48**                | **%**         | **10.92**                   | **%**      | 12.33 | % | 10.70 | % |
| Total capital ratio           | ** ** | **16.29**                | **%**         | **12.17**                   | **%**      | 16.23 | % | 11.95 | % |
| Leverage ratio                | ** ** | **10.18**                | **%**         | **8.98**                    | **%**      | 10.02 | % | 9.14 | % |
|                               |            |                          |               |                             |            |  |  |  |  |  |  |  |  |

 

Bankshares has an ongoing share repurchase program.  Purchases may be made from time to time,subject to regulatory requirements, in open market or in privately negotiatedtransactions. Purchased shares are retired. At March 31, 2005, there were476,327 shares remaining available for repurchase under the plan.

 

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10. SegmentReporting

 

Operatingsegments as defined by SFAS No. 131, *Disclosures about Segmentsof an Enterprise and Related Information,* are components of anenterprise with separate financial information. The component engages in business activities from which it derivesrevenues and incurs expenses and whose operating results management relies onfor decision-making and performance assessment. Bankshares has two reportablesegments – Banking and Investment and Wealth Management  (“IWM”).

 

Thefollowing tables present selected segment information for the three monthsended March 31, 2005 and 2004. The components in the “Other” columnconsist of amounts for the nonbank affiliates, unallocated corporate expensesincluding income taxes and intercompany eliminations. Certain expense amountssuch as operations overhead have been reclassified from internal financialreporting in order to provide for full cost absorption. These reclassificationsare shown in the “Adjustments” line.

 
| ** **                        | ** ** | **For the 3  months ended March 31, 2005** | ** **     |
|-----------------------------------|------------|-------------------------------------------------|----------------|
| **(Dollars in thousands)**        | ** ** | **Banking**                                     | ** **     | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income               | ** ** | **$**                                           | **143,094**    | ** ** | **$** | **—** | ** ** | **$** | **(11** | **)** | **$** | **143,083** | ** ** |
| Provision for loan losses         | ** ** | **(756**                                        | **)**          | **—** | ** ** | **—** | ** ** | **(756** | **)** |
| Noninterest income                | ** ** | **29,491**                                      | ** **     | **24,313** | ** ** | **4,065** | ** ** | **57,869** | ** ** |
| Noninterest expenses              | ** ** | **(80,451**                                     | **)**          | **(16,846** | **)** | **(2,856** | **)** | **(100,153** | **)** |
| Adjustments                       | ** ** | **3,929**                                       | ** **     | **(1,209** | **)** | **(2,720** | **)** | **—** | ** ** |
| Income (loss) before income taxes | ** ** | **95,307**                                      | ** **     | **6,258** | ** ** | **(1,522** | **)** | **100,043** | ** ** |
| Income tax (expense) benefit      | ** ** | **(33,047**                                     | **)**          | **(2,506** | **)** | **(1,863** | **)** | **(37,416** | **)** |
| Net income (loss)                 | ** ** | **$**                                           | **62,260**     | ** ** | **$** | **3,752** | ** ** | **$** | **(3,385** | **)** | **$** | **62,627** | ** ** |
| Average loans                     | ** ** | **$**                                           | **10,313,937** | ** ** | ** ** | ** ** | **$** | **424** | ** ** | **$** | **10,314,361** | ** ** |
| Average earning assets            | ** ** | **13,199,433**                                  | ** **     | ** ** | ** ** | **21,734** | ** ** | **13,221,167** | ** ** |
| Average assets                    | ** ** | **14,348,599**                                  | ** **     | ** ** | ** ** | **159,745** | ** ** | **14,508,344** | ** ** |
| Average deposits                  | ** ** | **10,903,318**                                  | ** **     | ** ** | ** ** | **(184,584** | **)** | **10,718,734** | ** ** |
| Average equity                    | ** ** | **1,805,588**                                   | ** **     | ** ** | ** ** | **144,688** | ** ** | **1,950,276** | ** ** |

 
| ** **                        | ** ** | **For the 3  months ended March 31, 2004** | ** ** |
|-----------------------------------|------------|-------------------------------------------------|------------|
| **(Dollars in thousands)**        | ** ** | **Banking**                                     | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income               |       | $                                               | 130,345    |   | $ | — |   | $ | 60 |   | $ | 130,405 |   |
| Provision for loan losses         |       | (2,426                                          | )          | — |   | — |   | (2,426 | ) |
| Noninterest income                |       | 27,095                                          |       | 22,382 |   | 3,677 |   | 53,154 |   |
| Noninterest expenses              |       | (75,527                                         | )          | (17,379 | ) | (480 | ) | (93,386 | ) |
| Adjustments                       |       | 3,231                                           |       | (796 | ) | (2,435 | ) | — |   |
| Income (loss) before income taxes |       | 82,718                                          |       | 4,207 |   | 822 |   | 87,747 |   |
| Income tax (expense) benefit      |       | (29,046                                         | )          | (1,683 | ) | (1,321 | ) | (32,050 | ) |
| Net income (loss)                 |       | $                                               | 53,672     |   | $ | 2,524 |   | $ | (499 | ) | $ | 55,697 |   |
| Average loans                     |       | $                                               | 9,338,236  |   |   |   | $ | 197 |   | $ | 9,338,433 |   |
| Average earning assets            |       | 12,348,307                                      |       |   |   | 23,886 |   | 12,372,193 |   |
| Average assets                    |       | 13,069,701                                      |       |   |   | 548,492 |   | 13,618,193 |   |
| Average deposits                  |       | 10,138,846                                      |       |   |   | (72,201 | ) | 10,066,645 |   |
| Average equity                    |       | 1,373,147                                       |       |   |   | 475,314 |   | 1,848,461 |   |

 

11

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11. DerivativeInstruments and Hedging Activities

 

FASBStatement No. 133 (SFAS No. 133), *Accounting for DerivativeInstruments and Hedging Activities,*FASB Statement No. 138(SFAS No. 138), *Accounting for CertainDerivative Instruments and Certain Hedging Activities – an amendment to FASBStatement No. 133*and**FASB StatementNo. 149 (SFAS No. 149), *Amendment of Statement No. 133on Derivative Instruments and Hedging Activities *(collectively referred to as “derivatives”),establishes accounting and reporting standards for derivative instruments andfor hedging activities. Bankshares maintains an overall interest rate riskmanagement strategy that incorporates the use of derivative instruments tominimize significant unplanned fluctuations in earnings that are caused byinterest rate volatility.  Currently,derivative instruments that are used as part of the interest rate riskmanagement strategy have been restricted to interest rate swaps.  Interest rate swaps generally involve theexchange of fixed-rate and variable-rate interest payments between two parties,based on a common notional principal amount and maturity date. As of March 31,2005, Bankshares has interest rate swaps to convert a portion of itsnonprepayable fixed-rate debt to floating-rate debt.  Bankshares also arranges interest rate swaps,caps and swaptions for commercial loan customers through its capital marketsgroup.  Derivative transactions done withloan customers are hedged by means of an off-setting derivative trade with athird party.  In this way, Banksharesmanages the market risk arising from capital markets related derivativeactivity.

 

Thefair value of derivative instruments relating to hedging activities recorded inother assets was $1.6 million (notional $261.2 million) and $7.1 million(notional $294.5 million) at March 31, 2005 and December 31, 2004,respectively.  The fair value ofderivative instruments relating to hedging activities recorded in otherliabilities was $10.0 million (notional $175.7 million) and $6.8 million(notional $136.0 million) at March 31, 2005 and December 31, 2004,respectively.

 

Changesin the fair value of a derivative that is designated and qualifies as a fairvalue hedge, along with the gain or loss on the hedged asset or liability thatis attributable to the hedged risk, are recorded as other noninterest income inthe results of operations. For all hedge relationships, ineffectivenessresulting from differences between the changes in fair values or cash flows ofthe hedged item and changes in fair value of the derivative are recognized asother noninterest income in the results of operations. The net interestsettlement on derivatives designated as fair value or cash flow hedges istreated as an adjustment of the interest income or interest expense of thehedged assets or liabilities. The fair-value hedges of nonprepayable fixed-ratedebt were effective for the reported periods. The impact of the hedgesdecreased interest expense $1.6 million in the first three months of 2005 and$2.8 million for the same period in 2004.

 

Thefollowing tables summarize the gross position of derivatives relating tohedging activities at March 31, 2005 and December 31, 2004:

 
| ** **                          | ** ** | **March 31,  2005** | ** **  | **December 31,  2004** | ** ** |
|-------------------------------------|------------|--------------------------|-------------|-----------------------------|------------|
| ** **                          | ** ** | **Notional  or**         | ** **  | **Credit**                  | ** ** | **Estimated** | ** ** | **Notional  or** | ** ** | **Credit** | ** ** | **Estimated** | ** ** |
| ** **                          | ** ** | **Contractual**          | ** **  | **Risk**                    | ** ** | **Net** | ** ** | **Contractual** | ** ** | **Risk** | ** ** | **Net** | ** ** |
| **(Dollars in thousands)**          | ** ** | **Amount**               | ** **  | **Amount  (1)**             | ** ** | **Fair  Value** | ** ** | **Amount** | ** ** | **Amount  (1)** | ** ** | **Fair  Value** | ** ** |
| *Asset/Liability Management Hedges* |       |                     |        |                        |       |   |   |   |   |   |   |   |   |
| Interest Rate Contracts:            |       |                     |        |                        |       |   |   |   |   |   |   |   |   |
| Swaps                               | ** ** | **$**                    | **350,000** | ** **                  | **$**      | **4,082** | ** ** | **$** | **(9,021** | ) | $ | 350,000 |   | $ | 6,297 |   | $ | (143 | ) |
|                                |       |                     |        |                        |       |   |   |   |   |   |   |   |   |
| *Customer Accommodations*           |       |                     |        |                        |       |   |   |   |   |   |   |   |   |
| Interest Rate Contracts:            |       |                     |        |                        |       |   |   |   |   |   |   |   |   |
| Swaps                               | ** ** | **$**                    | **75,024**  | ** **                  | **$**      | **826** | ** ** | **$** | **632** |   | $ | 68,575 |   | $ | 684 |   | $ | 398 |   |
| Swaptions/Caps Purchased            | ** ** | **5,941**                | ** **  | **68**                      | ** ** | **68** |   | 5,971 |   | 80 |   | 80 |   |
| Swaptions/Caps Sold                 | ** ** | **5,941**                | ** **  | **—**                  | ** ** | **(68** | ) | 5,971 |   | — |   | (80 | ) |
|                                     |            |                          |             |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          Creditrisk amounts reflect the replacement cost for those contracts in a gainposition in the event of nonperformance by all counterparties.

 

Mortgageloans held-for-sale have inherent forward contract (agreements to sell orpurchase loans at a specific rate or yield) characteristics. Risk may arisefrom the corresponding parties’ inability to meet the terms of their contractsand from movement in interest rates. Bankshares has forward commitments to selland fund individual fixed-rate and variable-rate mortgage loans that arereported at fair value. The fair value of the forward contracts was $1.5million at March 31, 2005 and $1.2 million at December 31, 2004.

 

12

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12. Stock-basedCompensation Expense

 

Bankshareshas several stock-based compensation programs for its directors, management andemployees. Compensation costs for stock options and restricted stock awards aremeasured under the fair value method and are included in salary expense.  Another form of stock-based compensation isphantom stock, which is used for a portion of the Bankshares’ Directors’Deferred Compensation Plan. This plan requires that substantially all deferredfees be settled in Bankshares’ stock. The compensation cost for the phantomstock is included in other expenses. Employee stock-based compensation amounts, included in salaries expense,for the quarters ended March 31, 2005 and 2004, respectively, are summarizedin the following table:

 
| ** **                      | ** ** | **For the 3  months ended March 31** | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|
| **(Dollars in thousands)**      | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| Stock options expense           | ** ** | **$**                                     | **713**    |   | $ | 406 |   |
| Restricted stock awards expense | ** ** | **642**                                   |       | 487 |   |
| Included in salaries expense    | ** ** | **$**                                     | **1,355**  |   | $ | 893 |   |

 

13. Pension &Other Postretirement Benefit Plans

 

Banksharessponsors qualified and nonqualified pension plans and other postretirementbenefit plans for its employees.  Thefollowing table summarizes the components of the net periodic benefit cost forthe pension plans for the three months ended March 31, 2005 and 2004,respectively.

 
| ** **                           | ** ** | **For the 3  months ended March 31, 2005** | ** ** | **For the 3  months ended March 31, 2004** | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| **(Dollars in thousands)**           | ** ** | **Qualified**                                   | ** ** | **Nonqualified**                                | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                         | ** ** | **$**                                           | **1,778**  | ** **                                      | **$**      | **165** | ** ** | **$** | **1,943** |   | $ | 1,572 |   | $ | 141 |   | $ | 1,713 |   |
| Interest cost                        | ** ** | **2,813**                                       | ** ** | **35**                                          | ** ** | **2,848** |   | 2,549 |   | 101 |   | 2,650 |   |
| Expected return on plan assets       | ** ** | **(4,138**                                      | **)**      | **—**                                      | ** ** | **(4,138** | **)** | (3,845 | ) | — |   | (3,845 | ) |
| Amortization of prior service cost   | ** ** | **300**                                         | ** ** | **—**                                      | ** ** | **300** |   | 195 |   | 6 |   | 201 |   |
| Recognized net actuarial (gain) loss | ** ** | **350**                                         | ** ** | **—**                                      | ** ** | **350** |   | 153 |   | 29 |   | 182 |   |
| Amortization of transition asset     | ** ** | **—**                                      | ** ** | **—**                                      | ** ** | **—** |   | — |   | 24 |   | 24 |   |
| Net periodic benefit cost            | ** ** | **$**                                           | **1,103**  | ** **                                      | **$**      | **200** | ** ** | **$** | **1,303** |   | $ | 624 |   | $ | 301 |   | $ | 925 |   |

 

Thefollowing table summarizes the components of the net periodic benefit cost forthe other postretirement benefit plans for the three months ended March 31,2005 and 2004, respectively.

 
| ** **                           | ** ** | **For the 3  months ended March 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|
| **(Dollars in thousands)**           | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Service cost                         | ** ** | **$**                                      | **133**    |   | $ | 65 |   |
| Interest cost                        | ** ** | **249**                                    |       | 214 |   |
| Expected return on plan assets       | ** ** | **—**                                 |       | — |   |
| Amortization of prior service cost   | ** ** | **—**                                 |       | — |   |
| Recognized net actuarial (gain) loss | ** ** | **88**                                     |       | 38 |   |
| Amortization of transition asset     | ** ** | **—**                                 |       | — |   |
| Net periodic benefit cost            | ** ** | **$**                                      | **470**    |   | $ | 317 |   |

 

Aspreviously disclosed in its financial statements for the year ended December 31,2004, Bankshares generally makes cash contributions to the pension plan inamounts up to that permitted by guidelines established under employee benefitand tax laws after taking into consideration the funded status. If it isdetermined that there will be cash contributions, they are normally made aftervaluations have been finalized for the plan year and prior to the tax returnfiling date.  Bankshares does notanticipate making a contribution in 2005.

 

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14. RecentAccounting Standards

 

In December 2003,the American Institute of Certified Public Accountants issued Statement ofPosition (“SOP”) 03-3, “Accounting for Certain Loans or Debt SecuritiesAcquired in a Transfer,” which addresses the accounting for differences betweencontractual cash flows and expected cash flows for loans acquired in a transferwhen those differences are attributable at least in part to creditquality.  It includes such loans acquiredin purchase business combinations where there is evidence of deterioration incredit quality since origination. This SOP requires the difference betweenexpected cash flows and the purchase price to be accreted as an adjustment toyield over the life of the acquired loans; the difference between contractualcash flows and expected cash flows is not subject to accretion. This SOP wouldrepresent a change from past practice where the allowance for loan losses wascarried over in purchase accounting. The SOP is effective for loans acquiredafter December 15, 2004. Bankshares will utilize this SOP in evaluatingthe impact it will have on operations and financial statements with respect toCommunity Bank of Northern Virginia and will apply this SOP to any newacquisitions.

 

In November 2004,the Emerging Issues Task Force (“EITF”) published Issue 03-1, “TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments.” The Task Force discussed the meaning of other-than-temporaryimpairment and its application to certain investments carried at cost. The TaskForce requested that the FASB staff consider other impairment models withinU.S. GAAP when developing its views. The Task Force also requested that thescope of the impairment issue be expanded to include equity investments andinvestments subject to FASB Statement No. 115, “Accounting for CertainInvestments in Debt and Equity Securities,” and that that issue be addressed bythe Task Force as a separate EITF issue. At the EITF meeting, the Task Forcereached a consensus on one issue that certain quantitative and qualitativedisclosures should be required for securities accounted for under Statement 115that are impaired at the balance sheet date but for which another-than-temporary impairment has not been recognized. The Board ratified theconsensus on that one issue at its November 25, 2004 meeting. In September 2004,the Financial Accounting Standards Board (“FASB”) directed the FASB staff toissue two proposed FASB Staff Positions (“FSP”): Proposed FSP EITF Issue 03-1-a,which provides guidance for the application of paragraph 16 of EITF Issue 03-1to debt securities that are impaired because of interest rate and/or sectorspread increases, and Proposed FSP EITF Issue 03-1-b, which delaysthe effective date of Issue 03-1 for debt securities that are impairedbecause of interest rate and/or sector spread increases. The outcome of theproposed guidance under certain interpretations could have an adverse impact onBankshares’ capital and earnings as it relates to securities deemed impairedwithin the available-for-sale investment portfolio. Bankshares cannot determinethe potential impact until the FASB finalizes the proposed statement.

 

In December 2004,the FASB issued Statement No. 123 (Revised 2004) SFAS No. 123R, “Share-BasedPayment,” which requires that the compensation cost relating to share-basedpayment transactions be recognized in financial statements. Share-basedcompensation arrangements include share options, restricted share plans,performance-based awards, share appreciation rights and employee share purchaseplans. That cost will be measured based on the fair value of the equity orliability instruments issued. SFAS No. 123R replaces SFAS No. 123, “Accountingfor Stock-Based Compensation,” and supersedes Accounting Principles Board (“APB”)Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 123permitted entities the option of continuing to apply the guidance in Opinion25, as long as the Notes to the financial statements disclosed what net incomewould have been had the preferable fair-value-based method been used.Bankshares’ adopted the cost recognition provision of SFAS No. 123, “Accountingfor Stock-Based Compensation,” in 1995 and has been expensing compensation costrelated to stock options. Bankshares does not anticipate this revision willhave a material effect on the financial statements. On April 14, 2005, theSecurities and Exchange Commission (SEC) approved a new rule that delaysfor public companies the effective date of SFAS No. 123R. Under the SEC’s rule SFAS,No. 123R is now effective for annual periods that begin after June 15,2005.

 

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# ** **

# **Item 2.  Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

# ** **

#### **MERCANTILE BANKSHARES CORPORATION**

#### ** **

HIGHLIGHTS

 

**ConsolidatedFinancial Results**

 

Netincome for the quarter ended March 31, 2005 was $62.6 million, a 12.4%increase from net income of $55.7 million for the same period in 2004 and a3.3% increase over the $60.6 million reported for the fourth quarter of2004.  For the quarter ended March 31,2005, diluted net income per share was $.78, an increase of 13.0% from the $.69reported for the same period of last year and an increase of 2.6% from the $.76reported for the fourth quarter of last year. Adjusted weighted average shares outstanding decreased from 80.3 millionfor the quarter ended March 31, 2004, to 79.9 million for the quarterended March 31, 2005.

 

Net interestincome for the quarter ended March 31, 2005 increased 9.7% to $143.1million from $130.4 million for the first quarter of last year.  The growth in net interest income wasattributable to a 10.5% growth in average loans and a 14 basis pointimprovement in the net interest margin. Loan growth was solid in allcategories, except for consumer loans which were up only slightly. Thestrongest growth was in average construction loans, which increased 20.4%.Twelve basis points of the improvement in the net interest margin wasattributable to the effect of noninterest-bearing funds, which consistprimarily of demand deposits and shareholders’ equity.

 

At March 31,2005, nonperforming assets amounted to $31.4 million or 0.30% of period-end loansand other real estate owned, a decline from $48.1 million at March 31,2004. Nonperforming assets were $31.1 million at December 31, 2004. Thecomparable nonperforming asset ratios were 0.51% and 0.30% at March 31,2004 and December 31, 2004, respectively. The level of “monitored” loans, or loans with characteristics suggestingthat they could be classified as nonperforming in the near future, amounted to$2.2 million at March 31, 2005. Monitored loans were $26.6 million at March 31, 2004 and $6.4 millionat December 31, 2004. Nonperforming loans as a percentage of total loansremain at historic low levels.

 

Noninterestincome, which includes investment and wealth management fees, service chargeson deposit accounts, mortgage banking-related fees, securities gains andlosses, nonmarketable investments income and other income, increased 8.9% to$57.9 million for the first quarter of 2005 from $53.2 million for the firstquarter of 2004.

 

Noninterestexpenses, which include salaries, employee benefits, net occupancy expense ofbank premises, furniture and equipment expenses, communications and suppliesand other expenses, increased by 7.2% for the quarter ended March 31, 2005to $100.2 million from $93.4 million for the first quarter of 2004.

 

Banksharesalso reports cash operating earnings, defined as “GAAP” (Generally AcceptedAccounting Principles) earnings excluding the amortization of intangible assetsassociated with purchase accounting for business combinations; securities gainsand losses; and other significant gains, losses or expenses (such as thoseassociated with integrating acquired entities’ operations into Bankshares)unrelated to Bankshares’ core operations. Cash operating earnings totaled $63.1 million for the first quarter of2005, an increase of 11.1% over the $56.8 million for the same period for 2004and a 1.4% increase over the $62.2 million for the fourth quarter of 2004.  Diluted cash operating earnings per share forthe first quarter of 2005 and 2004 were $.79 and $.71, respectively, and $.78per share for the fourth quarter of 2004. A reconciliation of net income (GAAP basis) to cash operating earningscan be found on page 34 of this filing.

 

Managementbelieves that reporting several key measures based on cash operating earningsand tangible equity (equity less intangible assets and their relatedamortization expense) is important, as this more closely approximates the basisfor measuring the adequacy of capital for regulatory purposes.  For the three months ended March 31,2005, return on average assets was 1.75%, return on average tangible equity was18.57% and average tangible equity to average tangible assets was 10.00%.  Comparable ratios for the three months ended March 31,2004 were 1.64%, 18.01% and 9.75%, respectively.  A reconciliation of these ratios from theirrespective GAAP basis ratios can be found on page 34 of this filing.

 

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SEGMENT REPORTING

 

Asnoted in Note No. 10 “Segment Reporting”, Bankshares report two businesssegments - Banking and Investment and Wealth Management (“IWM”) for whichfinancial information is segregated for use in assessing performance andallocating resources when reporting to the Board of Directors. Segmentfinancial information is subjective and, unlike financial accounting, is notnecessarily based on GAAP. As a result, the financial information of thereporting segments is not necessarily comparable with similar informationreported by others and may not be comparable with Bankshares’ consolidatedresults. Certain expense amounts, such as operations overhead, have beenreclassified from internal financial reporting in order to provide for properallocation of costs in the reported data. A schedule disclosing thedetails of these operating segments can be found in Note No. 10 of thefinancial statements.

 

**Banking**

 

TheBanking segment consists of 13 affiliate banks. Mortgage banking activities arenot viewed as a separate business line due to the insignificant impact on thecore business of Bankshares and, accordingly, are included in the Bankingsegment.

 

In thesecond quarter of 2005, Bankshares will consolidate Fidelity Bank into Farmersand Mechanics. The consolidation of these banks allows the surviving banks toserve their local customers with greater size, scale and expertise. Also in thesecond quarter of 2005, Mercantile Potomac Bank will merge into Mercantile-SafeDeposit and Trust Company. This combination allows Bankshares to provide theresources necessary for the expansion into the Washington D.C. and NorthernVirginia markets. The acquisition of Community Bank of Northern Virginia isalso expected to occur in the second quarter and become a part of theMercantile Potomac Division of Mercantile-Safe Deposit and Trust Company.Mercantile Potomac Bank and Fidelity Bank will continue to serve theirrespective markets under their own names with local leadership and localdecision-making. The consolidations of Fidelity Bank into Farmers and Mechanicsand Mercantile Potomac Bank into Mercantile-Safe Deposit and Trust Company andare both subject to regulatory approvals.

 

Forthe first quarter of 2005 compared with the first quarter of 2004 net incomefor Banking increased 16.0% to $62.3 million, from $53.7 million.  Net interest income for Banking increased9.8% to $143.1 million for the three months ended March 31, 2005. Thegrowth in net interest income in 2005 reflected a 6.9% increase in averageearning assets, and a 14 basis point improvement in the net interest marginfrom 4.30% at March 31, 2004 to 4.44% at March 31, 2005. The increasein average loan balances of 10.4% for the first quarter of 2005 reflectedstrong growth in loans related to the real estate market. Commercial realestate loan balances increased 12.8%, residential real estate loan balancesincreased 11.6% and construction loan balances increased 20.4%. Commercial loanbalances also reflected the improved economic environment with a 9.6% growthrate, while consumer loans remained flat and lease financings declined by 29.7%. Average deposits included growth innoninterest-bearing, interest checking, savings accounts and time depositsgreater than $100,000, offset by a reduction in balances associated with moneymarket accounts and other time deposits in the first quarter of 2005, comparedwith the first quarter of 2004. The improvement in the net interest margin wasprimarily attributable to an 11 basis point improvement in the benefit providedby noninterest- bearing sources of funds.

 

As areflection of the overall improvement in the Banking credit quality trends,there was a decrease of $1.7 million in the provision for loan losses for 2005.Banking recorded a provision for loan losses of $0.8 million for the firstquarter of 2005 compared with $2.4 million for the same period of 2004. Theallowance as a percent of loans was 1.43% at March 31, 2005 compared with1.46% at December 31, 2004 and 1.66% at March 31, 2004.

 

Noninterestincome increased by $2.4 million, with a gain from the sale of a branch relatedto the consolidation of overlapping branches of $1.1 million, gains onsecurities sold of $0.4 million, insurance fees increasing by $0.7 million andelectronic banking fees increasing by $0.8 million, accounting for the largestgains. These gains were partially offset by a decrease of $0.8 million inmortgage banking fees and $0.3 million in service charges on deposit accounts.The first quarter growth in fee-based revenue was attributable to increasedinsurance sales, pricing, increased customer usage of electronic bankingproducts offset by reduced mortgage origination income and cash managementanalysis fees.

 

Noninterestexpenses were $80.5 million in the first quarter of 2005, compared to $75.5million for the same period of 2004, an increase of $4.9 million (6.5%). Noninterestexpenses net of adjustments were $76.5 million for the first quarter of 2005,compared with $72.3 million for the same period of 2004, a $4.2 millionincrease (5.8%). The increase in noninterest expenses was primarilyattributable to $1.1 million in electronic banking expenses and $0.4 million ininsurance commission costs, which were partially offset by the revenuesgenerated by these services. Other increases in noninterest expenses wereattributable to personnel expenses of $0.6 million and occupancy costs of $0.5million. With the outsourcing to Sungard, IWM is no longer reimbursing theBanking segment for previously shared mainframe computer and technology costs,which increased current period expenses.

 

16

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**Investment &Wealth Management**

 

Net income in IWMincreased to $3.8 million in 2005, from $2.5 million in 2004. Compared with thefourth quarter of 2004, net income increased 16.8% from $3.3 million.

 

At March 31,2005, assets under administration by IWM were $48.0 billion, an increase of$1.5 billion from the first quarter of 2004. Bankshares had investmentmanagement responsibility for $21.7 billion, up from $21.4 billion for the sameperiod last year.

 

Revenuesincreased $1.9 million, or 8.6% to $24.3 million in 2005 from $22.4 million inthe first quarter of 2004. On a linked-quarter basis IWM revenue increased $1.3million or 5.9% from $23.0 million in the fourth quarter of 2004. Revenueincreases were achieved in the three principal client segments: private wealth,institutional and brokerage. Growth in IWM revenues was due to net new businessflows, particularly in our institutional business, and to better equitymarkets. Weaker fixed income markets modestly offset stronger equity markets.

 

Expensesdecreased 3.1% to $16.8 million in 2005. The $1.2 million increase inoutsourcing expenses related to the IWM SunGard service contract was offset bya reduction in operation personnel expenses and technology allocations from theBanking segment.

 

Duringthe first quarter of 2004, Bankshares entered into a seven-year servicecontract with SunGard Wealth Management Services to provide a new coreaccounting system and back-office operations that began in January of2005. Conversion costs of approximately $1.8 million that were incurred in 2004are being amortized over the life of the contract.

 

**Other**

 

The components inthe “Other” column consist of amounts for the nonbanking affiliates,unallocated corporate expenses and intercompany eliminations.

 

Forthe first quarter of 2005 compared to the same period of 2004, noninterestincome increased $0.4 million related to income from private equityinvestments. Noninterest expense increased $2.4 million. This increase is duemostly to $2.1 million in accrued costs, including a $1.3 million settlement,related to the Pileggi litigation matter.

 

The “adjustments”line, which represents corporate allocations from the lead Bank (MSD&T),increased $0.3 million in 2005 over the first quarter of 2004.

 

17

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**BANKSHARESEARNINGS PERFORMANCE**

**Analysisof Interest Rates and Interest Differentials**

The followingtable presents the distribution of the average consolidated balance sheet,interest income/expense and annualized yields earned and rates paid through thethree months ended March 31, 2005 and 2004.

 
| ** **                                             | ** ** | **2005**         | ** **     | **2004**        | ** **  |
|--------------------------------------------------------|------------|------------------|----------------|-----------------|-------------|
| ** **                                             | ** ** | **Average**      | ** **     | **Income  (1)** | ** **  | **Yield (1)** | ** ** | **Average** | ** ** | **Income  (1)** | ** ** | **Yield (1)** | ** ** |
| **(Dollars in thousands)**                             | ** ** | **Balance  (2)** | ** **     | **/ Expense**   | ** **  | **/ Rate** | ** ** | **Balance  (2)** | ** ** | **/ Expense** | ** ** | **/ Rate** | ** ** |
| Earning assets                                         |       |             | ** **     |            |        |   |   |   |   |   |   |   |   |
| Loans:                                                 |       |             | ** **     |            |        |   |   |   |   |   |   |   |   |
| Commercial                                             | ** ** | **$**            | **2,848,452**  | ** **      | **$**       | **41,467** | ** ** | **5.90** | **%** | $ | 2,623,891 |   | $ | 33,693 |   | 5.16 | % |
| Commercial real estate                                 | ** ** | **3,133,446**    | ** **     | **48,534**      | ** **  | **6.28** | ** ** | 2,777,493 |   | 40,656 |   | 5.89 |   |
| Construction                                           | ** ** | **1,328,633**    | ** **     | **20,451**      | ** **  | **6.24** | ** ** | 1,103,901 |   | 14,209 |   | 5.18 |   |
| Residential real estate                                | ** ** | **1,517,291**    | ** **     | **21,797**      | ** **  | **5.83** | ** ** | 1,358,975 |   | 20,488 |   | 6.06 |   |
| Consumer                                               | ** ** | **1,486,539**    | ** **     | **21,396**      | ** **  | **5.84** | ** ** | 1,474,173 |   | 21,229 |   | 5.79 |   |
| Total loans                                            | ** ** | **10,314,361**   | ** **     | **153,645**     | ** **  | **6.04** | ** ** | 9,338,433 |   | 130,275 |   | 5.61 |   |
| Federal funds sold, et al                              | ** ** | **31,854**       | ** **     | **343**         | ** **  | **4.37** | ** ** | 47,791 |   | 106 |   | 0.89 |   |
| Securities:                                            |       |             | ** **     |            |        |   | ** ** |   |   |   |   |   |   |
| Taxable securities                                     |       |             | ** **     |            |        |   | ** ** |   |   |   |   |   |   |
| U.S. Treasury securities                               | ** ** | **565,914**      | ** **     | **5,175**       | ** **  | **3.71** | ** ** | 798,980 |   | 7,786 |   | 3.92 |   |
| U.S. Agency securities                                 | ** ** | **860,316**      | ** **     | **6,894**       | ** **  | **3.25** | ** ** | 761,720 |   | 7,308 |   | 3.86 |   |
| Mortgage-backed securities                             | ** ** | **1,303,700**    | ** **     | **12,923**      | ** **  | **4.02** | ** ** | 1,277,802 |   | 12,307 |   | 3.87 |   |
| Other investments (3)                                  | ** ** | **63,943**       | ** **     | **649**         | ** **  | **4.12** | ** ** | 42,934 |   | 338 |   | 3.17 |   |
| Tax-exempt securities                                  |       |             | ** **     |            |        |   | ** ** |   |   |   |   |   |   |
| States and political subdivisions                      | ** ** | **80,921**       | ** **     | **1,192**       | ** **  | **5.97** | ** ** | 104,375 |   | 1,451 |   | 5.59 |   |
| Total securities                                       | ** ** | **2,874,794**    | ** **     | **26,833**      | ** **  | **3.79** | ** ** | 2,985,811 |   | 29,190 |   | 3.93 |   |
| Interest-bearing deposits in other banks               | ** ** | **158**          | ** **     | **1**           | ** **  | **1.47** | ** ** | 158 |   | — |   | 1.09 |   |
| Total earning assets                                   | ** ** | **13,221,167**   | ** **     | **180,822**     | ** **  | **5.55** | ** ** | 12,372,193 |   | 159,571 |   | 5.19 |   |
| Cash and due from banks                                | ** ** | **290,911**      | ** **     |            |        |   | ** ** | 285,524 |   |   |   |   |   |
| Bank premises and equipment, net                       | ** ** | **141,426**      | ** **     |            |        |   | ** ** | 141,632 |   |   |   |   |   |
| Other assets                                           | ** ** | **1,004,526**    | ** **     |            |        |   | ** ** | 975,241 |   |   |   |   |   |
| Less: allowance for loan losses                        | ** ** | **(149,686**     | **)**          |            |        |   | ** ** | (156,397 | ) |   |   |   |   |
| Total assets                                           | ** ** | **$**            | **14,508,344** | ** **      |        |   |   | ** ** | $ | 13,618,193 |   |   |   |   |   |
| Interest-bearing liabilities                           |       |             | ** **     |            |        |   | ** ** |   |   |   |   |   |   |
| Deposits:                                              |       |             | ** **     |            |        |   | ** ** |   |   |   |   |   |   |
| Savings                                                | ** ** | **$**            | **1,459,580**  | ** **      | **1,151**   | ** ** | **0.32** | ** ** | $ | 1,364,181 |   | 984 |   | 0.29 |   |
| Checking plus interest accounts                        | ** ** | **1,350,521**    | ** **     | **515**         | ** **  | **0.15** | ** ** | 1,236,552 |   | 461 |   | 0.15 |   |
| Money market                                           | ** ** | **1,550,919**    | ** **     | **3,589**       | ** **  | **0.94** | ** ** | 1,590,460 |   | 2,362 |   | 0.60 |   |
| Time deposits $100,000 and over                        | ** ** | **1,427,571**    | ** **     | **9,347**       | ** **  | **2.66** | ** ** | 1,287,695 |   | 6,379 |   | 1.99 |   |
| Other time deposits                                    | ** ** | **1,905,548**    | ** **     | **10,703**      | ** **  | **2.28** | ** ** | 1,979,433 |   | 10,581 |   | 2.15 |   |
| Total interest-bearing deposits                        | ** ** | **7,694,139**    | ** **     | **25,305**      | ** **  | **1.33** | ** ** | 7,458,321 |   | 20,767 |   | 1.12 |   |
| Short-term borrowings                                  | ** ** | **1,000,929**    | ** **     | **4,042**       | ** **  | **1.64** | ** ** | 919,388 |   | 1,419 |   | 0.62 |   |
| Long-term debt                                         | ** ** | **689,372**      | ** **     | **6,815**       | ** **  | **4.01** | ** ** | 649,058 |   | 5,255 |   | 3.26 |   |
| Total interest-bearing funds                           | ** ** | **9,384,440**    | ** **     | **36,162**      | ** **  | **1.56** | ** ** | 9,026,767 |   | 27,441 |   | 1.22 |   |
| Noninterest-bearing deposits                           | ** ** | **3,024,595**    | ** **     |            |        |   | ** ** | 2,608,324 |   |   |   |   |   |
| Other liabilities and accrued expenses                 | ** ** | **149,033**      | ** **     |            |        |   | ** ** | 134,641 |   |   |   |   |   |
| Total liabilities                                      | ** ** | **12,558,068**   | ** **     |            |        |   | ** ** | 11,769,732 |   |   |   |   |   |
| Shareholders’ equity                              | ** ** | **1,950,276**    | ** **     |            |        |   | ** ** | 1,848,461 |   |   |   |   |   |
| Total liabilities & shareholders’ equity | ** ** | **$**            | **14,508,344** | ** **      |        |   |   | ** ** | $ | 13,618,193 |   |   |   |   |   |
| Net interest rate spread                               | ** ** | ** **       | ** **     | **$**           | **144,660** | ** ** | **3.99** | **%** |   |   | $ | 132,130 |   | 3.97 | % |
| Effect of noninterest-bearing funds                    | ** ** | ** **       | ** **     |            |        | **0.45** | ** ** |   |   |   |   | 0.33 |   |
| Net interest margin on earning assets                  | ** ** | ** **       | ** **     |            |        | **4.44** | **%** |   |   |   |   | 4.30 | % |
| Tax-equivalent adjustment included in:                 |       |             | ** **     |            |        |   | ** ** |   |   |   |   |   |   |
| Loan income                                            | ** ** | ** **       | ** **     | **$**           | **1,101**   |   |   | ** ** |   |   | $ | 1,146 |   |   |   |
| Investment securities income                           | ** ** | ** **       | ** **     | **476**         |        |   | ** ** |   |   | 579 |   |   |   |
| Total                                                  | ** ** | ** **       | ** **     | **$**           | **1,577**   |   |   | ** ** |   |   | $ | 1,725 |   |   |   |

 

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(1) Presented on a tax-equivalent basis using the statutoryfederal corporate income tax rate of 35% (see non-GAAP reconciliation).

(2) Averageinvestment securities are reported at amortized cost; excludes unrealized gains(losses) on securities available-for-sale. Nonaccrual loans are included inaverage loans.

(3) Investmentsin hedge funds and other nonmarketable investments were reclassified in theprior period from securities available-for-sale into other assets to conform tothe current presentation.

 

18

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**Rate / Volume Analysis**

A rate/volume analysis, whichdemonstrates changes in interest income and expense for significant assets andliabilities, appears below:

 
| ** **                                 | ** ** | **For the 3 months ended  March 31,  2005 vs. 2004** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                 | ** ** | **Due to variances in**                                   | ** ** |
| **(Dollars  in thousands)**                | ** ** | **Total**                                                 | ** ** | **Rates** | ** ** | **Volumes (5)** | ** ** |
| Interest earned on:                        |       |                                                      |       |   |   |   |   |
| Loans:                                     |       |                                                      |       |   |   |   |   |
| Commercial (1)                             |       | $                                                         | 7,774      |   | $ | 4,784 |   | $ | 2,990 |   |
| Commercial real estate (2)                 |       | 7,878                                                     |       | 2,701 |   | 5,177 |   |
| Construction (3)                           |       | 6,242                                                     |       | 2,900 |   | 3,342 |   |
| Residential real estate                    |       | 1,309                                                     |       | (796 | ) | 2,105 |   |
| Consumer                                   |       | 167                                                       |       | 165 |   | 2 |   |
| Taxable securities (4)                     |       | (2,098                                                    | )          | (1,222 | ) | (876 | ) |
| Tax-exempt securities (4)                  |       | (259                                                      | )          | 99 |   | (358 | ) |
| Federal funds sold, et al                  |       | 237                                                       |       | 409 |   | (172 | ) |
| Interest-bearing deposits in  other banks  |       | 1                                                         |       | 1 |   | 0 |   |
| Total interest income                      |       | 21,251                                                    |       | 9,042 |   | 12,209 |   |
|                                       |       |                                                      |       |   |   |   |   |
| Interest paid on:                          |       |                                                      |       |   |   |   |   |
| Savings deposits                           |       | 167                                                       |       | 100 |   | 67 |   |
| Checking plus interest deposits            |       | 54                                                        |       | 14 |   | 40 |   |
| Money market accounts                      |       | 1,227                                                     |       | 1,338 |   | (111 | ) |
| Certificates of deposit  $100,000 and over |       | 2,968                                                     |       | 2,105 |   | 863 |   |
| Other time deposits                        |       | 122                                                       |       | 625 |   | (503 | ) |
| Short-term borrowings                      |       | 2,623                                                     |       | 2,305 |   | 318 |   |
| Long-term debt                             |       | 1,560                                                     |       | 1,205 |   | 355 |   |
| Total interest expense                     |       | 8,721                                                     |       | 7,692 |   | 1,029 |   |
| Net interest earned                        |       | $                                                         | 12,530     |   | $ | 1,349 |   | $ | 11,181 |   |

 

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(1)          Interestquarter-to-date tax-equivalent adjustment of $0.8 million for both 2005 and2004, respectively, are included in the commercial loan rate variances.

(2)          Interestquarter-to-date tax-equivalent adjustment of $0.1 million for both 2005 and2004, respectively, are included in the commercial real estate loan ratevariances.

(3)          Interestquarter-to-date tax-equivalent adjustment of $0.2 million for both 2005 and2004, respectively, are included in the construction loan rate variances.

(4)          Interestquarter-to-date tax-equivalent adjustment of $0.5 million and $0.6 million for2005 and 2004, respectively, are included in the investment securities ratevariances.

(5)          Changesattributable to mix (rate and volume) and the additional day in the quarter areincluded in the volume variances.

 

19

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**Net Interest Income and NetInterest Margin**

 

In the firstquarter of 2005 net interest income, on a tax-equivalent basis, was $144.7million, compared with $132.1 million in the first quarter of 2004, whichrepresented a $12.5 million (9.5%) increase from 2004.  The increase was primarily due to strong loangrowth and a higher net interest margin.

 

The net interestmargin increased to 4.44% in the first quarter 2005 from 4.30% in the firstquarter of 2004.  The increase wasprimarily attributable to the benefit received from the investment ofnoninterest-bearing funds. This benefit increased 12 basis points from thefirst quarter of 2004 to 45 basis points for the first quarter of 2005primarily due to a $416.3 million increase in noninterest-bearing deposits andthe rising rate environment. The net interest spread increased 2 basis pointsdue to higher yields on loans resulting from prime rate increases. Thesefactors were partially offset by reduced investment portfolio yields from thefirst quarter of 2004 as current yields on new investments remained below theportfolio’s average yields. The net interest margin increased 1 basis pointfrom the fourth quarter of 2004.

 

Average earningassets in the first quarter of 2005 increased $0.8 billion (6.9%) from the sameperiod in 2004. The increase in average earning assets was primarily driven byincreases in average loans partially offset by a decline in investmentsecurities. Loans averaged $10.3 billion in first quarter of 2005, comparedwith $9.3 billion in first quarter of 2004, an increase of 10.5%. During thefirst quarter of 2005, total average loan growth was driven by growth incommercial real estate of $356.0 million (12.8%), construction loan growth of$224.7 million (20.4%), commercial loan growth of $224.6 million (8.6%), andresidential mortgage loan growth of $158.3 million (11.6%).

 

Mortgage andconsumer financing activities slowed in 2004 due to higher interest rates andmarket saturation. As a result, growth in residential mortgage loans resultedfrom the purchase of approximately $89 million in residential mortgage loansfrom Mercantile Mortgage Corporation’s joint venture mostly in the secondquarter of 2004.

 

Average investmentsecurities for the first quarter of 2005 declined by $111.0 million (3.7%),compared with the same period of 2004, reflecting the reinvestment of proceedsfrom security maturities into the funding of loan growth. Bankshares utilizesthe investment portfolio as part of its overall asset/liability managementpractices to minimize structural interest rate and market valuation risksassociated with changes in interest rates. In connection with changing interestrates and its risk management activities, Bankshares made the decision toadjust the composition of the investment portfolio to include a greaterproportion of short-term mortgage-backed securities, agency and asset-backedsecurities and a lesser proportion of U.S. Treasury securities. As a result,U.S. Treasury securities declined $233.1 million (29.2%), while agencysecurities increased $98.6 million (12.9%) and mortgage-backed securitiesincreased $25.9 million (2.0%). Refer to the “Interest Rate Risk” section forfurther information on the sensitivity of net interest income to changes ininterest rates.

 

Average coredeposits (total deposits less certificates of deposit of $100,000 and over) arean important contributor to growth in net interest income and the net interestmargin. This low-cost stable funding source increased 5.8% from a year ago.Average core deposits were $9.3 billion and $8.8 billion and funded 64% ofaverage total assets in the first quarter of 2005 and 2004, respectively.  Average noninterest-bearing checking accountsfor the first quarter of 2005 were higher by $416.3 million (16.0%), comparedwith the same period of 2004. Consumer and business noninterest-bearingdeposits increased 19.5% and 10.6%, respectively from a year ago. Total averageinterest-bearing deposits increased by $235.8 million (3.2%) for the firstquarter of 2005, compared to the same period of 2004. The year-over-yearincrease in average interest-bearing deposits during the first quarter of 2005included an increase in checking plus interest accounts of $114.0 million(9.2%), savings accounts of $95.4 million (7.0%) and time deposits greater than$100,000 of $139.9 million (10.9%), partially offset by a decline in other timedeposits of $73.9 million (3.7%) and money market accounts of $39.5 million(2.5%). The decrease in average money market accounts and other time depositswas primarily due to pricing decisions by management in connection withBankshares’ overall funding and risk management activities.

 

Based on currentmarket conditions, which includes a recent slowing of mortgage refinancingactivity and a continued measured increase in the overall rate environment,management expects the net interest margin to continue to expand modestly, aspricing pressure on deposit gathering will partially offset the improvement inearning asset yields.

 

20

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# **NoninterestIncome**

 
| ** **                                  | ** ** | **For the 3 months ended  March 31,** | ** ** | **% Change** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|--------------|------------|
| **(Dollars  in thousands)**                 | ** ** | **2005**                                   | ** ** | **2004**     | ** ** | **2005/2004** | ** ** |
| Investment and wealth  management           | ** ** | **$**                                      | **24,057** |         | $          | 21,983 |   | 9.4 | % |
| Service charges on deposit  accounts        | ** ** | **10,426**                                 |       | 10,692       |       | (2.5 | ) |
| Mortgage banking-related fees:              |       |                                       |       |         |       |   |   |
| Commercial                                  | ** ** | **1,514**                                  |       | 1,920        |       | (21.1 | ) |
| Residential                                 | ** ** | **769**                                    |       | 1,020        |       | (24.6 | ) |
| Total mortgage banking-related  fees        | ** ** | **2,283**                                  |       | 2,940        |       | (22.3 | ) |
| Net investment securities gains  / (losses) | ** ** | **414**                                    |       | (55          | )          | 852.7 |   |
| Nonmarketable investments                   |       |                                       |       |         |       |   |   |
| Private equity and other  investments       | ** ** | **2,461**                                  |       | 389          |       | 532.6 |   |
| Hedge funds                                 | ** ** | **1,964**                                  |       | 3,021        |       | (35.0 | ) |
| Bank-owned life insurance                   | ** ** | **846**                                    |       | 794          |       | 6.5 |   |
| Total nonmarketable investments             | ** ** | **5,271**                                  |       | 4,204        |       | 25.4 |   |
| Other income:                               |       |                                       |       |         |       |   |   |
| Electronic banking fees                     | ** ** | **5,173**                                  |       | 4,417        |       | 17.1 |   |
| Charges and fees on loans                   | ** ** | **2,795**                                  |       | 2,458        |       | 13.7 |   |
| Insurance                                   | ** ** | **4,540**                                  |       | 3,828        |       | 18.6 |   |
| All other income                            | ** ** | **2,910**                                  |       | 2,687        |       | 8.3 |   |
| Total other income                          | ** ** | **15,418**                                 |       | 13,390       |       | 15.1 |   |
| Total                                       | ** ** | **$**                                      | **57,869** |         | $          | 53,154 |   | 8.9 |   |

 

Noninterest incomefor the quarter ended March 31, 2005 increased by $4.7 million, or 8.9%,to $57.9 million compared with $53.2 million for the same period in 2004. Noninterestincome increased 3.8% from the fourth quarter of 2004. The table above showsthe major components of noninterest income. Investment and wealth management revenue represents the largest sourceof noninterest income and increased 9.4% over the prior year and 5.8% over thefourth quarter of 2004. Growth in IWM revenues was due to net new businessflows during the past year, particularly in our institutional business, and tobetter equity markets.

 

Service charges ondeposits decreased slightly from the prior year. The decrease was relatedprimarily to our business customers. For the first quarter of 2005 compared tothe first quarter of 2004, service charges decreased by $0.3 million, or 2.5%.Service charges on deposits decreased 7.8% compared to the fourth quarter of2004.

 

Mortgagebanking-related fees were $0.7 million lower than the first quarter of 2004,with both commercial and residential fees lower than the year-earlier period.These lower fees were due primarily to volume decreases in the commercialbusiness and lower profit margins in the residential business.

 

Investment in hedge funds and other nonmarketable investments werereclassified from securities into other assets, for the periods presented, withtheir income or loss reported as other income. On a year-over-year basis,income from private equity and other investments increased $2.1 million, hedgefunds income declined $1.1 million and bank-owned life insurance (“BOLI”)increased slightly. The increase in nonmarketable investments was dueprimarily to better performance of several private equity investments.

 

Other income was$15.4 million for the first quarter of 2005 compared with $13.4 million for thesame period in the prior year. The year-over-year increase in other incomeincludes a $0.8 million increase in electronic banking fees driven by merchantand check card services and a $0.7 million increase in insurance relatedrevenues. Also included in other income were gains on the sales of branchesrelated to the consolidation of overlapping branches amounting to $1.1 millionand $0.7 million for the quarters ended March 31, 2005 and 2004,respectively.

 

21

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# **NoninterestExpenses**

 
| ** **                              | ** ** | **For the 3 months ended  March 31,** | ** **  | **% Change** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|-------------|--------------|------------|
| **(Dollars  in thousands)**             | ** ** | **2005**                                   | ** **  | **2004**     | ** ** | **2005/2004** | ** ** |
| Salaries                                | ** ** | **$**                                      | **46,554**  |         | $          | 44,788 |   | 3.9 | % |
| Employee benefits                       | ** ** | **11,897**                                 |        | 12,513       |       | (4.9 | ) |
| Net occupancy expense of bank  premises | ** ** | **6,922**                                  |        | 6,060        |       | 14.2 |   |
| Furniture and equipment  expenses       | ** ** | **7,279**                                  |        | 7,364        |       | (1.2 | ) |
| Communications and supplies             | ** ** | **4,040**                                  |        | 4,304        |       | (6.1 | ) |
| Other expenses:                         |       |                                       |        |         |       |   |   |
| Professional services                   | ** ** | **5,125**                                  |        | 3,834        |       | 33.7 |   |
| Advertising and promotional  expenses   | ** ** | **1,711**                                  |        | 1,703        |       | 0.5 |   |
| Electronic banking expense              | ** ** | **3,241**                                  |        | 2,153        |       | 50.5 |   |
| Amortization of intangible assets       | ** ** | **2,072**                                  |        | 2,032        |       | 2.0 |   |
| Outsourcing expense                     | ** ** | **2,690**                                  |        | 1,459        |       | 84.4 |   |
| All other expenses                      | ** ** | **8,622**                                  |        | 7,176        |       | 20.2 |   |
| Total other expenses                    | ** ** | **23,461**                                 |        | 18,357       |       | 27.8 |   |
| Total                                   | ** ** | **$**                                      | **100,153** |         | $          | 93,386 |   | 7.2 |   |
|                                         |            |                                            |             |              |            |  |  |  |  |  |  |

 

Noninterestexpenses for the three months ended March 31, 2005 increased by $6.8million, or 7.2% to $100.2 million compared with $93.4 million for the threemonths ended March 31, 2004. Noninterest expenses decreased 5.5% from thefourth quarter of 2004. The table above shows the major components of noninterestexpenses.  The principal reasons for theyear-over-year increase were increased expenses associated with compliance andlitigation cost.

 

The efficiencyratio, a key measure of expense management, decreased in the first quarter of2005 compared with the same quarter of 2004. The efficiency ratio is computedby dividing noninterest expenses by the sum of net interest income on atax-equivalent basis and noninterest income. Bankshares’ efficiency ratio was49.45% for the three months ended March 31, 2005 compared with 50.40% forthe three months ended March 31, 2004. On a non-GAAP basis, the cashoperating efficiency ratio excludes the amortization of intangible assetsassociated with purchase accounting for business combinations; securities gainsand losses; and other significant gains, losses or expenses (such as thoseassociated with integrating acquired entities’ operations into Bankshares)unrelated to Bankshares’ core operations. Bankshares’ cash operating efficiency ratio was 48.80% and 49.24% for thethree months ended March 31, 2005 and 2004, respectively. For thereconciliation of GAAP to non-GAAP measures, see page 34 in this filing.

 

Salary expense increased$1.8 million or 3.9% from the first quarter of 2004.  Savings from the affiliate bank rationalizationwere offset by a $1.1 million increase in incentive compensation and salescommissions, combined with normal merit salary increases. On a linked-quarterbasis theses expenses decreased 5.9% due to savings realized from theconsolidation of 11 affiliate banks into four banks, which occurred in thethird quarter of 2004, the outsourcing of the IWM systems and back-office toSunGard and lower incentive compensation accruals.

 

Benefits expensefor the first quarter of 2005 decreased from the same period in the prior year.The decrease included a $1.3 million rebate from a medical insurance providerdue to favorable claims experience, partially offset by higher payroll taxesand pension expense.

 

Net occupancyexpense, which includes premises depreciation, rents, maintenance andutilities, increased nearly $0.9 million or 14.2% over the prior year. Thisincrease was related to the loss of outside tenant income of $1.2 million dueto the sale of Bankshares’ headquarters building in December 2004.

 

Other expensesconsist of professional services, marketing, electronic banking and severalother categories such as travel and membership, amortization, licensing,insurance and sundry expenses. For the three months ended March 31, 2005compared with the three months ended March 31, 2004, other expensesincreased $5.1 million or 27.8%. Included in other expenses was $2.1 million inaccrued costs, including a $1.3 million settlement, related to the Pileggilitigation matter. Management does not expect to incur any further chargesrelated to this matter. For additional information see Part II - OtherInformation,  “Item 1. Legal Proceedings.”Also contributing to higher other expenses was an increase of $1.1 million inelectronic banking fees, due to higher volume and processing fees, and anincrease of $1.2 million in outsourcing fees attributable to the IWMback-office conversion to SunGard. Higher accruals for external audit feesaccounted for the majority of the remaining increase over the prior year.

 

22

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ANALYSIS OF FINANCIALCONDITION

 

At March 31,2005 compared to March 31, 2004, total assets increased 3.4% or $485.5million. At March 31, 2005 compared with December 31, 2004, totalassets increased 1.4% or $202.1 million.

 

A comparative schedule ofaverage balances is included in the table on page 18.

 

**Securities Available-for-Sale**

** **

The securitiesavailable-for-sale portfolio includes both debt and marketable equitysecurities. Bankshares’ holds debt securities available-for-sale primarily forliquidity, interest rate risk management and yield enhancement purposes.Accordingly, this portfolio primarily includes very liquid, high qualityfederal agency-backed debt securities. At March 31, 2005, the portfoliototaled $2.8 billion of debt securities available-for-sale, compared with $2.9billion at December 31, 2004. Twenty securities were in a continuous lossposition for 12 months or more at March 31, 2005, which consistedprimarily of mortgage-backed securities. Because the declines in fair valuewere due to changes in market interest rates, not in estimated cash flows, noother-than-temporary impairment was recorded at March 31, 2005. There wasa net unrealized loss on debt securities available-for-sale of $36.7 millionand $4.1 million at March 31, 2005 and December 31, 2004,respectively.

 

Theweighted-average expected maturity of debt securities available-for-sale was2.3 years at March 31, 2005. Since approximately 46% of this portfolio ismortgage-backed securities, the expected remaining maturity may differ fromcontractual maturity because borrowers may have the right to prepay obligationsbefore the underlying mortgages mature. See Note No. 4 “InvestmentSecurities” to the Financial Statements for securities available-for-sale bysecurity type.

 

**Loan Portfolio**

** **

Total loans at March 31,2005 were $10.4 billion, compared with $10.2 billion at December 31, 2004,an increase of 1.8%. The increase in total loans is driven by growth inconstruction lending, commercial real estate and residential mortgages.Construction loans totaled $1.35 billion at March 31, 2005, compared with$1.27 billion at December 31, 2004, an increase of $79.0 million (6.2%).Commercial real estate loans increased $58.2 million (1.9%) from the beginningof the year primarily due to new customer relationships.  Residential real estate loans increased $57.7million (3.9%) from December 31, 2004. Consumer loans reflected a $2.5million (0.2%) modest growth in this time period as new production in theindirect loan portfolio slightly exceeded paydowns during the first quarter of2005. Commercial loans declined by $15.9 million (0.6%) from December 31,2004 due to payoffs of existing loans exceeding new loan production and lineutilization. Total loans at March 31, 2005 increased $978.8 million or10.4% over March 31, 2004.

 

 **Deposits**

** **

At March 31,2005, total deposits increased 4.1% or $427.7 million compared to theyear-earlier period. Growth in deposits was in core deposits from customers inthe local markets. The affiliate banking model positions Bankshares to competenot only with the large national and regional banking companies in thegathering of these funds, but also with local community banks. Based onhistorical experience, Bankshares expects to retain these deposits in a risinginterest rate environment although pricing pressure is expected to intensify.

 

Total deposits at March 31,2005, were $11.0 billion, an increase of $172.1 million (1.6%) over December 31,2004. The increase in total deposits was primarily the result of increases ininterest-bearing and noninterest-bearing checking accounts, savings accountsand time deposits greater than $100,000, partially offset by a decrease inother time deposits. Noninterest-bearing deposits were $3.10 billion at March 31,2005, compared to $3.05 billion at December 31, 2004, an increase of $49.6million (1.6%) primarily due to higher business banking deposits.Interest-bearing deposits totaled $7.9 billion at March 31, 2005, comparedwith $7.8 billion at December 31, 2004, an increase of $122.4 million(1.6%). The increase in interest-bearing deposits included increases ininterest-bearing checking accounts of $39.7 million (2.9%), savings accounts of$37.5 million (2.6%) and time deposits greater than $100,000 of $78.1 million(5.6%). These increases were partially offset by a decrease in other timedeposits of $34.9 million (1.8%) primarily related to mortgage escrow accounts.

 

23

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**Borrowings**

** **

Banksharesutilizes both short-term and long-term borrowings to fund growth of earningassets in excess of deposit growth. Short-term borrowings, which includefederal funds purchased, securities sold under agreements to repurchase andother short-term borrowings, were $857.0 million at March 31, 2005,compared with $887.9 million at December 31, 2004. Short-term funding ismanaged to levels deemed appropriate given alternative funding sources. Thereduction of $30.9 million (3.5%) in short-term borrowings reflected areduction in commercial paper outstanding during the period. Long-term debt was$681.3 million at March 31, 2005, a decrease of $9.6 million (1.4%),compared with the $691.0 million at December 31, 2004. The decrease inlong-term debt was primarily the result of fair value adjustments to interestrate swap hedges related to this debt.

 

**Capital**

** **

Shareholders’equity at March 31, 2005 was $1.9 billion. Bankshares has authorization enabling it to repurchase up toapproximately 0.5 million additional shares.

 

At March 31,2005 and December 31, 2004, the cash dividend payout ratio was 44.30% and45.45%, respectively. A change to the Directors’ Deferred Compensation Plan wasapproved at the 2004 Annual Shareholders’ meeting. Beginning April 1,2004, all deferred directors’ fees are covered by the plan. At April 1,2004, directors had the option to leave their deferred balance in the oldphantom stock plan, or convert their balance into vested shares under the newplan. These vested shares will be issued after a director retires.  For more details, see the Statements ofChanges in Consolidated Shareholders’ Equity and Note No. 12.

 

RISK MANAGEMENT

 

**Credit Risk Analysis**

** **

Bankshares’ loansand commitments are substantially to borrowers located in the immediate region.Bankshares has set an internal limit for each affiliate bank on the maximumamount of credit that may be extended to a single borrower that is well belowthe regulatory limit. For more information on credit risk see “Risk Management– Credit Risk Analysis” in the Mercantile Bankshares Corporation’s 2004 AnnualReport on Form 10-K.

 

**Nonperforming Assets**

** **

Nonperformingassets consist of nonaccrual loans, renegotiated loans and other real estateowned (i.e., real estate acquired in foreclosure or in lieu offoreclosure).  With respect to nonaccrualloans, Bankshares’ policy is that, regardless of the value of the underlyingcollateral and/or guarantees, no interest is accrued on the entire balance onceeither principal or interest payments on any loan become 90 days past due atthe end of a calendar quarter.  Allaccrued and uncollected interest on such loans is eliminated from the incomestatement and is recognized only as collected. If a loan is impaired and has aspecific loss allocation based on an analysis under SFAS No. 114, “**Accounting by Creditors for Impairment of a Loan—anamendment of FASB Statements No. 5 and 15,**” all paymentsare then applied against the loan’s principal. A loan may be put on nonaccrualstatus sooner than this standard if, in management’s judgment, such action iswarranted.

 

During the threemonths ended March 31, 2005, nonperforming assets increased slightly to$31.4 million from $31.1 million at December 31, 2004. Nonperformingassets as a percent of period-end loans and other real estate owned was 0.30%at both March 31, 2005 and December 31, 2004.

 

At March 31,2005 and December 31, 2004, monitored loans, or loans with characteristicssuggesting that they could be classified as nonperforming in the near future,were $2.2 million and $6.4 million, respectively. Contributing to this decreasewas the migration of the one remaining loan secured by a commercial aircraft tononaccrual status. The outstanding balance was $2.4 million, of which $0.7million was charged off.

 

24

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The table below presentsa comparison of nonperforming assets at March 31, 2005, December 31,2004 and March 31, 2004.

 
| **(Dollars  in thousands)**                                                        | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** | **March 31,  2004** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|--------------------------|------------|
| Nonaccrual loans*(1)*                                                              |       |                     | ** ** |                        |       |                     |       |
| Commercial                                                                         | ** ** | **$**                    | **25,637** | ** **                  | $          | 25,030                   |       | $ | 37,000 |   |
| Commercial real estate                                                             | ** ** | **2,775**                | ** ** | 1,959                       |       | 4,837                    |       |
| Construction                                                                       | ** ** | **6**                    | ** ** | 9                           |       | 159                      |       |
| Residential real estate                                                            | ** ** | **1,642**                | ** ** | 2,748                       |       | 3,961                    |       |
| Consumer                                                                           | ** ** | **812**                  | ** ** | 672                         |       | 1,313                    |       |
| Lease financing                                                                    | ** ** | **362**                  | ** ** | 480                         |       | 737                      |       |
| Total                                                                              | ** ** | **31,234**               | ** ** | 30,898                      |       | 48,007                   |       |
| Renegotiated loans*(1)*                                                            | ** ** | **—**               | ** ** | —                      |       | —                   |       |
| Loans contractually past due 90  days or more and still accruing interest          | ** ** | **—**               | ** ** | —                      |       | —                   |       |
| Total nonperforming loans                                                          | ** ** | **31,234**               | ** ** | 30,898                      |       | 48,007                   |       |
| Other real estate owned                                                            | ** ** | **145**                  | ** ** | 212                         |       | 134                      |       |
| Total nonperforming assets                                                         | ** ** | **$**                    | **31,379** | ** **                  | $          | 31,110                   |       | $ | 48,141 |   |
| Nonperforming loans as a  percent of period-end loans                              | ** ** | **0.30**                 | **%**      | 0.30                        | %          | 0.51                     | %          |
| Nonperforming assets as a  percent of period-end loans and other real estate owned | ** ** | **0.30**                 | **%**      | 0.30                        | %          | 0.51                     | %          |

 

----

(1)          Aggregate gross interestincome of $0.7 million, $2.5 million and $0.8 million for the first threemonths of 2005, the year 2004 and the first three months of 2004, respectively,on nonaccrual and renegotiated loans, would have been recorded if these loanshad been accruing on their original terms throughout the period or sinceorigination if held for part of the period. The amount of interest income on the nonaccrual and renegotiated loansthat was recorded totaled $0.2 million, $0.8 million and $0.3 million for thefirst three months of 2005, the year 2004 and the first three months of 2004,respectively.

 

**Note:**Bankshareswas monitoring loans estimated to aggregate $2.2 million at March 31,2005, $6.4 million at December 31, 2004 and $26.6 million at March 31,2004, not classified as nonaccrual or renegotiated loans.  These loans had characteristics thatindicated they might result in such classification in the future.

 

**Allowance and Provision for LoanLosses**

** **

Each Banksharesaffiliate is required to maintain an allowance for loan losses adequate toabsorb losses inherent in it’s loan portfolio. Each affiliate’s reserve isdedicated to that affiliate only and is not available to absorb losses fromanother affiliate.   Management at eachaffiliate, along with Bankshares’ management, conducts a regular review toassure that adequacy.  On a periodic, butnot-less-than quarterly, basis significant credit exposures, nonperformingloans, impaired loans, historical losses by loan type and various statisticalmeasurements of asset quality are examined to assure the adequacy of theallowance for loan losses. Management believes that the allowance for loanlosses is at an adequate level to absorb losses inherent in the portfolio.

 

The allowance forloan losses has been established through provisions for loan losses chargedagainst income. Loans deemed uncollectible are charged against the allowancefor loan losses and any subsequent recoveries are credited to theallowance.  Intensive collection effortscontinue after charge-off in order to maximize recovery amounts.  The provision for loan losses for the firstquarter of 2005 was $0.8 million, a 68.8% decrease from the same period lastyear. No provision was recorded in the fourth quarter of 2004. The decline inthe provision reflects a continued improvement in the economy and improvingcredit quality within Bankshares’ affiliate banks.  Net charge-offs for the three months ended March 31,2005 were $0.7 million, a 34.3% decrease from $1.1 million for the same periodlast year. The allowance for loan losses as a percent of period-end loansdecreased to 1.43% at March 31, 2005 from 1.46% at December 31, 2004and 1.66% at March 31, 2004.

 

25

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The following tablepresents a summary of the activity in the Allowance for Loan Losses.

 
| ** **                                                | ** ** | **For the 3 months ended  March 31,** | ** **     |
|-----------------------------------------------------------|------------|--------------------------------------------|----------------|
| **(Dollars  in thousands)**                               | ** ** | **2005**                                   | ** **     | **2004** | ** ** |
| Allowance balance - beginning                             | ** ** | **$**                                      | **149,002**    | ** ** | $ | 155,337 |   |
| Charge-offs:                                              |       |                                       | ** **     |   |   |
| Commercial                                                | ** ** | **(1,299**                                 | **)**          | (690 | ) |
| Commercial real estate                                    | ** ** | **(32**                                    | **)**          | (28 | ) |
| Construction                                              | ** ** | **—**                                 | ** **     | — |   |
| Residential real estate                                   | ** ** | **(11**                                    | **)**          | (101 | ) |
| Consumer                                                  | ** ** | **(600**                                   | **)**          | (1,117 | ) |
| Lease financing                                           | ** ** | **—**                                 | ** **     | — |   |
| Total                                                     | ** ** | **(1,942**                                 | **)**          | (1,936 | ) |
| Recoveries:                                               |       |                                       | ** **     |   |   |
| Commercial                                                | ** ** | **469**                                    | ** **     | 100 |   |
| Commercial real estate                                    | ** ** | **6**                                      | ** **     | 18 |   |
| Construction                                              | ** ** | **—**                                 | ** **     | 4 |   |
| Residential real estate                                   | ** ** | **35**                                     | ** **     | 52 |   |
| Consumer                                                  | ** ** | **565**                                    | ** **     | 634 |   |
| Lease financing                                           | ** ** | **126**                                    | ** **     | — |   |
| Total                                                     | ** ** | **1,201**                                  | ** **     | 808 |   |
| Net charge-offs                                           | ** ** | **(741**                                   | **)**          | (1,128 | ) |
| Provision for loan losses                                 | ** ** | **756**                                    | ** **     | 2,426 |   |
| Allowance balance - ending                                | ** ** | **$**                                      | **149,017**    | ** ** | $ | 156,635 |   |
| Average loans                                             | ** ** | **$**                                      | **10,314,361** | ** ** | $ | 9,338,433 |   |
| Percent of net charge-offs  (annualized) to average loans | ** ** | **0.03**                                   | **%**          | 0.05 | % |
| Period-end loans                                          | ** ** | **$**                                      | **10,413,222** | ** ** | $ | 9,434,420 |   |
| Percent of allowance for loan  losses to period-end loans | ** ** | **1.43**                                   | **%**          | 1.66 | % |

 

**Interest Rate Risk**

 

The objective of interestrate risk management is to contain the risks associated with interest ratefluctuations. The process involves identification and management of thesensitivity of net interest income to changing interest rates and other marketfactors. Interest rate risk, one of the more prominent risks in terms ofpotential earnings impact, is an inevitable part of being a financialintermediary. For more information see “Risk Management – Interest Rate Risk”in the Mercantile Bankshares Corporation’s 2004 Annual Report on Form 10-K.

 

EARNINGS SIMULATION MODELPROJECTIONS

 

Bankshares assessesinterest rate risk by comparing projected net interest income in the currentrate environment with various interest rate scenarios that differ in thedirection of interest rate changes, the degree of change over time, the speedof the change and the projected shape of the yield curve.  This analysis incorporates substantially allof Bankshares’ assets and liabilities and off-balance sheet instruments.Through these simulations, management estimates the impact on net interestincome of a 200 basis point upward and 100 basis point downward change ininterest rates. The following table summarizes the effect a positive 100 and200 basis point change and a negative 100 basis point change in interest rateswould have on Bankshares’ net interest income over the next 12 months.

 
| ** **                                    | ** ** | **Calculated increase /  (decrease) in  projected net interest income** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| **Change in  interest rates  (basis points)** | ** ** | **March 31,  2005**                                                | ** ** | **December 31,  2004** | ** ** |
| +200                                          | ** ** | **4.9**                                                                 | **%**      | 5.5 | % |
| +100                                          | ** ** | **2.4**                                                                 | **%**      | 2.8 | % |
| -100                                          | ** ** | **(2.6**                                                                | **)%**     | (3.0 | )% |

 

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At March 31,2005, Bankshares’ interest sensitivity position was asset sensitive.  Based on its most recent simulation model,Bankshares’ net interest income would increase by $14.9 million or 2.4% and$30.0 million or 4.9% if interest rates were to move up gradually over the nextsix months by 100 basis points or 200 basis points, respectively.  A downward movement of 100 basis points wouldreduce net interest income by $15.7 million or 2.6%.  Bankshares manages the interest rate riskprofile within policy limits. At March 31, 2005, and December 31,2004, Bankshares was within its policy guidelines. In response to action by theFederal Reserve to increase short-term interest rates, Bankshares primeinterest rate continues to rise. Bankshares has approximately $3 billion in loans that will reprice dailyor monthly as market rates change. The effects of a rising rate environment oninterest expense are less predictable due to customer behavior that shifts themix of deposit products. Current trends have seen growth in noninterest-bearingdemand deposit and savings accounts, while money market accounts andcertificates of deposit have decreased. Approximately $1.2 billion in short andlong-term debt will also be subject to this rate increase over the near term.As rates continue to rise, management expects, based on Bankshares’ interestsensitivity position, that the net interest margin and net interest income willexpand modestly.

 

Bankshares also utilizesinterest rate derivatives to hedge interest rate risk exposures. The creditrisk amount and estimated net fair values of these derivatives as of March 31,2005 and December 31, 2004 are presented in Note No. 11 (DerivativeInstruments and Hedging Activities) to the Financial Statements. Derivativesare used for asset/liability management in three ways:

•                  Toconvert long-term fixed-rate debt to floating-rate payments by entering intoreceive-fixed swaps at issuance,

•                  Toconvert the cash flows from selected asset and/or liabilityinstruments/portfolios from fixed to floating payments or vice versa, and

•                  Tohedge the mortgage origination pipeline by utilizing forward rate commitmentsfor loans held-for-sale.

 

MARKET VALUE OF EQUITYMODELING

 

Bankshares also utilizesthe market value of equity as a measurement tool in managing interest ratesensitivity. The market value of equity measures the degree to which the marketvalues of Bankshares’ assets and liabilities and off-balance sheet instrumentswill change given a change in interest rates. ALCO guidelines limit the changein market value of equity in a 200 basis point parallel rate shock to 25% ofthe market value of equity assuming interest rates at March 31, 2005. Theup 200 basis point scenario resulted in a 1.79% increase at March 31, 2005and a 2.16% increase at December 31, 2004. The down 200 basis pointscenario resulted in a 7.23% decrease at March 31, 2005 and a 8.63%decrease at December 31, 2004. At March 31, 2005 and December 31,2004, Bankshares was within its policy guidelines.

 

The valuation analysis isdependent upon certain key assumptions about the nature of indeterminatematurities of assets and liabilities. Management estimates the average life andrate characteristics of asset and liability accounts based on historicalanalysis and management’s expectation of rate behavior. These assumptions areperiodically validated and updated.

 

**Market Risk – Trading Activities**

** **

In the fourth quarter2004, Bankshares began marketing capital market products to its customers. Froma market risk perspective, Bankshares’ net income is exposed to changes ininterest rates, credit spreads, and equity and their implied volatilities. Theprimary purpose of Bankshares’ trading business is to accommodate customers inthe management of their market price risks. Derivative transactions executedwith customers are simultaneously hedged in the capital markets. Allderivatives transacted with customers used to hedge capital market transactionswith customers are carried at fair value. The Asset/Liability ManagementCommittee establishes and monitors counterparty risk limits. The notionalamount, exposure amount and estimated net fair value of all customeraccommodation derivatives at March 31, 2005 are included in Note No. 11(Derivative Instruments and Hedging Activities) to the Financial Statements.

 

**Market Risk – Equity Markets**

** **

Bankshares isdirectly and indirectly affected by changes in the equity markets. Bankshares hasmade investments in private equities. These investments are made within capitalallocations approved by management. Management reviews these investments atleast quarterly and assesses them for possible other-than-temporary impairment.Private equity investments totaled $18.4 million at March 31, 2005 and$18.9 million at March 31, 2004.

 

Changes in equitymarket prices may also indirectly affect Bankshares’ net income (1) byaffecting the value of third party assets under management or administration withinIWM and, hence, fee income, (2) by affecting particular borrowers, whoseability to repay principal and/or interest may be affected by the stock market,or (3) by affecting brokerage activity, related commission income andother business activities.

 

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**Liquidity Risk**

** **

Liquidity risk is thepossibility that Bankshares will not be able to fund present and futurefinancial obligations. The objective of liquidity management is to maintain theability to meet commitments to fund loans, purchase securities and repaydeposits and other liabilities in accordance with their terms. To achieve thisobjective, the Asset/Liability Management Committee establishes and monitorsliquidity guidelines that require sufficient asset-based liquidity to coverpotential funding requirements and to avoid over-reliance on volatile, lessreliable funding markets. Debt securities in the available-for-sale portfolioprovide liquidity, in addition to the immediately liquid resources of cash anddue from banks and federal funds sold and securities purchased under resaleagreements. By limiting the maturity of securities and maintaining aconservative investment posture, management can rely on the investmentportfolio to help meet any short-term funding needs. U.S. Treasury and agencysecurities, which provide the greatest liquidity, averaged $1.4 billion in thefirst quarter of 2005 a 6.9% decrease from the average of $1.5 billion for thefourth quarter of 2004 and a 8.6% decrease from the average of $1.6 billion forthe first quarter of 2004.

 

Core customer depositshave historically provided a sizable source of relatively stable and low-costfunds. For the three months ended March 31, 2005, core deposits (totaldeposits less certificates of deposit of $100,000 and over), averaged $9.3billion compared with $9.3 billion for the fourth quarter of 2004 and $8.8billion for the first quarter of 2004. Although not viewed as core deposits, asubstantial portion of short-term borrowings comprised of securities sold underagreements to repurchase and commercial paper, originate from core depositrelationships tied to the overnight cash management program offered tocustomers. Long-term debt and short-term borrowings funded the remaining assets.

 

In addition to thesesources, Bankshares has access to national markets for certificates of deposit,commercial paper and debt financing. Should it need to further supplement itsliquidity, Bankshares has $1.8 billion in lines with the FHLB Atlanta and back-upcommercial paper lines of $40 million with commercial banks. Bankshares isrequired to obtain approval from holders of Bankshares’ 6.72% and 6.80%unsecured senior notes if it incrementally borrows in excess of $150 millionunder these FHLB lines.

 

Liquidity is alsoavailable through Bankshares’ ability to raise funds in the capital markets.Bankshares accesses capital markets for long-term funding by issuing registereddebt and private placements. In December 2004, Moody’s Investors Serviceaffirmed Mercantile Bankshares Corporation’s commercial paper rating of  “P-1” and the Corporation’s subordinated debtrating of  “A2.” Also in December 2004,Standard & Poor’s Ratings Service affirmed Bankshares’ rating of  “A+/Stable/A-1”, and counterparty ratingof  “A+/Stable/A-1.” Rating agencies basetheir ratings on many quantitative and qualitative factors, including capitaladequacy, liquidity, asset quality, quality of the management team, businessmix and level and quality of earnings.

 

For additional informationsee “Risk Management – Liquidity Risk” in the Mercantile Bankshares Corporation’s2004 Annual Report on Form 10-K.

 

**Contractual Obligations andCommitments**

** **

Through the normal courseof business, Bankshares enters into certain contractual obligations and othercommitments. Such obligations generally relate to funding operations throughdebt arrangements as well as leases of premises and equipment.  As a financial services provider, Banksharesroutinely enters into commitments to extend credit, including loan commitments,standby letters of credit and financial guarantees. For a discussion of thesecommitments see Note No. 6 “Commitments” above. For a discussion ofcontractual commitments see “Off-Balance Sheet Arrangements and ContractualObligations” in the Mercantile Bankshares Corporation’s 2004 Annual Report on Form 10-K.  Items disclosed in the Annual Report on Form 10-Khave not changed materially since the report was filed.

 

**Cautionary Statement**

** **

This report containsfinancial information determined by methods other than in accordance withGenerally Accepted Accounting Principles (“GAAP”). Bankshares’ management usesthese non-GAAP measures in their analysis of the Company’s performance. Inparticular, net interest income, net interest margin and the cash operatingefficiency ratio are calculated on a fully tax-equivalent basis (“FTE”).  The FTE basis is determined by adjusting netinterest income to reflect tax-exempt interest income on a before-taxequivalent basis. These measures typically adjust GAAP performance measures toexclude intangible assets and the amortization of intangible assets related tothe consummation of mergers. These operating earnings measures may also excludeother significant gains, losses or expenses that are not considered componentsof core earnings. Since these items and their impact on Bankshares’ performanceare difficult to predict, management believes presentations of financialmeasures excluding the impact of these items provide useful supplementalinformation that is essential to a proper understanding of the operatingresults and financial position of Bankshares’ core businesses. Thesedisclosures should not be viewed as a substitute for results determined inaccordance with GAAP, nor are they necessarily comparable to operating earningsperformance measures that may be presented by other companies.

 

28

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This report containsforward-looking statements within the meaning of and pursuant to the safeharbor provisions of the Private Securities Litigation Reform Act of 1995.  A forward-looking statement encompasses anyestimate, prediction, opinion or statement of belief contained in this report,and the underlying management assumptions. Such statements in this report include: identification of trends; loangrowth; deposit retention; comments on adequacy of the allowance for loanlosses; credit quality; changes in leasing activities; effects of assetsensitivity and interest rate changes; information concerning market riskreferenced in Item 3; expected pro forma assets, loans and deposits of thebanks resulting from the planned reorganization; and the anticipated effect ofthe proposed reorganization on operations, regulatory compliance and service tobanking customers.  Forward-lookingstatements are based on current expectations and assessments of potentialdevelopments affecting market conditions, interest rates and other economicconditions, and results may ultimately vary from the statements made in thisreport.  In addition, the followingfactors, among others, could cause actual results to differ materially from theanticipated results or expectations expressed in the forward-lookingstatements: administrative and operational efficiencies may not improve to thedegree projected; and competitive pressures and regulatory complexities thataffect our banks may be stronger than expected.

 

29

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**Supplemental Information by Quarter**

Select Financial Data

*(Dollars in thousands, except per share data)*

* *
| ** **                                                                            | ** ** | **1Q 05**      | ** **     | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 04**  | ** ** | **1Q 04**  | ** ** | **1Q 05  vs  4Q 04** | ** ** | **1Q 05  vs  1Q 04** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|----------------|------------|------------|------------|------------|------------|------------|------------|------------|----------------------|------------|----------------------|------------|
| **OPERATING RESULTS**                                                                 |       |           | ** **     |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Net interest income                                                                   | ** ** | **$**          | **143,083**    | ** ** | $          | 143,710    |       | $          | 138,182    |       | $          | 133,484              |       | $                    | 130,405    |   | (0.4 | )% | 9.7 | % |
| Net interest income - taxable equivalent (1)                                          | ** ** | **144,660**    | ** **     | 145,370    |       | 139,866    |       | 135,159    |       | 132,130    |       | (0.5                 | )          | 9.5                  |       |
| Provision for loan losses                                                             | ** ** | **756**        | ** **     | —     |       | 2,442      |       | 2,353      |       | 2,426      |       | —               |       | (68.8                | )          |
| Net income                                                                            | ** ** | **62,627**     | ** **     | 60,612     |       | 56,785     |       | 56,313     |       | 55,697     |       | 3.3                  |       | 12.4                 |       |
| **PER COMMON SHARE DATA**                                                             |       |           | ** **     |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Basic net income                                                                      | ** ** | **$**          | **.79**        | ** ** | $          | .77        |       | $          | .72        |       | $          | .71                  |       | $                    | .70        |   | 2.6 | % | 12.9 | % |
| Diluted net income                                                                    | ** ** | **.78**        | ** **     | .76        |       | .71        |       | .71        |       | .69        |       | 2.6                  |       | 13.0                 |       |
| Dividends paid                                                                        | ** ** | **.35**        | ** **     | .35        |       | .35        |       | .35        |       | .33        |       | —               |       | 6.1                  |       |
| Book value at period end                                                              | ** ** | **24.39**      | ** **     | 24.18      |       | 23.85      |       | 23.28      |       | 23.61      |       | 0.9                  |       | 3.3                  |       |
| Market value at period end                                                            | ** ** | **50.86**      | ** **     | 52.20      |       | 47.96      |       | 46.82      |       | 42.93      |       | (2.6                 | )          | 18.5                 |       |
| Market range:                                                                         |       |           | ** **     |       |       |       |       |       |       |       |       |                 |       |                 |       |
| High                                                                                  | ** ** | **52.35**      | ** **     | 53.09      |       | 49.34      |       | 47.93      |       | 46.01      |       | (1.4                 | )          | 13.8                 |       |
| Low                                                                                   | ** ** | **48.40**      | ** **     | 47.07      |       | 44.18      |       | 40.31      |       | 41.50      |       | 2.8                  |       | 16.6                 |       |
| **AVERAGE BALANCE SHEET DATA**                                                        |       |           | ** **     |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Total loans                                                                           | ** ** | **$**          | **10,314,361** | ** ** | $          | 10,084,344 |       | $          | 9,825,793  |       | $          | 9,623,884            |       | $                    | 9,338,433  |   | 2.3 | % | 10.5 | % |
| Total earning assets                                                                  | ** ** | **13,221,167** | ** **     | 13,056,972 |       | 12,831,612 |       | 12,668,674 |       | 12,372,193 |       | 1.3                  |       | 6.9                  |       |
| Total assets                                                                          | ** ** | **14,508,344** | ** **     | 14,310,894 |       | 14,099,488 |       | 13,939,185 |       | 13,618,193 |       | 1.4                  |       | 6.5                  |       |
| Total deposits                                                                        | ** ** | **10,718,734** | ** **     | 10,675,933 |       | 10,507,716 |       | 10,398,257 |       | 10,066,645 |       | 0.4                  |       | 6.5                  |       |
| Shareholders’ equity                                                             | ** ** | **1,950,276**  | ** **     | 1,911,151  |       | 1,877,844  |       | 1,851,761  |       | 1,848,461  |       | 2.0                  |       | 5.5                  |       |
| **STATISTICS AND RATIOS (Net income annualized)**                                     |       |           | ** **     |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Return on average assets                                                              | ** ** | **1.75**       | **%**          | 1.68       | %          | 1.60       | %          | 1.62       | %          | 1.64       | %          |                 |       |                 |       |
| Return on average equity                                                              | ** ** | **13.02**      | ** **     | 12.62      |       | 12.03      |       | 12.23      |       | 12.12      |       |                 |       |                 |       |
| Return on average tangible equity (2)                                                 | ** ** | **18.57**      | ** **     | 18.16      |       | 17.63      |       | 18.14      |       | 18.01      |       |                 |       |                 |       |
| Average equity to average assets                                                      | ** ** | **13.44**      | ** **     | 13.35      |       | 13.32      |       | 13.28      |       | 13.57      |       |                 |       |                 |       |
| Average tangible equity to average tangible assets (2)                                | ** ** | **10.00**      | ** **     | 9.84       |       | 9.67       |       | 9.55       |       | 9.75       |       |                 |       |                 |       |
| Net interest rate spread - taxable equivalent                                         | ** ** | **3.99**       | ** **     | 4.02       |       | 3.99       |       | 3.96       |       | 3.97       |       |                 |       |                 |       |
| Net interest margin on earning assets - taxable equivalent                            | ** ** | **4.44**       | ** **     | 4.43       |       | 4.34       |       | 4.29       |       | 4.30       |       |                 |       |                 |       |
| Efficiency ratio (1),(3)                                                              | ** ** | **49.45**      | ** **     | 52.70      |       | 51.20      |       | 50.12      |       | 50.40      |       |                 |       |                 |       |
| Operating efficiency ratio (1),(3)                                                    | ** ** | **48.80**      | ** **     | 51.20      |       | 48.96      |       | 49.01      |       | 49.24      |       |                 |       |                 |       |
| Dividend payout ratio                                                                 | ** ** | **44.30**      | ** **     | 45.45      |       | 48.61      |       | 49.30      |       | 47.14      |       |                 |       |                 |       |
|                                                                                  |       |           | ** **     |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Bank offices                                                                          | ** ** | **225**        | ** **     | 226        |       | 229        |       | 229        |       | 229        |       | (1                   | )          | (4                   | )          |
| Employees                                                                             | ** ** | **3,423**      | ** **     | 3,479      |       | 3,418      |       | 3,508      |       | 3,575      |       | (56                  | )          | (152                 | )          |
| **CREDIT QUALITY DATA AT PERIOD END**                                                 |       |           | ** **     |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Net charge-offs / (recoveries)                                                        | ** ** | **$**          | **741**        | ** ** | $          | 12,439     |       | $          | (568       | )          | $          | 557                  |       | $                    | 1,128      |   | (94.0 | )% | (34.3 | )% |
| Nonaccrual loans                                                                      | ** ** | **31,234**     | ** **     | 30,898     |       | 38,902     |       | 39,888     |       | 48,007     |       | 1.1                  |       | (34.9                | )          |
| Restructured loans                                                                    | ** ** | **—**     | ** **     | —     |       | —     |       | —     |       | —     |       | —               |       | —               |       |
| Total nonperforming loans                                                             | ** ** | **31,234**     | ** **     | 30,898     |       | 38,902     |       | 39,888     |       | 48,007     |       | 1.1                  |       | (34.9                | )          |
| Other real estate owned, net                                                          | ** ** | **145**        | ** **     | 212        |       | 388        |       | 402        |       | 134        |       | (31.6                | )          | 8.2                  |       |
| Total nonperforming assets                                                            | ** ** | **31,379**     | ** **     | 31,110     |       | 39,290     |       | 40,290     |       | 48,141     |       | 0.9                  |       | (34.8                | )          |
| **CREDIT QUALITY RATIOS**                                                             |       |           | ** **     |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Provision for loan losses (annualized) as a percent of period-end loans               | ** ** | **.03**        | **%**          | —     | %          | .10        | %          | .10        | %          | .10        | %          |                 |       |                 |       |
| Net charge-offs / (recoveries) - annualized as a percent of period-end  loans         | ** ** | **.03**        | ** **     | .48        |       | (.02       | )          | .02        |       | .05        |       |                 |       |                 |       |
| Nonperforming loans as a percent of period-end loans                                  | ** ** | **.30**        | ** **     | .30        |       | .39        |       | .41        |       | .51        |       |                 |       |                 |       |
| Allowance for loan losses as a percent of period-end loans                            | ** ** | **1.43**       | ** **     | 1.46       |       | 1.61       |       | 1.62       |       | 1.66       |       |                 |       |                 |       |
| Allowance for loan losses as a percent of nonperforming loans                         | ** ** | **477.10**     | ** **     | 482.24     |       | 414.99     |       | 397.19     |       | 326.28     |       |                 |       |                 |       |
| Other real estate owned as a percent of period-end loans and other real  estate owned | ** ** | **—**     | ** **     | —     |       | —     |       | —     |       | —     |       |                 |       |                 |       |
| Nonperforming assets as a percent of period-end loans and other real  estate owned    | ** ** | **.30**        | ** **     | .30        |       | .39        |       | .41        |       | .51        |       |                 |       |                 |       |
| Nonperforming assets as a percent of total assets                                     | ** ** | **.21**        | ** **     | .22        |       | .27        |       | .29        |       | .34        |       |                 |       |                 |       |

 

----

(1), (2), (3) See Reconciliation of Non-GAAP measures for additionalinformation.

 

30

----

 

**Statements of Consolidated Income**

*(Dollars in thousands, except per share data)*

 
| ** **                                              | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **1Q 05** | ** ** | **1Q 05** | ** ** |
|---------------------------------------------------------|------------|-------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|-----------|------------|-----------|------------|
| ** **                                              | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**    | ** ** | **vs**    | ** ** |
| ** **                                              | ** ** | **1Q 05**   | ** **  | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 04**  | ** ** | **1Q 04**  | ** ** | **4Q 04** | ** ** | **1Q 04** | ** ** |
| **INTEREST INCOME**                                     |       |        |        |       |       |       |       |       |       |       |       |      |       |      |       |
| Interest and fees on loans                              | ** ** | **$**       | **152,544** |       | $          | 147,114    |       | $          | 138,117    |       | $          | 132,171   |       | $         | 129,129    |   | 3.7 | % | 18.1 | % |
| Interest and dividends on investment securities:        |       |        |        |       |       |       |       |       |       |       |       |      |       |      |       |
| Taxable interest income                                 | ** ** | **24,992**  |        | 25,809     |       | 26,048     |       | 26,165     |       | 27,401     |       | (3.2      | )          | (8.8      | )          |
| Tax-exempt interest income                              | ** ** | **721**     |        | 766        |       | 803        |       | 820        |       | 877        |       | (5.9      | )          | (17.8     | )          |
| Other investment income                                 | ** ** | **644**     |        | 1,157      |       | 472        |       | 352        |       | 333        |       | (44.3     | )          | 93.4      |       |
| ** **                                              |       | **26,357**  |        | 27,732     |       | 27,323     |       | 27,337     |       | 28,611     |       | (5.0      | )          | (7.9      | )          |
| Other interest income                                   | ** ** | **344**     |        | 414        |       | 449        |       | 534        |       | 106        |       | (16.9     | )          | 224.5     |       |
| Total interest income                                   | ** ** | **179,245** |        | 175,260    |       | 165,889    |       | 160,042    |       | 157,846    |       | 2.3       |       | 13.6      |       |
| **INTEREST EXPENSE**                                    |       |        |        |       |       |       |       |       |       |       |       |      |       |      |       |
| Interest on deposits                                    | ** ** | **25,305**  |        | 22,621     |       | 20,142     |       | 19,873     |       | 20,767     |       | 11.9      |       | 21.9      |       |
| Interest on short-term borrowings                       | ** ** | **4,042**   |        | 2,955      |       | 1,990      |       | 1,480      |       | 1,419      |       | 36.8      |       | 184.8     |       |
| Interest on long-term debt                              | ** ** | **6,815**   |        | 5,974      |       | 5,575      |       | 5,205      |       | 5,255      |       | 14.1      |       | 29.7      |       |
| Total interest expense                                  | ** ** | **36,162**  |        | 31,550     |       | 27,707     |       | 26,558     |       | 27,441     |       | 14.6      |       | 31.8      |       |
|                                                    |       |        |        |       |       |       |       |       |       |       |       |      |       |      |       |
| **NET INTEREST INCOME**                                 | ** ** | **143,083** |        | 143,710    |       | 138,182    |       | 133,484    |       | 130,405    |       | (0.4      | )          | 9.7       |       |
| Provision for loan losses                               | ** ** | **756**     |        | —     |       | 2,442      |       | 2,353      |       | 2,426      |       |      |       | (68.8     | )          |
| **NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES** | ** ** | **142,327** |        | 143,710    |       | 135,740    |       | 131,131    |       | 127,979    |       | (1.0      | )          | 11.2      |       |
| **NONINTEREST INCOME**                                  |       |        |        |       |       |       |       |       |       |       |       |      |       |      |       |
| Investment and wealth management                        | ** ** | **24,057**  |        | 22,735     |       | 22,396     |       | 22,936     |       | 21,983     |       | 5.8       |       | 9.4       |       |
| Service charges on deposit accounts                     | ** ** | **10,426**  |        | 11,312     |       | 11,278     |       | 10,981     |       | 10,692     |       | (7.8      | )          | (2.5      | )          |
| Mortgage banking-related fees                           | ** ** | **2,283**   |        | 3,199      |       | 3,063      |       | 2,293      |       | 2,940      |       | (28.6     | )          | (22.3     | )          |
| Investment securities gains and (losses)                | ** ** | **414**     |        | 705        |       | (1         | )          | 590        |       | (55        | )          | (41.3     | )          | 852.7     |       |
| Nonmarketable investments                               | ** ** | **5,271**   |        | 4,001      |       | 2,767      |       | 450        |       | 4,204      |       | 31.7      |       | 25.4      |       |
| Other income                                            | ** ** | **15,418**  |        | 13,776     |       | 14,418     |       | 13,876     |       | 13,390     |       | 11.9      |       | 15.1      |       |
| Total noninterest income                                | ** ** | **57,869**  |        | 55,728     |       | 53,921     |       | 51,126     |       | 53,154     |       | 3.8       |       | 8.9       |       |
| **NONINTEREST EXPENSES**                                |       |        |        |       |       |       |       |       |       |       |       |      |       |      |       |
| Salaries                                                | ** ** | **46,554**  |        | 49,448     |       | 48,696     |       | 44,689     |       | 44,788     |       | (5.9      | )          | 3.9       |       |
| Employee benefits                                       | ** ** | **11,897**  |        | 10,678     |       | 10,557     |       | 10,928     |       | 12,513     |       | 11.4      |       | (4.9      | )          |
| Net occupancy expense of bank premises                  | ** ** | **6,922**   |        | 6,300      |       | 6,128      |       | 5,819      |       | 6,060      |       | 9.9       |       | 14.2      |       |
| Furniture and equipment expenses                        | ** ** | **7,279**   |        | 8,566      |       | 7,936      |       | 7,573      |       | 7,364      |       | (15.0     | )          | (1.2      | )          |
| Communications and supplies                             | ** ** | **4,040**   |        | 4,294      |       | 4,111      |       | 4,195      |       | 4,304      |       | (5.9      | )          | (6.1      | )          |
| Other expenses                                          | ** ** | **23,461**  |        | 26,702     |       | 21,789     |       | 20,163     |       | 18,357     |       | (12.1     | )          | 27.8      |       |
| Total noninterest expenses                              | ** ** | **100,153** |        | 105,988    |       | 99,217     |       | 93,367     |       | 93,386     |       | (5.5      | )          | 7.2       |       |
| Income before income taxes                              | ** ** | **100,043** |        | 93,450     |       | 90,444     |       | 88,890     |       | 87,747     |       | 7.1       |       | 14.0      |       |
| Applicable income taxes                                 | ** ** | **37,416**  |        | 32,838     |       | 33,659     |       | 32,577     |       | 32,050     |       | 13.9      |       | 16.7      |       |
| **NET INCOME**                                          | ** ** | **$**       | **62,627**  |       | $          | 60,612     |       | $          | 56,785     |       | $          | 56,313    |       | $         | 55,697     |   | 3.3 |   | 12.4 |   |
|                                                    |       |        |        |       |       |       |       |       |       |       |       |      |       |      |       |
| Weighted average shares outstanding                     | ** ** | **79,228**  |        | 79,075     |       | 78,965     |       | 79,119     |       | 79,725     |       | 0.2       |       | (0.6      | )          |
| Adjusted weighted average shares outstanding            | ** ** | **79,875**  |        | 79,800     |       | 79,611     |       | 79,751     |       | 80,258     |       | 0.1       |       | (0.5      | )          |
| **NET INCOME PER COMMON SHARE:**                        |       |        |        |       |       |       |       |       |       |       |       |      |       |      |       |
| Basic                                                   | ** ** | **$**       | **.79**     |       | $          | .77        |       | $          | .72        |       | $          | .71       |       | $         | .70        |   | 2.6 |   | 12.9 |   |
| Diluted                                                 | ** ** | **$**       | **.78**     |       | $          | .76        |       | $          | .71        |       | $          | .71       |       | $         | .69        |   | 2.6 |   | 13.0 |   |

 

31

----

 

**Statements of ConsolidatedNoninterest Income and Noninterest Expenses**

*(Dollars in thousands)*

* *
| ** **                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **1Q 05**  | ** ** | **1Q 05**  | ** ** |
|------------------------------------------|------------|------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**     | ** ** | **vs**     | ** ** |
| ** **                               | ** ** | **1Q 05**  | ** **  | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 04**  | ** ** | **1Q 04**  | ** ** | **4Q 04**  | ** ** | **1Q 04**  | ** ** |
| **Noninterest Income**                   | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Investment and wealth management         | ** ** | **$**      | **24,057**  |       | $          | 22,735     |       | $          | 22,396     |       | $          | 22,936     |       | $          | 21,983     |   | 5.8 | % | 9.4 | % |
| Service charges on deposit accounts      | ** ** | **10,426** |        | 11,312     |       | 11,278     |       | 10,981     |       | 10,692     |       | (7.8       | )          | (2.5       | )          |
| Mortgage banking-related fees:           |       |       |        |       |       |       |       |       |       |       |       |       |       |       |       |
| Commercial                               | ** ** | **1,514**  |        | 2,600      |       | 2,395      |       | 1,563      |       | 1,920      |       | (41.8      | )          | (21.1      | )          |
| Residential                              | ** ** | **769**    |        | 599        |       | 668        |       | 730        |       | 1,020      |       | 28.4       |       | (24.6      | )          |
| Total mortgage banking-related fees      | ** ** | **2,283**  |        | 3,199      |       | 3,063      |       | 2,293      |       | 2,940      |       | (28.6      | )          | (22.3      | )          |
| Investment securities gains and (losses) | ** ** | **414**    |        | 705        |       | (1         | )          | 590        |       | (55        | )          | (41.3      | )          | 852.7      |       |
| Nonmarketable investments                |       |       |        |       |       |       |       |       |       |       |       |       |       |       |       |
| Private equity and other investments     | ** ** | **2,461**  |        | 179        |       | 1,628      |       | 373        |       | 389        |       | 1,274.9    |       | 532.6      |       |
| Hedge funds                              | ** ** | **1,964**  |        | 2,875      |       | 341        |       | (708       | )          | 3,021      |       | (31.7      | )          | (35.0      | )          |
| Bank-owned life insurance                | ** ** | **846**    |        | 947        |       | 798        |       | 785        |       | 794        |       | (10.7      | )          | 6.5        |       |
| Total nonmarketable investments          | ** ** | **5,271**  |        | 4,001      |       | 2,767      |       | 450        |       | 4,204      |       | 31.7       |       | 25.4       |       |
| Other income:                            |       |       |        |       |       |       |       |       |       |       |       |       |       |       |       |
| Electronic banking fees                  | ** ** | **5,173**  |        | 5,312      |       | 6,029      |       | 6,008      |       | 4,417      |       | (2.6       | )          | 17.1       |       |
| Charges and fees on loans                | ** ** | **2,795**  |        | 2,892      |       | 2,647      |       | 2,835      |       | 2,458      |       | (3.4       | )          | 13.7       |       |
| Insurance                                | ** ** | **4,540**  |        | 3,046      |       | 3,218      |       | 3,267      |       | 3,828      |       | 49.0       |       | 18.6       |       |
| All other income                         | ** ** | **2,910**  |        | 2,526      |       | 2,524      |       | 1,766      |       | 2,687      |       | 15.2       |       | 8.3        |       |
| Total other income                       | ** ** | **15,418** |        | 13,776     |       | 14,418     |       | 13,876     |       | 13,390     |       | 11.9       |       | 15.1       |       |
| Total                                    | ** ** | **$**      | **57,869**  |       | $          | 55,728     |       | $          | 53,921     |       | $          | 51,126     |       | $          | 53,154     |   | 3.8 |   | 8.9 |   |
|                                     |       |       |        |       |       |       |       |       |       |       |       |       |       |       |       |
| ** **                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **1Q 05**  | ** ** | **1Q 05**  | ** ** |
| ** **                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**     | ** ** | **vs**     | ** ** |
| ** **                               | ** ** | **1Q 05**  | ** **  | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 04**  | ** ** | **1Q 04**  | ** ** | **4Q 04**  | ** ** | **1Q 04**  | ** ** |
| **Noninterest Expenses**                 | ** ** | ** ** | ** **  |       |       |       |       |       |       |       |       |       |       |       |       |   |   |   |   |   |
| Salaries                                 | ** ** | **$**      | **46,554**  |       | $          | 49,448     |       | $          | 48,696     |       | $          | 44,689     |       | $          | 44,788     |   | (5.9 | )% | 3.9 | % |
| Employee benefits                        | ** ** | **11,897** |        | 10,678     |       | 10,557     |       | 10,928     |       | 12,513     |       | 11.4       |       | (4.9       | )          |
| Net occupancy expense of bank premises   | ** ** | **6,922**  |        | 6,300      |       | 6,128      |       | 5,819      |       | 6,060      |       | 9.9        |       | 14.2       |       |
| Furniture and equipment expenses         | ** ** | **7,279**  |        | 8,566      |       | 7,936      |       | 7,573      |       | 7,364      |       | (15.0      | )          | (1.2       | )          |
| Communications and supplies              | ** ** | **4,040**  |        | 4,294      |       | 4,111      |       | 4,195      |       | 4,304      |       | (5.9       | )          | (6.1       | )          |
| Other expenses:                          |       |       |        |       |       |       |       |       |       |       |       |       |       |       |       |
| Professional services                    | ** ** | **5,125**  |        | 9,315      |       | 7,157      |       | 4,996      |       | 3,834      |       | (45.0      | )          | 33.7       |       |
| Advertising and promotional expenses     | ** ** | **1,711**  |        | 2,833      |       | 1,747      |       | 2,135      |       | 1,703      |       | (39.6      | )          | 0.5        |       |
| Electronic banking expenses              | ** ** | **3,241**  |        | 3,051      |       | 3,299      |       | 3,006      |       | 2,153      |       | 6.2        |       | 50.5       |       |
| Amortization of intangible assets        | ** ** | **2,072**  |        | 2,009      |       | 2,044      |       | 2,057      |       | 2,032      |       | 3.1        |       | 2.0        |       |
| Outsourcing expenses                     | ** ** | **2,690**  |        | 1,305      |       | 1,351      |       | 1,227      |       | 1,459      |       | 106.1      |       | 84.4       |       |
| All other expenses                       | ** ** | **8,622**  |        | 8,189      |       | 6,191      |       | 6,742      |       | 7,176      |       | 5.3        |       | 20.2       |       |
| Total other expenses                     | ** ** | **23,461** |        | 26,702     |       | 21,789     |       | 20,163     |       | 18,357     |       | (12.1      | )          | 27.8       |       |
| Total                                    | ** ** | **$**      | **100,153** |       | $          | 105,988    |       | $          | 99,217     |       | $          | 93,367     |       | $          | 93,386     |   | (5.5 | ) | 7.2 |   |

 

32

----

 

 

**Consolidated Average BalanceSheets**

*(Dollars in thousands)*

* *
| ** **                                             | ** ** | ** **           | ** **     | ** **           | ** ** | ** **           | ** ** | ** **          | ** ** | ** **           | ** ** | ** **          | ** ** | ** **           | ** ** | ** **          | ** ** | ** **           | ** ** | ** **          | ** ** | **Average Balance** | ** ** |
|--------------------------------------------------------|------------|----------------------|----------------|----------------------|------------|----------------------|------------|---------------------|------------|----------------------|------------|---------------------|------------|----------------------|------------|---------------------|------------|----------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                             | ** ** | **1Q 05**            | ** **     | **4Q 04**            | ** ** | **3Q 04**            | ** ** | **2Q 04**           | ** ** | **1Q 04**            | ** ** | **1Q 05**           | ** ** | **1Q 05**            | ** ** |
| ** **                                             | ** ** | **Average  Balance** | ** **     | **Yield(1)  / Rate** | ** ** | **Average  Balance** | ** ** | **Yield(1)  /Rate** | ** ** | **Average  Balance** | ** ** | **Yield(1)  /Rate** | ** ** | **Average  Balance** | ** ** | **Yield(1)  /Rate** | ** ** | **Average  Balance** | ** ** | **Yield(1)  /Rate** | ** ** | **vs  4Q 04**       | ** ** | **vs  1Q 04** | ** ** |
| **Earning assets  Loans:**                             | ** ** | ** **           | ** **     | ** **           | ** ** | ** **           | ** ** | ** **          | ** ** | ** **           | ** ** | ** **          | ** ** | ** **           | ** ** | ** **          | ** ** | ** **           | ** ** | ** **          | ** ** | ** **          | ** ** | ** ** | ** ** |
| Commercial                                             | ** ** | **$**                | **2,848,452**  | ** **           | **5.90**   | %                    | $          | 2,813,318           |       | 5.63                 | %          | $                   | 2,744,195  |                 | 5.34       | %                   | $          | 2,719,232            |       | 5.15                | %          | $                   | 2,623,891  |   | 5.16 | % | 1.2 | % | 8.6 | % |
| Commercial real estate                                 | ** ** | **3,133,446**        | ** **     | **6.28**             |       | 3,083,266            |       | 6.09                |       | 2,969,515            |       | 5.91                |       | 2,879,434            |       | 5.82                |       | 2,777,493            |       | 5.89                |       | 1.6                 |       | 12.8 |   |
| Construction                                           | ** ** | **1,328,633**        | ** **     | **6.24**             |       | 1,215,282            |       | 5.93                |       | 1,142,921            |       | 5.49                |       | 1,113,301            |       | 5.21                |       | 1,103,901            |       | 5.18                |       | 9.3                 |       | 20.4 |   |
| Residential real estate                                | ** ** | **1,517,291**        | ** **     | **5.83**             |       | 1,488,523            |       | 5.84                |       | 1,490,763            |       | 5.80                |       | 1,437,331            |       | 5.91                |       | 1,358,975            |       | 6.06                |       | 1.9                 |       | 11.6 |   |
| Consumer                                               | ** ** | **1,486,539**        | ** **     | **5.84**             |       | 1,483,955            |       | 5.70                |       | 1,478,399            |       | 5.60                |       | 1,474,586            |       | 5.81                |       | 1,474,173            |       | 5.79                |       | 0.2                 |       | 0.8 |   |
| Total loans                                            | ** ** | **10,314,361**       | ** **     | **6.04**             |       | 10,084,344           |       | 5.85                |       | 9,825,793            |       | 5.64                |       | 9,623,884            |       | 5.57                |       | 9,338,433            |       | 5.61                |       | 2.3                 |       | 10.5 |   |
| Federal funds sold, et al                              | ** ** | **31,854**           | ** **     | **4.37**             |       | 44,113               |       | 3.72                |       | 50,035               |       | 3.57                |       | 95,504               |       | 2.24                |       | 47,791               |       | .89                 |       | (27.8               | )          | (33.3 | ) |
| Securities: (2)                                        |       |                 |           |                 |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                |       |   |   |
| Taxable securities                                     |       |                 |           |                 |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                |       |   |   |
| U.S. Treasury and gov. agencies                        | ** ** | **1,426,230**        | ** **     | **3.43**             |       | 1,532,514            |       | 3.53                |       | 1,571,102            |       | 3.59                |       | 1,543,661            |       | 3.74                |       | 1,560,700            |       | 3.89                |       | (6.9                | )          | (8.6 | ) |
| Mortgage-backed                                        | ** ** | **1,303,700**        | ** **     | **4.02**             |       | 1,243,520            |       | 3.90                |       | 1,228,539            |       | 3.84                |       | 1,254,512            |       | 3.78                |       | 1,277,802            |       | 3.87                |       | 4.8                 |       | 2.0 |   |
| Other investments                                      | ** ** | **63,943**           | ** **     | **4.12**             |       | 68,004               |       | 7.12                |       | 65,264               |       | 2.90                |       | 52,773               |       | 2.73                |       | 42,934               |       | 3.17                |       | (6.0                | )          | 48.9 |   |
| Tax-exempt securities                                  |       |                 |           |                 |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                |       |   |   |
| States and political subdivisions                      | ** ** | **80,921**           | ** **     | **5.97**             |       | 84,319               |       | 5.99                |       | 90,721               |       | 5.82                |       | 98,182               |       | 5.55                |       | 104,375              |       | 5.59                |       | (4.0                | )          | (22.5 | ) |
| Total securities                                       | ** ** | **2,874,794**        | ** **     | **3.79**             |       | 2,928,357            |       | 3.84                |       | 2,955,626            |       | 3.75                |       | 2,949,128            |       | 3.80                |       | 2,985,811            |       | 3.93                |       | (1.8                | )          | (3.7 | ) |
| Interest-bearing deposits in banks                     | ** ** | **158**              | ** **     | **1.47**             |       | 158                  |       | 1.45                |       | 158                  |       | 1.08                |       | 158                  |       | 1.06                |       | 158                  |       | 1.09                |       | —              |       | — |   |
| Total earning assets                                   | ** ** | **13,221,167**       | ** **     | **5.55**             |       | 13,056,972           |       | 5.39                |       | 12,831,612           |       | 5.20                |       | 12,668,674           |       | 5.13                |       | 12,372,193           |       | 5.19                |       | 1.3                 |       | 6.9 |   |
| Cash and due from banks                                | ** ** | **290,911**          |           |                 |       | 285,742              |       |                |       | 296,203              |       |                |       | 298,440              |       |                |       | 285,524              |       |                |       | 1.8                 |       | 1.9 |   |
| Bank premises and equipment,net                        | ** ** | **141,426**          |           |                 |       | 140,556              |       |                |       | 141,536              |       |                |       | 141,757              |       |                |       | 141,632              |       |                |       | 0.6                 |       | (0.1 | ) |
| Other assets                                           | ** ** | **1,004,526**        |           |                 |       | 985,411              |       |                |       | 990,468              |       |                |       | 988,430              |       |                |       | 975,241              |       |                |       | 1.9                 |       | 3.0 |   |
| Less: allowance for loan losses                        | ** ** | **(149,686**         | **)**          |                 |       | (157,787             | )          |                |       | (160,331             | )          |                |       | (158,116             | )          |                |       | (156,397             | )          |                |       | (5.1                | )          | (4.3 | ) |
| Total assets                                           | ** ** | **$**                | **14,508,344** |                 |       |                 | $          | 14,310,894          |       |                 |       | $                   | 14,099,488 |                 |       |                | $          | 13,939,185           |       |                |       | $                   | 13,618,193 |   |   |   | 1.4 |   | 6.5 |   |
|                                                   |       |                 |           |                 |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                |       |   |   |
| Interest-bearing liabilities                           |       |                 |           |                 |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                |       |   |   |
| Deposits:                                              |       |                 |           |                 |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                |       |   |   |
| Savings                                                | ** ** | **$**                | **1,459,580**  | ** **           | **.32**    |                 | $          | 1,445,223           |       | .30                  |       | $                   | 1,457,432  |                 | .29        |                | $          | 1,434,288            |       | .29                 |       | $                   | 1,364,181  |   | .29 |   | 1.0 |   | 7.0 |   |
| Checking plus interest                                 | ** ** | **1,350,521**        | ** **     | **.15**              |       | 1,326,074            |       | .15                 |       | 1,291,808            |       | .15                 |       | 1,302,313            |       | .15                 |       | 1,236,552            |       | .15                 |       | 1.8                 |       | 9.2 |   |
| Money market                                           | ** ** | **1,550,919**        | ** **     | **.94**              |       | 1,572,997            |       | .75                 |       | 1,556,212            |       | .55                 |       | 1,564,295            |       | .54                 |       | 1,590,460            |       | .60                 |       | (1.4                | )          | (2.5 | ) |
| Time deposits $100,000 and over                        | ** ** | **1,427,571**        | ** **     | **2.66**             |       | 1,354,677            |       | 2.22                |       | 1,299,918            |       | 1.90                |       | 1,315,119            |       | 1.82                |       | 1,287,695            |       | 1.99                |       | 5.4                 |       | 10.9 |   |
| Other time deposits                                    | ** ** | **1,905,548**        | ** **     | **2.28**             |       | 1,882,646            |       | 2.22                |       | 1,918,216            |       | 2.12                |       | 1,955,632            |       | 2.12                |       | 1,979,433            |       | 2.15                |       | 1.2                 |       | (3.7 | ) |
| Total interest-bearing deposits                        | ** ** | **7,694,139**        | ** **     | **1.33**             |       | 7,581,617            |       | 1.19                |       | 7,523,586            |       | 1.07                |       | 7,571,647            |       | 1.06                |       | 7,458,321            |       | 1.12                |       | 1.5                 |       | 3.2 |   |
| Short-term borrowings                                  | ** ** | **1,000,929**        | ** **     | **1.64**             |       | 956,368              |       | 1.23                |       | 942,789              |       | .84                 |       | 910,854              |       | .65                 |       | 919,388              |       | .62                 |       | 4.7                 |       | 8.9 |   |
| Long-term debt                                         | ** ** | **689,372**          | ** **     | **4.01**             |       | 642,675              |       | 3.70                |       | 641,264              |       | 3.46                |       | 648,576              |       | 3.23                |       | 649,058              |       | 3.26                |       | 7.3                 |       | 6.2 |   |
| Total interest-bearing funds                           | ** ** | **9,384,440**        | ** **     | **1.56**             |       | 9,180,660            |       | 1.37                |       | 9,107,639            |       | 1.21                |       | 9,131,077            |       | 1.17                |       | 9,026,767            |       | 1.22                |       | 2.2                 |       | 4.0 |   |
| Noninterest-bearing deposits                           | ** ** | **3,024,595**        |           |                 |       | 3,094,316            |       |                |       | 2,984,130            |       |                |       | 2,826,610            |       |                |       | 2,608,324            |       |                |       | (2.3                | )          | 16.0 |   |
| Other liabilities and accrued expenses                 | ** ** | **149,033**          |           |                 |       | 124,767              |       |                |       | 129,875              |       |                |       | 129,737              |       |                |       | 134,641              |       |                |       | 19.4                |       | 10.7 |   |
| Total liabilities                                      | ** ** | **12,558,068**       |           |                 |       | 12,399,743           |       |                |       | 12,221,644           |       |                |       | 12,087,424           |       |                |       | 11,769,732           |       |                |       | 1.3                 |       | 6.7 |   |
| Shareholders’ equity                              | ** ** | **1,950,276**        |           |                 |       | 1,911,151            |       |                |       | 1,877,844            |       |                |       | 1,851,761            |       |                |       | 1,848,461            |       |                |       | 2.0                 |       | 5.5 |   |
| Total liabilities & shareholders’ equity | ** ** | **$**                | **14,508,344** |                 |       |                 | $          | 14,310,894          |       |                 |       | $                   | 14,099,488 |                 |       |                | $          | 13,939,185           |       |                |       | $                   | 13,618,193 |   |   |   | 1.4 |   | 6.5 |   |
|                                                   |       |                 |           |                 |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                 |       |                |       |                |       |   |   |
| Net interest rate spread                               | ** ** | ** **           |           | **3.99**             | **%**      |                 |       | 4.02                | %          |                 |       | 3.99                | %          |                 |       | 3.96                | %          |                 |       | 3.97                | %          |                |       |   |   |
| Effect of noninterest-bearing funds                    | ** ** | ** **           |           | **.45**              | ** ** |                 |       | .41                 |       |                 |       | .35                 |       |                 |       | .33                 |       |                 |       | .33                 |       |                |       |   |   |
| Net interest margin on earning assets                  | ** ** | ** **           |           | **4.44**             | **%**      |                 |       | 4.43                | %          |                 |       | 4.34                | %          |                 |       | 4.29                | %          |                 |       | 4.30                | %          |                |       |   |   |

 

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(1) Presented on atax-equivalent basis using the statutory federal corporate income tax rate of35% (see reconciliation of non-GAAP measures).

(2) Nonaccrual loansare included in average loans.

(3) Balancesreported at amortized cost; excludes unrealized gains (losses) on securitiesavailable-for-sale.

 

33

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**Reconciliation of Non-GAAPMeasures (unaudited)**

 
| **(Dollars  in thousands)** | *** *** | **1Q 05** | ** ** | **4Q 04** | ** ** | **3Q 04** | ** ** | **2Q 04** | ** ** | **1Q 04** | ** ** |
|-----------------------------|--------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|

 

(1)          The net interest margin and efficiency ratiosare presented on a fully tax-equivalent (“FTE”) and annualized basis. The FTEbasis adjusts for the tax-favored status of income from certain loans andinvestments.  Management believes thismeasure to be the preferred industry measurement of the net interest income andprovides a relevant comparison between taxable and non-taxable investments.

 
| Net interest income (GAAP  basis)         | ** ** | **$**     | **143,083** | ** ** | $      | 143,710 |   | $     | 138,182 |   | $      | 133,484 |   | $ | 130,405 |   |
|-------------------------------------------|------------|-----------|-------------|------------|--------|---------|--------|-------|---------|--------|--------|---------|--------|---|---------|--------|
| Taxable-equivalent adjustment             | ** ** | **1,577** | ** **  | 1,660      |   | 1,684   |   | 1,675 |    | 1,725  |   |
| Net interest income - taxable  equivalent | ** ** | **$**     | **144,660** | ** ** | $      | 145,370 |   | $     | 139,866 |   | $      | 135,159 |   | $ | 132,130 |   |

 

(2)          Management excludes the balance of intangibleassets and their related amortization expense from its calculation of return onaverage tangible equity and average tangible equity to average tangible assets.This adjustment allows management to review the core operating results and corecapital position of Bankshares. This is consistent with the treatment by bankregulatory agencies which exclude goodwill and other intangible assets fromtheir calculation of risk-based capital ratios.

 
| Return on average equity (GAAP  basis)                          | ** ** | **13.02** | **%**      | 12.62  | %      | 12.03  | %      | 12.23  | %      | 12.12  | %      |
|-----------------------------------------------------------------|------------|-----------|------------|--------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding average  intangible assets and amortization | ** ** | **5.55**  | ** ** | 5.54   |   | 5.60   |   | 5.91   |   | 5.89   |   |
| Return on average tangible  equity                              | ** ** | **18.57** | **%**      | 18.16  | %      | 17.63  | %      | 18.14  | %      | 18.01  | %      |
|                                                            |       |      | ** ** |   |   |   |   |   |   |   |   |
| Average equity to average  assets (GAAP basis)                  | ** ** | **13.44** | **%**      | 13.35  | %      | 13.32  | %      | 13.28  | %      | 13.57  | %      |
| Impact of excluding average  intangible assets and amortization | ** ** | **(3.44** | **)**      | (3.51  | )      | (3.65  | )      | (3.73  | )      | (3.82  | )      |
| Average tangible equity to  average tangible assets             | ** ** | **10.00** | **%**      | 9.84   | %      | 9.67   | %      | 9.55   | %      | 9.75   | %      |

 

When computing the cash operating efficiency ratio and cash operatingearnings, management excludes the amortization of intangible assets,restructuring charges, merger-related expenses, gains on sales of premises andgains and losses from sales of investment securities in order to assess thecore operating results of Bankshares and because of the uncertainty as totiming and amount of gain or losses to be recognized.

 

(3)          The efficiency ratio is measured by dividingnoninterest expenses by the sum of net interest income on a FTE basis andnoninterest income.

 
| Efficiency ratio (GAAP basis)                       | ** **                           | **49.45**  | **%**      | 52.70      | %      | 51.20  | %      | 50.12  | %      | 50.40  | %      |
|-----------------------------------------------------|--------------------------------------|------------|------------|------------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding: Securities  gains and (losses) | ** **                           | **0.10**   | ** ** | 0.18       |   | — |   | 0.16   |   | (0.01  | )      |
|                                                | Gains on sales of premises           | ** ** | **0.27**   | ** ** | 0.01   |   | 0.20   |   | 0.06   |   | 0.17   |   |
|                                                | Amortization of deposit  intangibles | ** ** | **(0.67**  | **)**      | (0.68  | )      | (0.71  | )      | (0.73  | )      | (0.74  | ) |
|                                                | Amortization of other  intangibles   | ** ** | **(0.35**  | **)**      | (0.31  | )      | (0.35  | )      | (0.37  | )      | (0.36  | ) |
|                                                | Restructuring charges                | ** ** | **—** | ** ** | (0.70  | )      | (1.38  | )      | (0.23  | )      | — |   |
|                                                | Merger-related expenses              | ** ** | **—** | ** ** | — |   | — |   | — |   | (0.22  | ) |
| Cash operating efficiency ratio                     | ** **                           | **48.80**  | **%**      | 51.20      | %      | 48.96  | %      | 49.01  | %      | 49.24  | %      |

 

(4)          Bankshares presents cashoperating earnings and diluted cash operating earnings per share in order toassess the core operating results.

 
| Net income (GAAP basis)                                | ** **                                     | **$**      | **62,627** | ** ** | $      | 60,612 |   | $      | 56,785 |   | $      | 56,313 |   | $ | 55,697 |   |
|--------------------------------------------------------|------------------------------------------------|------------|------------|------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---|--------|--------|
| Less: Securities (gains) and  losses, net of tax       | ** **                                     | **(250**   | **)**      | (426       | )      | 1      |   | (357   | )      | 33     |   |
|                                                   | Gains on sales of premises, net  of tax        | ** ** | **(693**   | **)**      | (26    | )      | (442   | )      | (144   | )      | (394   | )      |
| Plus: Amortization of deposit  intangibles, net of tax | ** **                                     | **826**    | ** ** | 826        |   | 826    |   | 826    |   | 826    |   |
|                                                   | Amortization of other  intangibles, net of tax | ** ** | **426**    | ** ** | 388    |   | 409    |   | 417    |   | 402    |   |
|                                                   | Restructuring charges, net of  tax             | ** ** | **—** | ** ** | 850    |   | 1,610  |   | 251    |   | — |   |
|                                                   | Merger-related expenses, net of  tax           | ** ** | **156**    | ** ** | — |   | — |   | — |   | 248    |   |
| Cash operating earnings                                | ** **                                     | **$**      | **63,092** | ** ** | $      | 62,224 |   | $      | 59,189 |   | $      | 57,306 |   | $ | 56,812 |   |
|                                                   |                                           |       | ** ** |       |   |   |   |   |   |   |   |
| Diluted net income per share  (GAAP basis)             | ** **                                     | **$**      | **0.78**   | ** ** | $      | 0.76   |   | $      | 0.71   |   | $      | 0.71   |   | $ | 0.69   |   |
| Less: Securities (gains) and  losses, net of tax       | ** **                                     | **—** | ** ** | (0.01      | )      | — |   | — |   | — |   |
|                                                   | Gains on sales of premises, net  of tax        | ** ** | **(0.01**  | **)**      | — |   | (0.01  | )      | — |   | — |   |
| Plus: Amortization of deposit  intangibles, net of tax | ** **                                     | **0.01**   | ** ** | 0.01       |   | 0.01   |   | 0.01   |   | 0.01   |   |
|                                                   | Amortization of other  intangibles, net of tax | ** ** | **0.01**   | ** ** | 0.01   |   | 0.01   |   | — |   | 0.01   |   |
|                                                   | Restructuring charges, net of  tax             | ** ** | **—** | ** ** | 0.01   |   | 0.02   |   | — |   | — |   |
|                                                   | Merger-related expenses, net of  tax           | ** ** | **—** | ** ** | — |   | — |   | — |   | — |   |
| Diluted cash operating earnings  per share             | ** **                                     | **$**      | **0.79**   | ** ** | $      | 0.78   |   | $      | 0.74   |   | $      | 0.72   |   | $ | 0.71   |   |

 

34

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# **Item 3. Quantitative and Qualitative Disclosures AboutMarket Risk**

# ** **

Informationresponsive to this item as of December 31, 2004 appears under the captions“*Risk Management”, “Interest Rate SensitivityAnalysis (Static Gap)”* and*“Earnings SimulationModel Projections”* of the registrant’s Form 10-K for the yearended December 31, 2004. There was no material change in such informationas of March 31, 2005.

 

# **Item 4. Controls and Procedures**

# ** **

As of March 31,2005, Bankshares’ management, under the supervision and with the participationof Bankshares’ principal executive officer and principal financial officer,evaluated the effectiveness of the design and operation of our disclosurecontrols and procedures, (as that term is defined in Rules 13a-15(e) and15d-15(e)) and internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f)) under the Securities and Exchange Act of 1934, as amended. Based onthe evaluation, the principal executive officer and principal financial officerconcluded that Bankshares’ disclosure controls and procedures are effective.There were no significant changes in Bankshares’ internal controls overfinancial reporting during the last fiscal quarter.

 

# **PART II – OTHER INFORMATION**

# ** **

# **Item 1. Legal Proceedings**

# ** **

Aspreviously disclosed, on July 12, 2004, former employee John Pileggi fileda lawsuit against Mercantile Bankshares Corporation (“Bankshares”),Mercantile-Safe Deposit and Trust Company (“MSD&T”) and Edward J. Kelly, III,Chairman and CEO of Bankshares alleging that the public statements made by thedefendants regarding the circumstances of Mr. Pileggi’s termination gaverise to claims of libel, invasion of privacy and false light. Mr. Pileggialso alleged breach of his employment contract and made a claim pursuant to achange-in-control agreement. The complaint sought actual and punitive damagesamounting to in excess of $240 million.

 

On September 27,2004, Bankshares filed a countersuit against Mr. Pileggi alleging that duringhis employment, Mr. Pileggi engaged in activities that constituted fraud,breach of contract, and breach of his fiduciary duty. The countersuit soughtcompensatory and punitive damages amounting to $8.2 million.

 

On March 30,2005, Bankshares, MSD&T, Mr. Kelly and Mr. Pileggi agreed todismiss all claims and provide full releases from any future claims. Inaddition, Mercantile has agreed to pay Mr. Pileggi $1.3 million in respectof Mr. Pileggi’s employment contract and certain related benefits. Mercantilealso has agreed, subject to certain conditions, to pay a portion of the legalfees incurred by Mr. Pileggi.

 

**Item 6. Exhibits**

 

Exhibits

 

31.1 Section 302 Certification of ChiefExecutive Officer. Filed as an exhibit hereto and incorporated herein by reference

 

31.2 Section 302 Certification of ChiefFinancial Officer. Filed as an exhibit hereto and incorporated herein byreference

 

32.1 Section 906 Certification of ChiefExecutive Officer. Filed as an exhibit hereto and incorporated herein byreference

 

32.2 Section 906 Certification of ChiefFinancial Officer. Filed as an exhibit hereto and incorporated herein byreference

 

35

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**Signatures**

 

Pursuant to therequirements of the Securities Exchange Act of 1934 the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|             | **Mercantile****Bankshares Corporation** |                             |
|------------------|------------------------------------------|----------------------------------|
|             | (Registrant)                             |                             |
|             |                                     |                             |
| May 5, 2005 |                                     | /s/ Edward J. Kelly, III    |   |
| Date             |                                     | By: Edward J. Kelly, III    |   |
|             |                                     | Chairman of the Board,           |   |
|             |                                     | President and                    |   |
|             |                                     | Chief Executive Officer          |   |
|             |                                     |                             |   |
| May 5, 2005 |                                     | /s/ Terry L. Troupe              |   |
| Date             |                                     | By: Terry L. Troupe              |   |
|             |                                     | Executive Vice President and     |   |
|             |                                     | Chief Financial Officer          |   |
|             |                                     |                             |   |
| May 5, 2005 |                                     | /s/ William T. Skinner, Jr. |   |
| Date             |                                     | By: William T. Skinner, Jr. |   |
|             |                                     | Controller                       |   |

 

36

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