**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

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

 

**For the quarterly period ended September 30, 2005**

 

**OR**

 

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

 

**For thetransition period from               to               **

 

**Commission file number 0-5127**

 

**MERCANTILE BANKSHARES CORPORATION**

(Exact name of registrant as specified in its charter)

 
| **Maryland**                                                                        | ** ** | **52-0898572**      |
|-------------------------------------------------------------------------------------|------------|---------------------|
| (State or other jurisdiction of                                                     |       | (I.R.S. Employer    |
| incorporation or organization)                                                      |       | Identification No.) |
|                                                                                |       |                |
| **2 Hopkins Plaza**                                                                 |
| **Baltimore, Maryland 21201**                                                       |
| (Address of principal executive offices) (Zip Code)                                 |
|                                                                                |       |                |
| **(410) 237-5900**                                                                  |
| (Registrant’s telephone number, including area code)                           |
|                                                                                |       |                |
| **NONE**                                                                            |
| (Former name, former address and former fiscal year, if changed since  last report) |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements 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). Yesý  No o

 

Indicate by check mark whether the registrant isa shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No ý

 

 

Asof October 20, 2005, 82,082,915 shares of registrant’s Common Stock, $2 parvalue per share, were outstanding.

 

 

----

 

**MERCANTILE BANKSHARES CORPORATION**

Quarterly Report on Form10-Q

September 30, 2005

 

**Table of Contents**

 
| Part I - Financial Information                                                                       |                                                             |
|------------------------------------------------------------------------------------------------------|------------------------------------------------------------------|
| Item 1.  Financial Statements (Unaudited)                                                       |                                                             |
|                                                                                                 | Consolidated Balance Sheets                                      |   |
|                                                                                                 | Consolidated Statements of Income                                |   |
|                                                                                                 | Consolidated Statements of Changes in Shareholders’  Equity |   |
|                                                                                                 | Consolidated Statements of Cash Flows                            |   |
|                                                                                                 | Notes to Consolidated Financial Statements                       |   |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations |                                                             |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                  |                                                             |
| Item 4. Controls and Procedures                                                                      |                                                             |
|                                                                                                 |                                                             |
| Part  II - Other Information                                                                         |                                                             |
| Item  1. Legal Proceedings                                                                           |                                                             |
| Item 6.  Exhibits                                                                                    |                                                             |
|                                                                                                 |                                                             |
| Signatures                                                                                           |                                                             |

 

2

----

 

**PART I – FINANCIAL INFORMATION**

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

 

**MERCANTILE BANKSHARES CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

 
| **(Dollars  in thousands, except per share data)**                                                                                                                  | ** ** | **September 30,  2005** | ** **     | **December 31,  2004** | ** ** | **September 30,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|----------------|------------------------|------------|-------------------------|------------|
| **ASSETS**                                                                                                                                                          |       |                    |           |                   |       |                    |       |
| Cash and due from banks                                                                                                                                             | ** ** | **$**                   | **328,964**    |                   | $          | 244,875                 |       | $ | 290,401 |   |
| Interest-bearing deposits in other banks                                                                                                                            | ** ** | **200**                 |           | 158                    |       | 158                     |       |
| Federal funds sold                                                                                                                                                  | ** ** | **232,129**             |           | 101                    |       | 24,500                  |       |
| Total cash and cash equivalents                                                                                                                                     | ** ** | **561,293**             |           | 245,134                |       | 315,059                 |       |
| Investment securities available-for-sale                                                                                                                            | ** ** | **3,048,846**           |           | 2,908,694              |       | 2,955,674               |       |
| Investment securities held-to-maturity fair value of $17,380 (2005),  $21,094 (December 2004) and $23,000 (September 2004)                                          | ** ** | **16,804**              |           | 20,176                 |       | 21,909                  |       |
| Total investment securities                                                                                                                                         | ** ** | **3,065,650**           |           | 2,928,870              |       | 2,977,583               |       |
| Loans held-for-sale                                                                                                                                                 | ** ** | **42,307**              |           | 11,000                 |       | 15,984                  |       |
| Loans:                                                                                                                                                              |       |                    |           |                   |       |                    |       |
| Commercial and leasing                                                                                                                                              | ** ** | **2,925,445**           |           | 2,866,693              |       | 2,841,088               |       |
| Commercial real estate                                                                                                                                              | ** ** | **3,638,238**           |           | 3,122,701              |       | 3,022,463               |       |
| Construction                                                                                                                                                        | ** ** | **1,543,633**           |           | 1,268,350              |       | 1,170,704               |       |
| Residential real estate                                                                                                                                             | ** ** | **1,778,684**           |           | 1,677,932              |       | 1,692,700               |       |
| Home equity lines                                                                                                                                                   | ** ** | **520,214**             |           | 495,462                |       | 473,089                 |       |
| Consumer                                                                                                                                                            | ** ** | **1,039,845**           |           | 797,295                |       | 814,270                 |       |
| Total loans                                                                                                                                                         | ** ** | **11,446,059**          |           | 10,228,433             |       | 10,014,314              |       |
| Less: allowance for loan losses                                                                                                                                     | ** ** | **(157,176**            | **)**          | (149,002               | )          | (161,441                | )          |
| Loans, net                                                                                                                                                          | ** ** | **11,288,883**          |           | 10,079,431             |       | 9,852,873               |       |
| Bank premises and equipment, less accumulated depreciation of $147,395  (2005), $142,384 (December 2004) and $159,477 (September 2004)                              | ** ** | **146,615**             |           | 139,946                |       | 140,411                 |       |
| Other real estate owned, net                                                                                                                                        | ** ** | **777**                 |           | 212                    |       | 388                     |       |
| Goodwill                                                                                                                                                            | ** ** | **670,306**             |           | 507,791                |       | 507,791                 |       |
| Other intangible assets, net                                                                                                                                        | ** ** | **47,485**              |           | 48,226                 |       | 50,391                  |       |
| Other assets                                                                                                                                                        | ** ** | **580,138**             |           | 465,080                |       | 442,539                 |       |
| Total assets                                                                                                                                                        | ** ** | **$**                   | **16,403,454** |                   | $          | 14,425,690              |       | $ | 14,303,019 |   |
|                                                                                                                                                                |       |                    |           |                   |       |                    |       |
| **LIABILITIES**                                                                                                                                                     |       |                    |           |                   |       |                    |       |
| Deposits:                                                                                                                                                           |       |                    |           |                   |       |                    |       |
| Noninterest-bearing deposits                                                                                                                                        | ** ** | **$**                   | **3,329,331**  |                   | $          | 3,049,031               |       | $ | 3,167,398 |   |
| Interest-bearing deposits                                                                                                                                           | ** ** | **8,710,575**           |           | 7,750,168              |       | 7,554,685               |       |
| Total deposits                                                                                                                                                      | ** ** | **12,039,906**          |           | 10,799,199             |       | 10,722,083              |       |
| Short-term borrowings                                                                                                                                               | ** ** | **1,266,672**           |           | 887,857                |       | 923,447                 |       |
| Accrued expenses and other liabilities                                                                                                                              | ** ** | **165,398**             |           | 129,996                |       | 127,534                 |       |
| Long-term debt                                                                                                                                                      | ** ** | **780,087**             |           | 690,955                |       | 642,510                 |       |
| Total liabilities                                                                                                                                                   | ** ** | **14,252,063**          |           | 12,508,007             |       | 12,415,574              |       |
|                                                                                                                                                                |       |                    |           |                   |       |                    |       |
| **COMMITMENTS and CONTINGENCIES**                                                                                                                                   |       |                    |           |                   |       |                    |       |
|                                                                                                                                                                |       |                    |           |                   |       |                    |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                       |       |                    |           |                   |       |                    |       |
| Preferred stock, no par value; authorized 2,000,000 shares; issued and  outstanding - None                                                                          |       |                    |           |                   |       |                    |       |
| Common stock, $2 par value; authorized 130,000,000 shares; issued and  outstanding - 82,078,721 (2005), 79,300,506 (December 2004) and 79,152,310 (September  2004) | ** ** | **164,157**             |           | 158,601                |       | 158,305                 |       |
| Capital surplus                                                                                                                                                     | ** ** | **669,185**             |           | 530,705                |       | 525,011                 |       |
| Retained earnings                                                                                                                                                   | ** ** | **1,343,076**           |           | 1,231,102              |       | 1,198,039               |       |
| Accumulated other comprehensive (loss) income                                                                                                                       | ** ** | **(25,027**             | **)**          | (2,725                 | )          | 6,090                   |       |
| Total shareholders’ equity                                                                                                                                     | ** ** | **2,151,391**           |           | 1,917,683              |       | 1,887,445               |       |
| Total liabilities and shareholders’ equity                                                                                                                     | ** ** | **$**                   | **16,403,454** |                   | $          | 14,425,690              |       | $ | 14,303,019 |   |

 

See notes to consolidated financial statements

 

3

----

 

**MERCANTILE BANKSHARES CORPORATION**

**STATEMENTS OF CONSOLIDATED INCOME**

 
| ** **                                              | ** ** | **For the 9 months  ended September 30,** | ** **  | **For the 3 months  ended September 30,** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------|-------------|-------------------------------------------|------------|
| **(Dollars  in thousands, except per share data)**      | ** ** | **2005**                                  | ** **  | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| **INTEREST INCOME**                                     |       |                                      |        |                                      |       |   |   |   |   |
| Interest and fees on loans                              | ** ** | **$**                                     | **508,135** |                                      | $          | 399,417 | ** ** | **$** | **185,714** |   | $ | 138,117 |   |
| Interest and dividends on  investment securities:       |       |                                      |        |                                      |       |   |   |   |   |
| Taxable interest income                                 | ** ** | **77,052**                                |        | 79,614                                    | ** ** | **26,686** |   | 26,048 |   |
| Tax-exempt interest income                              | ** ** | **2,348**                                 |        | 2,500                                     | ** ** | **839** |   | 803 |   |
| Other investment income                                 | ** ** | **1,753**                                 |        | 1,157                                     | ** ** | **526** |   | 472 |   |
| Total interest and dividends on investment securities   | ** ** | **81,153**                                |        | 83,271                                    | ** ** | **28,051** |   | 27,323 |   |
| Other interest income                                   | ** ** | **1,546**                                 |        | 1,089                                     | ** ** | **760** |   | 449 |   |
| Total interest income                                   | ** ** | **590,834**                               |        | 483,777                                   | ** ** | **214,525** |   | 165,889 |   |
| **INTEREST EXPENSE**                                    |       |                                      |        |                                      |       |   |   |   |   |
| Interest on deposits                                    | ** ** | **95,280**                                |        | 60,782                                    | ** ** | **38,591** |   | 20,142 |   |
| Interest on short-term  borrowings                      | ** ** | **17,228**                                |        | 4,889                                     | ** ** | **7,702** |   | 1,990 |   |
| Interest on long-term debt                              | ** ** | **23,634**                                |        | 16,035                                    | ** ** | **8,990** |   | 5,575 |   |
| Total interest expense                                  | ** ** | **136,142**                               |        | 81,706                                    | ** ** | **55,283** |   | 27,707 |   |
| **NET INTEREST INCOME**                                 | ** ** | **454,692**                               |        | 402,071                                   | ** ** | **159,242** |   | 138,182 |   |
| Provision for loan losses                               | ** ** | **1,576**                                 |        | 7,221                                     | ** ** | **820** |   | 2,442 |   |
| **NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES** | ** ** | **453,116**                               |        | 394,850                                   | ** ** | **158,422** |   | 135,740 |   |
| **NONINTEREST INCOME**                                  |       |                                      |        |                                      |       |   |   |   |   |
| Investment and wealth  management                       | ** ** | **71,505**                                |        | 67,315                                    | ** ** | **23,668** |   | 22,396 |   |
| Service charges on deposit  accounts                    | ** ** | **32,992**                                |        | 32,951                                    | ** ** | **11,478** |   | 11,278 |   |
| Mortgage banking-related fees                           | ** ** | **10,329**                                |        | 8,296                                     | ** ** | **5,151** |   | 3,063 |   |
| Investment securities gains  and (losses)               | ** ** | **458**                                   |        | 534                                       | ** ** | **(32** | **)** | (1 | ) |
| Nonmarketable investments                               | ** ** | **13,683**                                |        | 7,421                                     | ** ** | **4,190** |   | 2,767 |   |
| Other income                                            | ** ** | **52,042**                                |        | 41,684                                    | ** ** | **18,619** |   | 14,418 |   |
| Total noninterest income                                | ** ** | **181,009**                               |        | 158,201                                   | ** ** | **63,074** |   | 53,921 |   |
| **NONINTEREST EXPENSES**                                |       |                                      |        |                                      |       |   |   |   |   |
| Salaries                                                | ** ** | **148,482**                               |        | 138,173                                   | ** ** | **51,748** |   | 48,696 |   |
| Employee benefits                                       | ** ** | **35,490**                                |        | 33,998                                    | ** ** | **11,637** |   | 10,557 |   |
| Net occupancy expense of bank  premises                 | ** ** | **20,918**                                |        | 18,007                                    | ** ** | **7,139** |   | 6,128 |   |
| Furniture and equipment  expenses                       | ** ** | **23,168**                                |        | 22,873                                    | ** ** | **7,965** |   | 7,936 |   |
| Communications and supplies                             | ** ** | **11,992**                                |        | 12,610                                    | ** ** | **3,933** |   | 4,111 |   |
| Other expenses                                          | ** ** | **72,398**                                |        | 60,309                                    | ** ** | **25,960** |   | 21,789 |   |
| Total noninterest expenses                              | ** ** | **312,448**                               |        | 285,970                                   | ** ** | **108,382** |   | 99,217 |   |
| Income before income taxes                              | ** ** | **321,677**                               |        | 267,081                                   | ** ** | **113,114** |   | 90,444 |   |
| Applicable income taxes                                 | ** ** | **120,221**                               |        | 98,286                                    | ** ** | **42,158** |   | 33,659 |   |
| **NET INCOME**                                          | ** ** | **$**                                     | **201,456** |                                      | $          | 168,795 | ** ** | **$** | **70,956** |   | $ | 56,785 |   |
| **NET INCOME PER SHARE OF COMMON STOCK:**               |       |                                      |        |                                      |       |   |   |   |   |
| Basic                                                   | ** ** | **$**                                     | **2.50**    |                                      | $          | 2.13 | ** ** | **$** | **0.87** |   | $ | 0.72 |   |
| Diluted                                                 | ** ** | **$**                                     | **2.48**    |                                      | $          | 2.11 | ** ** | **$** | **0.86** |   | $ | 0.71 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                     | ** ** | **$**                                     | **1.11**    |                                      | $          | 1.03 | ** ** | **$** | **0.38** |   | $ | 0.35 |   |

 

See notes to consolidated financial statements

 

4

----

 

**MERCANTILE BANKSHARES CORPORATION**

**STATEMENTS OF CHANGES INCONSOLIDATED SHAREHOLDERS’ EQUITY**

 

**For the 9 months ended September30, 2005 and 2004**

 
| ** **                                                                                            | ** ** | ** ** | ** **    | ** ** | ** ** | ** **  | ** ** | ** **   | ** **  | **Accumulated Other** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|------------|---------------|------------|------------|-------------|------------|--------------|-------------|-----------------------|------------|
| ** **                                                                                            | ** ** | ** ** | ** **    | **Common** | ** ** | **Capital** | ** ** | **Retained** | ** **  | **Comprehensive**     | ** ** |
| **(Dollars  in thousands, except per share data)**                                                    | ** ** | **Total**  | ** **    | **Stock**  | ** ** | **Surplus** | ** ** | **Earnings** | ** **  | **Income (Loss)**     | ** ** |
| BALANCE, DECEMBER 31, 2003                                                                            |       | $          | 1,841,441     |       | $          | 159,545     |       | $            | 548,664     |                  | $          | 1,110,748 |   | $ | 22,484 |   |
|                                                                                                  |       |       |          |       |       |        |       |         |        |                  |       |
| Net income                                                                                            |       | 168,795    |          |       |       |        |       | 168,795      |        |                  |       |
| Unrealized losses on securities available-for-sale, net of  reclassification adjustment, net of taxes |       | (16,394    | )             |       |       |        |       |         |        | (16,394               | )          |
| Comprehensive income                                                                                  |       | 152,401    |          |       |       |        |       |         |        |                  |       |
| Cash dividends paid:                                                                                  |       |       |          |       |       |        |       |         |        |                  |       |
| Common stock ($1.03 per share)                                                                        |       | (81,601    | )             |       |       |        |       | (81,601      | )           |                  |       |
| Issuance of 91,006 shares for dividend reinvestment and stock purchase  plan                          |       | 3,981      |          | 182        |       | 3,799       |       |         |        |                  |       |
| Issuance of 18,418 shares for employee stock purchase dividend  reinvestment plan                     |       | 822        |          | 37         |       | 785         |       |         |        |                  |       |
| Issuance of 244,698 shares for employee stock option plan                                             |       | 4,434      |          | 490        |       | 3,944       |       |         |        |                  |       |
| Directors’ deferred compensation plan:                                                           |       |       |          |       |       |        |       |         |        |                  |       |
| Transfer opening balance                                                                              |       | 6,406      |          |       |       | 6,406       |       |         |        |                  |       |
| Contribution                                                                                          |       | 404        |          |       |       | 404         |       |         |        |                  |       |
| Dividend                                                                                              |       | —     |          |       |       | 109         |       | (109         | )           |                  |       |
| Restricted stock awards:                                                                              |       |       |          |       |       |        |       |         |        |                  |       |
| Issuance of 25,483 shares                                                                             |       | 1,169      |          | 51         |       | 1,118       |       |         |        |                  |       |
| Deferred compensation                                                                                 |       | (1,385     | )             |       |       |        |       | (1,385       | )           |                  |       |
| Amortization                                                                                          |       | 1,591      |          |       |       |        |       | 1,591        |        |                  |       |
| Purchase of 1,000,000 shares under stock repurchase plan                                              |       | (44,110    | )             | (2,000     | )          | (42,110     | )          |         |        |                  |       |
| Vested stock options                                                                                  |       | 1,892      |          | —     |       | 1,892       |       | —       |        | —                |       |
| BALANCE, SEPTEMBER 30, 2004                                                                           |       | $          | 1,887,445     |       | $          | 158,305     |       | $            | 525,011     |                  | $          | 1,198,039 |   | $ | 6,090 |   |
|                                                                                                  |       |       |          |       |       |        |       |         |        |                  |       |   |   |   |   |   |
| BALANCE, DECEMBER 31, 2004                                                                            |       | $          | 1,917,683     |       | $          | 158,601     |       | $            | 530,705     |                  | $          | 1,231,102 |   | $ | (2,725 | ) |
|                                                                                                  |       |       |          |       |       |        |       |         |        |                  |       |
| Net income                                                                                            |       | 201,456    |          |       |       |        |       | 201,456      |        |                  |       |
| Unrealized losses on securities available-for-sale, net of  reclassification adjustment, net of taxes |       | (22,302    | )             |       |       |        |       |         |        | (22,302               | )          |
| Comprehensive income                                                                                  |       | 179,154    |          |       |       |        |       |         |        |                  |       |
| Cash dividends paid:                                                                                  |       |       |          |       |       |        |       |         |        |                  |       |
| Common stock ($1.11 per share)                                                                        |       | (89,017    | )             |       |       |        |       | (89,017      | )           |                  |       |
| Issuance of 2,444,408 shares for bank acquisition                                                     |       | 124,335    |          | 4,889      |       | 119,446     |       |         |        |                  |       |
| Fair value of 138,764 converted options related to employee stock  option plan of acquired bank       |       | 5,182      |          |       |       | 5,182       |       |         |        |                  |       |
| Issuance of 82,444 shares for dividend reinvestment and stock purchase  plan                          |       | 4,098      |          | 165        |       | 3,933       |       |         |        |                  |       |
| Issuance of 17,550 shares for employee stock purchase dividend  reinvestment plan                     |       | 873        |          | 35         |       | 838         |       |         |        |                  |       |
| Issuance of 181,808 shares for employee stock option plan                                             |       | 3,664      |          | 364        |       | 3,300       |       |         |        |                  |       |
| Directors’ deferred compensation plan:                                                           |       |       |          |       |       |        |       |         |        |                  |       |
| Issuance of 10,182 shares                                                                             |       | 439        |          | 19         |       | 420         |       |         |        |                  |       |
| Contribution                                                                                          |       | 520        |          |       |       | 520         |       |         |        |                  |       |
| Dividend                                                                                              |       | —     |          |       |       | 195         |       | (195         | )           |                  |       |
| Restricted stock awards:                                                                              |       |       |          |       |       |        |       |         |        |                  |       |
| Issuance of 41,823 shares                                                                             |       | 2,211      |          | 84         |       | 2,127       |       |         |        |                  |       |
| Deferred compensation                                                                                 |       | (2,242     | )             |       |       |        |       | (2,242       | )           |                  |       |
| Amortization                                                                                          |       | 1,972      |          |       |       |        |       | 1,972        |        |                  |       |
| Vested stock options                                                                                  |       | 2,519      |          | —     |       | 2,519       |       | —       |        | —                |       |
| **BALANCE, SEPTEMBER 30, 2005**                                                                       | ** ** | **$**      | **2,151,391** | ** ** | **$**      | **164,157** | ** ** | **$**        | **669,185** | ** **            | **$**      | **1,343,076** | ** ** | **$** | **(25,027** | **)** |

 

See notes to consolidated financial statements

 

5

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**MERCANTILE BANKSHARES CORPORATION**

#### **STATEMENTSOF CONSOLIDATED CASH FLOW**

 
| **Increase  (decrease) in cash and cash equivalents**                              | ** ** | **For the 9 months ended  September 30,** | ** **  |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|-------------|
| **(Dollars  in thousands)**                                                        | ** ** | **2005**                                  | ** **  | **2004** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                          |       |                                      |        |   |   |
| Net income                                                                         | ** ** | **$**                                     | **201,456** |   | $ | 168,795 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                                      |        |   |   |
| Provision for loan losses                                                          | ** ** | **1,576**                                 |        | 7,221 |   |
| Depreciation                                                                       | ** ** | **11,581**                                |        | 11,732 |   |
| Amortization of other intangible assets                                            | ** ** | **6,482**                                 |        | 6,132 |   |
| Write-downs of other real estate owned                                             | ** ** | **1**                                     |        | 14 |   |
| Gains on sales of other real estate owned                                          | ** ** | **(153**                                  | **)**       | (119 | ) |
| Gains on sales of investments securities                                           | ** ** | **(458**                                  | **)**       | (534 | ) |
| Gains on sales of premises                                                         | ** ** | **(4,341**                                | **)**       | (1,620 | ) |
| Loans held-for-sale                                                                | ** ** | **(31,307**                               | **)**       | (1,059 | ) |
| Net (increase) decrease in assets:                                                 |       |                                      |        |   |   |
| Interest receivable                                                                | ** ** | **(9,332**                                | **)**       | (3,049 | ) |
| Nonmarketable investments                                                          | ** ** | **11,912**                                |        | (4,367 | ) |
| Other assets                                                                       | ** ** | **(80**                                   | **)**       | 4,690 |   |
| Net increase (decrease) in liabilities:                                            |       |                                      |        |   |   |
| Interest payable                                                                   | ** ** | **13,710**                                |        | 5,031 |   |
| Other liabilities                                                                  | ** ** | **(10,811**                               | **)**       | (1,000 | ) |
| Net cash provided by operating activities                                          | ** ** | **190,236**                               |        | 191,867 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                          |       |                                      |        |   |   |
| Proceeds from maturities of investment securities held-to-maturity                 | ** ** | **3,372**                                 |        | 8,199 |   |
| Proceeds from maturities of investment securities available-for-sale               | ** ** | **655,641**                               |        | 727,003 |   |
| Proceeds from sales of investment securities available-for-sale                    | ** ** | **121,207**                               |        | 47,182 |   |
| Purchases of investment securities held-to-maturity                                | ** ** | **—**                                |        | (8,441 | ) |
| Purchases of investment securities available-for-sale                              | ** ** | **(782,084**                              | **)**       | (707,120 | ) |
| Net increase in customer loans                                                     | ** ** | **(551,290**                              | **)**       | (745,923 | ) |
| Proceeds from sales of other real estate owned                                     | ** ** | **273**                                   |        | 181 |   |
| Capital expenditures                                                               | ** ** | **(12,878**                               | **)**       | (9,021 | ) |
| Proceeds from sales of premises                                                    | ** ** | **7,981**                                 |        | 3,813 |   |
| Business acquisitions (net of cash received)                                       | ** ** | **(78,655**                               | **)**       | — |   |
| Purchase of nonmarketable investments                                              | ** ** | **(57,105**                               | **)**       | (5,119 | ) |
| Net cash used in investing activities                                              | ** ** | **(693,538**                              | **)**       | (689,246 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                          |       |                                      |        |   |   |
| Net increase in noninterest-bearing deposits                                       | ** ** | **172,450**                               |        | 416,677 |   |
| Net increase in interest-bearing deposits                                          | ** ** | **442,943**                               |        | 42,853 |   |
| Net increase in short-term borrowings                                              | ** ** | **369,109**                               |        | 114,426 |   |
| Repayment of long-term debt                                                        | ** ** | **(84,659**                               | **)**       | (7,745 | ) |
| Proceeds from issuance of shares                                                   | ** ** | **8,635**                                 |        | 9,237 |   |
| Repurchase of common shares                                                        | ** ** | **—**                                |        | (44,110 | ) |
| Dividends paid                                                                     | ** ** | **(89,017**                               | **)**       | (81,601 | ) |
| Net cash provided by financing activities                                          | ** ** | **819,461**                               |        | 449,737 |   |
| Net increase in cash and cash equivalents                                          | ** ** | **316,159**                               |        | (47,642 | ) |
| Cash and cash equivalents at beginning of period                                   | ** ** | **245,134**                               |        | 362,701 |   |
| Cash and cash equivalents at end of period                                         | ** ** | **$**                                     | **561,293** |   | $ | 315,059 |   |
| **SUPPLEMENTAL INFORMATION**                                                       |       |                                      |        |   |   |
| Cash payments for interest                                                         | ** ** | **$**                                     | **121,081** |   | $ | 76,651 |   |
| Cash payments for income taxes                                                     | ** ** | **133,745**                               |        | 100,098 |   |

 

See notes to consolidated financial statements

 

6

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**MERCANTILE BANKSHARES CORPORATION**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

1. Basis of Presentation

 

The consolidated financial statements, which includethe accounts of Mercantile Bankshares Corporation (“Bankshares”) (Nasdaq: MRBK)and all of its affiliates, are prepared in conformity with accountingprinciples generally accepted in the United States of America and followgeneral practice within the banking industry. In the opinion of management, the consolidated financial statementsinclude all adjustments necessary for a fair presentation of the interimperiod.  These adjustments are of anormal nature and include adjustments to eliminate all significant intercompanytransactions.  In view of the changingconditions in the national economy, the effect of actions taken by regulatoryauthorities and normal seasonal factors, the results for the interim period arenot necessarily indicative of annual performance.  For comparability, certain prior periodamounts have been reclassified to conform with current period presentation.

 

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and contingent assets and liabilities in thefinancial statements, and the disclosure of revenue and expenses during thereporting period.  These assumptions arebased on information available as of the date of the financial statements andcould differ from actual results.  SeeAnnual Report on Form 10-K for more detail.

 

2. Business Combinations / Restructuring

 

The following provides information concerningacquisitions and restructuring. Acquisitions are accounted for as purchaseswith the results of their operations subsequent to the acquisition dateincluded in Bankshares’ Statements of Consolidated Income.

 

On May 18, 2005, Bankshares completed its acquisitionof Community Bank of Northern Virginia (“CBNV”), a bank headquartered inSterling, Virginia, which was merged into Mercantile-Safe Deposit & TrustCompany.  CBNV operated fourteen branchoffices in the Northern Virginia metropolitan market at the time of theacquisition. The primary reason for the merger with CBNV was to expandBankshares’ distribution network in Northern Virginia, a higher growth market.The total consideration paid to CBNV shareholders in connection with theacquisition was $82.9 million in cash and 2.4 million shares of Bankshares’common stock.  CBNV transactions havebeen included in Bankshares’ financial results subsequent to May 18, 2005.  The assets and liabilities of CBNV wererecorded on the Consolidated Balance Sheet at their respective fair values. Thefair values have been determined as of May 18, 2005 and are subject torefinement, as further information becomes available. The transaction resultedin total assets acquired as of May 18, 2005 of $888.2 million, including $671.0 million of loans and leases;liabilities assumed were $842.3 million, including $626.9 million of deposits.Additionally, Bankshares recorded $162.5 million of goodwill and $4.6 millionof core deposit intangible (“CDI”).  CDIare subject to amortization and are being amortized over nine years on astraight-line basis.

 

Bankshares’ exit costs, referred to herein as “merger-related”costs, are defined to include those costs for its branch closings and relatedseverance, combining operations such as systems conversions, and printing/mailingcosts incurred by Bankshares prior to and after the merger date and areincluded in Bankshares’ results of operations. Bankshares expensed merger-related costs totaling $743 thousand and $1.1million for the three and nine-month periods ended September 30, 2005,respectively. The costs associated with these activities are included innoninterest expenses. Merger-related expenses incurred year to date consistedlargely of expenses for systems conversion costs. Bankshares will incuradditional merger-related expenses in the fourth quarter as systemsconversions, branch closings and integration of operations continue and theseexpenses will be reflected when incurred. Prior to the merger, CBNV recordedexit costs of $9.7 million relating to severance, system conversions, branchconsolidations and costs associated with terminating contracts. At September30, 2005, $810 thousand remained unpaid, which was primarily made up ofseverance and contract write-offs.

 

In the second quarter of 2005, Bankshares consolidatedFidelity Bank into Farmers & Mechanics Bank. The consolidation of thesebanks allows the surviving bank to serve its local customers with greater scaleand expertise. Also, in the second quarter of 2005, Mercantile Potomac Bankmerged into Mercantile-Safe Deposit and Trust Company. This combination allowsBankshares to provide the resources necessary for greater expansion into theWashington, D.C. and Northern Virginia markets.

 

7

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3. Earnings Per Share

 

Basic earnings per share (“EPS”) is computed bydividing income available to common shareholders by weighted average commonshares outstanding.  Diluted EPS iscomputed using the same components as basic EPS with the denominator adjustedfor the dilutive effect of stock awards. The following tables provide reconciliation between the computation ofbasic EPS and diluted EPS for the nine months and quarters ended September 30,2005 and 2004, respectively.

 
| ** **                                  | ** ** | **For the 9 months ended September 30,** | ** **  |
|---------------------------------------------|------------|------------------------------------------|-------------|
| ** **                                  | ** ** | **2005**                                 | ** **  | **2004** | ** ** |
| ** **                                  | ** ** | **Net**                                  | ** **  | **Weighted Average** | ** ** | ** ** | ** ** | **Net** | ** ** | **Weighted Average** | ** ** | ** ** | ** ** |
| **(In thousands, except per share  data)**  | ** ** | **Income**                               | ** **  | **Common Shares** | ** ** | **EPS** | ** ** | **Income** | ** ** | **Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                   | ** ** | **$**                                    | **201,456** | ** ** | **80,545** | ** ** | **$** | **2.50** |   | $ | 168,795 |   | 79,269 |   | $ | 2.13 |   |
| Dilutive effect of:                         |       |                                     |        |   |   |   |   |   |   |   |   |   |   |
| Stock options and restricted stock awards   | ** ** | ** **                               |        | **499** |   |   |   |   |   | 489 |   |   |   |
| Directors deferred compensation plan shares | ** ** | ** **                               |        | **172** |   |   |   |   |   | 101 |   |   |   |
| Diluted EPS                                 | ** ** | **$**                                    | **201,456** | ** ** | **81,216** | ** ** | **$** | **2.48** |   | $ | 168,795 |   | 79,859 |   | $ | 2.11 |   |
|                                        |       |                                     |        |   |   |   |   |   |   |   |   |   |   |
| ** **                                  | ** ** | **For the 3 months ended September 30,** | ** **  |
| ** **                                  | ** ** | **2005**                                 | ** **  | **2004** | ** ** |
| ** **                                  | ** ** | **Net**                                  | ** **  | **Weighted Average** | ** ** | ** ** | ** ** | **Net** | ** ** | **Weighted Average** | ** ** | ** ** | ** ** |
| **(In thousands, except per share  data)**  | ** ** | **Income**                               | ** **  | **Common Shares** | ** ** | **EPS** | ** ** | **Income** | ** ** | **Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                   | ** ** | **$**                                    | **70,956**  | ** ** | **81,865** | ** ** | **$** | **0.87** |   | $ | 56,785 |   | 78,965 |   | $ | 0.72 |   |
| Dilutive effect of:                         |       |                                     |        |   |   |   |   |   |   |   |   |   |   |
| Stock options and restricted stock awards   | ** ** | ** **                               |        | **594** |   |   |   |   |   | 491 |   |   |   |
| Directors deferred compensation plan shares | ** ** | ** **                               |        | **176** |   |   |   |   |   | 155 |   |   |   |
| Diluted EPS                                 | ** ** | **$**                                    | **70,956**  | ** ** | **82,635** | ** ** | **$** | **0.86** |   | $ | 56,785 |   | 79,611 |   | $ | 0.71 |   |

 

There were no antidilutive options and awards excluded from thecomputation of diluted earnings per share for the nine months or the threemonths ended September 30,2005. Antidilutive options and awards excluded fromthe computation of diluted earnings per share were 526,465 for the nine monthsended September 30, 2004 and 57,388 for the third quarter of 2004.

 

4. Investment Securities

 

At September 30, 2005 and December 31, 2004,securities with an amortized cost of $1.3 billion and $1.1 billion,respectively, were pledged as collateral for certain deposits as required byregulatory guidelines. The following table shows amortized cost and fair valueof investment securities at September 30, 2005 and December 31, 2004.

 
| ** **                               | ** ** | **September 30, 2005** | ** **    | **December 31, 2004** | ** ** |
|------------------------------------------|------------|------------------------|---------------|-----------------------|------------|
| ** **                               | ** ** | ** **             | ** **    | **Gross**             | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **Amortized**          | ** **    | **Unrealized**        | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **(Dollars in thousands)**               | ** ** | **Cost**               | ** **    | **Gains**             | ** ** | **Losses** | ** ** | **Value** | ** ** | **Cost** | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| Investment securities held-to-maturity   |       |                   |          |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| States and political subdivisions        | ** ** | **$**                  | **16,804**    | ** **            | **$**      | **593** | ** ** | **$** | **17** | ** ** | **$** | **17,380** |   | $ | 20,176 |   | $ | 921 |   | $ | 3 |   | $ | 21,094 |   |
|                                     |       |                   |          |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment securities available-for-sale |       |                   |          |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury                            | ** ** | **$**                  | **449,820**   | ** **            | **$**      | **160** | ** ** | **$** | **2,869** | ** ** | **$** | **447,111** |   | $ | 605,505 |   | $ | 4,534 |   | $ | 980 |   | $ | 609,059 |   |
| U.S. Government agencies                 | ** ** | **983,701**            | ** **    | **449**               | ** ** | **11,860** | ** ** | **972,290** |   | 853,930 |   | 3,742 |   | 4,699 |   | 852,973 |   |
| Mortgage-backed securities               | ** ** | **1,518,517**          | ** **    | **971**               | ** ** | **27,869** | ** ** | **1,491,619** |   | 1,326,056 |   | 4,372 |   | 13,127 |   | 1,317,301 |   |
| States and political subdivisions        | ** ** | **75,446**             | ** **    | **461**               | ** ** | **102** | ** ** | **75,805** |   | 61,984 |   | 917 |   | 31 |   | 62,870 |   |
| Other investments                        | ** ** | **61,185**             | ** **    | **1,029**             | ** ** | **193** | ** ** | **62,021** |   | 65,323 |   | 1,294 |   | 126 |   | 66,491 |   |
| Total                                    | ** ** | **$**                  | **3,088,669** | ** **            | **$**      | **3,070** | ** ** | **$** | **42,893** | ** ** | **$** | **3,048,846** |   | $ | 2,912,798 |   | $ | 14,859 |   | $ | 18,963 |   | $ | 2,908,694 |   |

 

8

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The following table shows the unrealized gross lossesand fair value of securities in the securities available-for-sale portfolio atSeptember 30, 2005, by length of time that individual securities in eachcategory have been in a continuous loss position.

 
| ** **                         | ** ** | **Less than 12 months** | ** ** | **12 months or more** | ** ** | **Total**      | ** ** |
|------------------------------------|------------|-------------------------|------------|-----------------------|------------|----------------|------------|
| ** **                         | ** ** | **Gross**               | ** ** | ** **            | ** ** | **Gross**      | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Unrealized**          | ** ** | **Fair**              | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **(Dollars  in thousands)**        | ** ** | **Losses**              | ** ** | **Value**             | ** ** | **Losses**     | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| U.S. Treasury                      | ** ** | **$**                   | **1,862**  | ** **            | **$**      | **393,080**    | ** ** | **$** | **1,007** | ** ** | **$** | **54,031** | ** ** | **$** | **2,869** | ** ** | **$** | **447,111** | ** ** |
| U.S. Government agencies           | ** ** | **6,310**               | ** ** | **636,279**           | ** ** | **5,550**      | ** ** | **336,011** | ** ** | **11,860** | ** ** | **972,290** | ** ** |
| Mortgage-backed securities         | ** ** | **13,350**              | ** ** | **1,123,270**         | ** ** | **14,519**     | ** ** | **368,349** | ** ** | **27,869** | ** ** | **1,491,619** | ** ** |
| States and political  subdivisions | ** ** | **98**                  | ** ** | **73,777**            | ** ** | **4**          | ** ** | **2,028** | ** ** | **102** | ** ** | **75,805** | ** ** |
| Other investments                  | ** ** | **193**                 | ** ** | **62,021**            | ** ** | **—**     | ** ** | **—** | ** ** | **193** | ** ** | **62,021** | ** ** |
| Total bonds                        | ** ** | **$**                   | **21,813** | ** **            | **$**      | **2,288,427**  | ** ** | **$** | **21,080** | ** ** | **$** | **760,419** | ** ** | **$** | **42,893** | ** ** | **$** | **3,048,846** | ** ** |

 

At September 30, 2005, there were $760.4 million ofindividual securities that had unrealized losses for a period greater than 12months. At September 30, 2005, these securities had an unrealized loss of $21.1million of which 68.9% were mortgage-backed securities. Management has assessedthe impairment of these securities and determined that the impairment istemporary. All principal and interest payments on available-for-sale debtsecurities in an unrealized loss position for greater than 12 months areexpected to be collected given the high credit quality of the U.S. governmentagency debt securities and Bankshares’ ability and intent to hold thesecurities. Because the declines in fair value were due to changes in marketinterest rates, not in estimated cash flows, no other-than-temporary impairmentwas recorded at September 30, 2005.

 

5. Impaired Loans

 

When scheduled principal orinterest payments are past due 90 days or more at quarter-end on any loan, theaccrual of interest income is discontinued and subsequent receipts on theseloans are recorded as a reduction of principal, and interest income is recordedonly once principal recovery is reasonably assured. Previously accrued butuncollected interest on these loans is charged against interest income.Generally, a loan may be restored to accruing status when all past dueprincipal, interest and late charges have been paid and the bank expectsrepayment of the remaining contractual principal and interest on a timely basis.

 

Under Statements of FinancialAccounting Standards (SFAS) Nos. 114 and 118, “Accounting by Creditors forImpairment of a Loan-an amendment of FASB Statements Nos. 5 and 15,” a loan isconsidered impaired, based on current information and events, if it is probablethat Bankshares will not collect all principal and interest payments accordingto the contractual terms of the loan agreement. The impairment of a loan ismeasured based on the present value of expected future cash flows discounted atthe loan’s effective interest rate, or the fair value of the collateral if therepayment is expected to be provided predominantly by the underlyingcollateral. Information with respect to impaired loans and the relatedvaluation allowance (if the measure of the impaired loan is less than therecorded investment) at September 30, 2005, December 31, 2004 and September 30,2004 is shown below.  See Annual Reporton Form 10-K for more detail.

 
| ** **                                                                       | ** ** | **September 30,** | ** **  | **December 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------|-------------|------------------|------------|-------------------|------------|
| **(Dollars  in thousands)**                                                      | ** ** | **2005**          | ** **  | **2004**         | ** ** | **2004**          | ** ** |
| Impaired loans with a specific  valuation allowance                              | ** ** | **$**             | **15,579**  |             | $          | 18,365            |       | $ | 25,045 |   |
| All other impaired loans                                                         | ** ** | **9,103**         |        | 9,113            |       | 10,306            |       |
| Total impaired loans                                                             | ** ** | **$**             | **24,682**  |             | $          | 27,478            |       | $ | 35,351 |   |
|                                                                             |       |              |        |             |       |              |       |
| Specific allowance for loan  losses applicable to impaired loans                 | ** ** | **$**             | **8,671**   |             | $          | 10,611            |       | $ | 14,499 |   |
| General allowance for loan  losses applicable to other than impaired loans       | ** ** | **148,505**       |        | 138,391          |       | 146,942           |       |
| Total allowance for loan losses                                                  | ** ** | **$**             | **157,176** |             | $          | 149,002           |       | $ | 161,441 |   |
|                                                                             |       |              |        |             |       |              |       |
| Year-to-date interest income on impaired loans recorded on the cash  basis       | ** ** | **$**             | **114**     |             | $          | 379               |       | $ | 300 |   |
| Year-to-date average recorded investment in impaired loans during the  period    | ** ** | **$**             | **27,332**  |             | $          | 39,025            |       | $ | 40,172 |   |
| Quarter-to-date interest income on impaired loans recorded on the cash  basis    | ** ** | **$**             | **61**      |             | $          | 79                |       | $ | 88 |   |
| Quarter-to-date average recorded investment in impaired loans during  the period | ** ** | **$**             | **26,223**  |             | $          | 35,583            |       | $ | 38,285 |   |

 

9

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**Note:** Impaired loans do notinclude large groups of smaller balance homogeneous loans that are evaluatedcollectively 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.

 

On May 18, 2005, Bankshares acquired approximately$671.0 million in loans as part of the CBNV acquisition. At acquisition, CBNVhad $7.4 million in an allowance for loan losses of which $7.1 million was carriedover to Bankshares in accordance with SFAS No. 141, “Business Combinations,”for those loans that do not fall within the scope of the American Institute ofCertified Public Accountants issued Statement of Position (“SOP”) 03-3, “Accountingfor Certain Loans or Debt Securities Acquired in a Transfer.” Under SOP 03-3,Bankshares determined that certain loans acquired in the CBNV acquisitiondisplayed evidence of deterioration of credit quality since their originationfor which it was probable that all contractual payments would not be collected.Bankshares determined two commercial real estate loans totaling $4.9 millionwere within the scope of SOP 03-3. The carrying value and accretable yields ofthese loans as of September 30, 2005 are shown below.

 
| ** **                    | ** ** | **September 30,**     | ** ** |
|-------------------------------|------------|-----------------------|------------|
| **(Dollars  in thousands)**   | ** ** | **2005**              | ** ** |
| Commercial real estate        | ** ** | **$**                 | **4,887**  | ** ** |
| Total                         | ** ** | **$**                 | **4,887**  | ** ** |
| ** **                    | ** ** | ** **            | ** ** |
| Carrying amount               | ** ** | **$**                 | **3,509**  | ** ** |
| ** **                    | ** ** | ** **            | ** ** |
| ** **                    | ** ** | **Accretable  yield** | ** ** |
| Balance at June 30, 2005      | ** ** | **$**                 | **634**    | ** ** |
| Additions                     | ** ** | **—**            | ** ** |
| Accretions                    | ** ** | **(96**               | **)**      |
| Disposals                     | ** ** | **—**            | ** ** |
| Balance at September 30, 2005 | ** ** | **$**                 | **538**    | ** ** |

 

6. Commitments & Contingencies

 

Bankshares is a party to financial instruments thatare not reflected in the balance sheet, which include commitments to extendcredit and standby letters of credit. Various commitments to extend credit(lines of credit) are made in the normal course of banking business. Letters ofcredit are issued for the benefit of customers by affiliated banks. Thesecommitments are subject to loan underwriting standards and geographicboundaries consistent with Bankshares’ loans outstanding. Bankshares’ lendingactivities are concentrated in Maryland, Delaware and Virginia.

 

Commitments to extend credit are agreements to lend toa customer as long as there is no violation of any condition established in thecontract. Commitments generally have fixed expiration dates or othertermination clauses and may require payment of a fee. Since many of thecommitments are expected to expire without being drawn upon, the totalcommitment amounts do not necessarily represent future cash requirements. Totalcommitments to extend credit were $4.6 billion at September 30, 2005, $4.2billion at December 31, 2004, and $4.1 billion at September 30, 2004.

 

Letters of credit are commitments issued to guaranteethe performance of a customer to a third party. Outstanding letters of creditwere $506.8 million at September 30, 2005, $379.8 million at December 31, 2004and $347.5 million at September 30, 2004. Fees received for issuing letters of credit are deferred and amortizedover the life of the commitment.  Theunamortized fees on letters of credit had a carrying value of $1.7 million atSeptember 30, 2005, and $1.3 million at both December 31, 2004 and September30, 2004.

 

Bankshares’ mortgage banking subsidiary is a FannieMae Delegated Underwriting and Servicing lender and has a loss sharingarrangement for loans originated on behalf of and sold to Fannie Mae.  The unamortized principal balance of theunderlying loans totaled $237.2 million, $190.7 million and $191.7 million atSeptember 30, 2005, December 31, 2004 and September 30, 2004,respectively.  A minimal loss reserve hasbeen established for potential losses on loans originated and sold in thesecondary market at September 30, 2005. The mortgage subsidiary also has originated and sold loans with recoursein the event of foreclosure on the underlying real estate.  The unamortized amount of principal balanceof loans sold with recourse totaled $1.3 million at September 30, 2005, $1.7million at December 31, 2004 and $1.8 million at September 30, 2004.  These mortgages are generally in goodstanding, are well-collateralized and no loss has ensued and no future loss isexpected.

 

Bankshares has committed to invest funds inthird-party private equity funds. At both September 30, 2005 and December 31,2004, $28.1 million remained unfunded, and at September 30, 2004, $21.9 millionremained unfunded.

 

10

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In the ordinary course of business, Bankshares and itssubsidiaries are involved in a number of pending and threatened legal actionsand proceedings. In certain of these actions and proceedings, claims forsubstantial monetary damages are asserted against Bankshares and itssubsidiaries. In view of the inherent difficulty of predicting the outcome ofsuch matters, Bankshares cannot state what the eventual outcome of pendingmatters will be. However, based on current knowledge, management does notbelieve that liabilities, if any, arising from pending litigation matters, willhave a material adverse effect on the consolidated financial position, earningsor liquidity of Bankshares. If payment associated with a claim becomes probableand the cost can be reasonably estimated, a contingent liability would beestablished based on information currently available, advice of counsel andavailable insurance coverage.

 

Between 2001 and 2003, on behalf of either individualplaintiffs or a putative class of plaintiffs, eight separate actions were filedin state and federal court against Community Bank of Northern Virginia (“CBNV”)and other defendants challenging the validity of second mortgage loans thedefendants made to the plaintiffs.  Allof the cases were either filed in or removed to the federal district court forthe Western District of Pennsylvania.  InJune 2003, the parties to the various actions informed the court that they hadreached an agreement in principle to settle the various actions.  On July 17, 2003, the court conditionallycertified a class for settlement purposes, preliminarily approved the classsettlement, and directed the issuance of notice to the class.

 

Thereafter, certain plaintiffs who had initially optedout of the proposed settlement and other objectors challenged the validity ofthe settlement in the district court. The district court denied their arguments and approved thesettlement.  These “opt out” plaintiffsand other objectors appealed the district court’s approval of the settlement tothe Third Circuit Court of Appeals.  InAugust 2005, the Third Circuit reversed the district court’s approval of thesettlement and remanded the case back to the district court with instructionsto consider and address certain specific issues when re-evaluating thesettlement. Certain individuals who were excluded from the settlement classhave filed two actions on behalf of a putative class of plaintiffs allegingclaims similar to those raised in the initial filing.  These actions recently were consolidated inthe Western District of Pennsylvania. Bankshares believes these actions are without merit and intends todefend the actions vigorously.

 

The contingency, which is estimable and probable, wasincorporated in determining the fair value of the liability assumed at theacquisition of CBNV.

 

7. Goodwill and Other Intangible Assets

 

Bankshares’ Consolidated Balance Sheet includedgoodwill of $670.3 million at September 30, 2005 and $507.8 million at December31, 2004. In 2005, Bankshares recorded $162.5 million in goodwill and $4.6million in estimated core deposit intangible in connection with the CBNVacquisition, which was allocated to Bankshares’ banking segment. The coredeposit intangible from CBNV is being amortized over a weighted averageremaining useful life of nine years on a straight line basis.

 

The following table discloses the gross carryingamount and accumulated amortization of intangible assets subject toamortization at September 30, 2005 and December 31, 2004.

 
| ** **                  | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|-----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **Gross Carrying**     | ** ** | **Accumulated**       | ** ** | **Net** | ** ** | **Gross Carrying** | ** ** | **Accumulated** | ** ** | **Net** | ** ** |
| **(Dollars  in thousands)** | ** ** | **Amount**             | ** ** | **Amortization**      | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **Amount** | ** ** |
| Core deposits               | ** ** | **$**                  | **54,509** | ** **            | **$**      | **(19,303** | **)** | **$** | **35,206** |   | $ | 49,881 |   | $ | (15,014 | ) | $ | 34,867 |   |
| Mortgage servicing          | ** ** | **2,483**              | ** ** | **(1,253**            | **)**      | **1,230** |   | 1,370 |   | (1,013 | ) | 357 |   |
| Customer lists and other    | ** ** | **17,010**             | ** ** | **(5,961**            | **)**      | **11,049** |   | 17,010 |   | (4,008 | ) | 13,002 |   |
| Total                       | ** ** | **$**                  | **74,002** | ** **            | **$**      | **(26,517** | **)** | **$** | **47,485** |   | $ | 68,261 |   | $ | (20,035 | ) | $ | 48,226 |   |

 

Identifiable intangible assets are amortized based on estimated livesof up to 15 years.  Management reviewsother intangible assets for impairment yearly, or whenever events or changes incircumstances indicate that their carrying amounts may not be recoverable.  For those intangible assets subject toamortization, impairment is indicated if the sum of undiscounted estimatedfuture net cash flows is less than the carrying amount of the asset.  Impairment is recognized by writing down thecarrying value or adjusting the estimated life of the asset.  Any impairment recognized in a valuationaccount is reflected in the income statement in the corresponding period.

 

11

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The following table shows the current period andestimated future amortization expense for amortized intangible assets. Theprojections of amortization expense shown for mortgage servicing rights arebased on asset balances and the interest rate environment as of September 30,2005. Future amortization expense may be significantly different depending uponchanges in the mortgage servicing portfolio, mortgage interest rates and marketconditions.

 
| ** **                                        | ** ** | **Core**     | ** ** | **Mortgage**  | ** ** | **Customer Lists** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|--------------|------------|---------------|------------|--------------------|------------|------------|------------|
| **(Dollars  in thousands)**                       | ** ** | **Deposits** | ** ** | **Servicing** | ** ** | **and Other**      | ** ** | **Total**  | ** ** |
| Nine months ended September 30, 2005 (actual)     | ** ** | **$**        | **4,289**  | ** **    | **$**      | **240**            | ** ** | **$**      | **1,953**  | ** ** | **$** | **6,482** | ** ** |
| Three months ended December 31, 2005 (estimated)  |       | 1,494        |       | 68            |       | 646                |       | 2,208      |       |
| Twelve months ended December 31, 2005 (estimated) |       | 5,783        |       | 308           |       | 2,599              |       | 8,690      |       |
|                                              |       |         |       |          |       |               |       |       |       |
| Estimate for year ended December 31,              | 2006       |         | 5,974      |          | 228        |               | 2,343      |       | 8,545      |   |
|                                              | 2007       |         | 5,716      |          | 182        |               | 2,149      |       | 8,047      |   |
|                                              | 2008       |         | 4,796      |          | 163        |               | 1,968      |       | 6,927      |   |
|                                              | 2009       |         | 4,527      |          | 152        |               | 1,028      |       | 5,707      |   |
|                                                   |            |              |            |               |            |                    |            |            |            |  |  |  |  |  |

 

8. Comprehensive Income

 

The following table summarizes the market value changeand related tax effect of unrealized gains (losses) on securitiesavailable-for-sale for the nine months and quarter ended September 30, 2005 and2004.  The net amount is included inaccumulated other comprehensive income (loss) in the Statements of Changes inConsolidated Shareholders’ Equity.

 
| ** **                                                            | ** **   | **For the 9 months ended September 30,** | ** ** |
|-----------------------------------------------------------------------|--------------|------------------------------------------|------------|
| ** **                                                            | ** **   | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                                                            | ** **   | ** **                               | ** ** | **Tax** | ** ** | ** ** | ** ** | ** ** | ** ** | **Tax** | ** ** | ** ** | ** ** |
| ** **                                                            | ** **   | **Pretax**                               | ** ** | **(Expense)** | ** ** | **Net** | ** ** | **Pretax** | ** ** | **(Expense)** | ** ** | **Net** | ** ** |
| **(Dollars in thousands)**                                            | *** *** | **Amount**                               | ** ** | **Benefit** | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Benefit** | ** ** | **Amount** | ** ** |
| Net Income                                                            | ** **   | ** **                               |       |   |   | **$** | **201,456** |   |   |   |   |   | $ | 168,795 |   |
| Other comprehensive income                                            |         |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding (losses) gains arising during the period           | ** **   | **(35,258**                              | **)**      | **13,234** | ** ** | **(22,024** | **)** | (25,865 | ) | 9,794 |   | (16,071 | ) |
| Reclassification adjustment for (gains) losses included in net income | ** **   | **(458**                                 | **)**      | **180** | ** ** | **(278** | **)** | (534 | ) | 211 |   | (323 | ) |
| Total other comprehensive (losses) income                             | ** **   | **(35,716**                              | **)**      | **13,414** | ** ** | **(22,302** | **)** | (26,399 | ) | 10,005 |   | (16,394 | ) |
| Total comprehensive income                                            | ** **   | ** **                               |       |   |   | **$** | **179,154** |   |   |   |   |   | $ | 152,401 |   |
|                                                                  |         |                                     |       |   |   |   |   |   |   |   |   |   |   |
| ** **                                                            | ** **   | **For the 3 months ended September 30,** | ** ** |
| ** **                                                            | ** **   | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                                                            | ** **   | ** **                               | ** ** | **Tax** | ** ** | ** ** | ** ** | ** ** | ** ** | **Tax** | ** ** | ** ** | ** ** |
| ** **                                                            | ** **   | **Pretax**                               | ** ** | **(Expense)** | ** ** | **Net** | ** ** | **Pretax** | ** ** | **(Expense)** | ** ** | **Net** | ** ** |
| **(Dollars in thousands)**                                            | ** **   | **Amount**                               | ** ** | **Benefit** | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Benefit** | ** ** | **Amount** | ** ** |
| Net Income                                                            | ** **   | ** **                               |       |   |   | **$** | **70,956** |   |   |   |   |   | $ | 56,785 |   |
| Other comprehensive income                                            |         |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding (losses) gains arising during the period           | ** **   | **(22,781**                              | **)**      | **8,459** | ** ** | **(14,322** | **)** | 22,395 |   | (8,205 | ) | 14,190 |   |
| Reclassification adjustment for (gains) losses included in net income | ** **   | **32**                                   | ** ** | **(13** | **)** | **19** |   | 1 |   | — |   | 1 |   |
| Total other comprehensive (losses) income                             | ** **   | **(22,749**                              | **)**      | **8,446** | ** ** | **(14,303** | **)** | 22,396 |   | (8,205 | ) | 14,191 |   |
| Total comprehensive income                                            | ** **   | ** **                               |       |   |   | **$** | **56,653** |   |   |   |   |   | $ | 70,976 |   |

 

12

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9. Capital Adequacy

 

Bankshares and its bank affiliates are subject tovarious regulatory capital adequacy requirements administered by federal andstate banking agencies.  Theserequirements include maintaining certain capital ratios above minimumlevels.  These capital ratios includetier I capital and total risk-based capital as percentages of net risk-weightedassets and tier I capital as a percentage of adjusted average total assets(leverage ratio).  The minimum ratios forcapital adequacy purposes are 4.00%, 8.00% and 4.00%, for the tier I capital,total capital and leverage ratios, respectively.  To be categorized as *well capitalized,*a bank must maintain minimum ratios of 6.00%, 10.00% and 5.00%, for its tier Icapital, total capital and leverage ratios, respectively.  As of September 30, 2005, Bankshares and allof its bank affiliates exceeded all capital adequacy requirements to beconsidered well capitalized.

 

Capital ratios and the amounts used to calculate themare presented in the following table for Bankshares and Mercantile-Safe Deposit& Trust Company (MSD&T), the lead bank, as of September 30, 2005 andDecember 31, 2004. The September 30, 2005 MSD&T capital ratios reflect theimpact of the consolidation of Mercantile Potomac Bank into MSD&T and theacquisition of CBNV.

 
| ** **                    | ** ** | **September 30, 2005** | ** **    | **December 31, 2004** | ** ** |
|-------------------------------|------------|------------------------|---------------|-----------------------|------------|
| **(Dollars  in thousands)**   | ** ** | **Bankshares**         | ** **    | **MSD&T**         | ** ** | **Bankshares** | ** ** | **MSD&T** | ** ** |
|                          |       |                   |          |                  |       |   |   |   |   |
| Tier I capital                | ** ** | **$**                  | **1,466,362** |                  | $          | 484,906 |   | $ | 1,370,112 |   | $ | 411,587 |   |
| Total risk-based capital      | ** ** | **1,925,034**          |          | 598,665               |       | 1,802,520 |   | 459,812 |   |
| Net risk-weighted assets      | ** ** | **12,670,868**         |          | 5,712,306             |       | 11,109,137 |   | 3,847,161 |   |
| Adjusted average total assets | ** ** | **15,278,974**         |          | 6,747,264             |       | 13,674,386 |   | 4,504,451 |   |
|                          |       |                   |          |                  |       |   |   |   |   |
| Tier I capital ratio          | ** ** | **11.57**              | **%**         | 8.49                  | %          | 12.33 | % | 10.70 | % |
| Total capital ratio           | ** ** | **15.19**              | **%**         | 10.48                 | %          | 16.23 | % | 11.95 | % |
| Leverage ratio                | ** ** | **9.60**               | **%**         | 7.19                  | %          | 10.02 | % | 9.14 | % |
|                               |            |                        |               |                       |            |  |  |  |  |  |  |  |  |

 

Bankshares has an ongoing sharerepurchase program.  Purchases may bemade from time to time, subject to regulatory requirements, in open market orin privately negotiated transactions. Purchased shares are retired. AtSeptember 30, 2005, there were 476,327 shares remaining available forrepurchase under the plan.

 

10. Segment Reporting

 

Operating segments as defined by SFAS No. 131, *Disclosuresabout Segments of an Enterprise and Related Information*, arecomponents of an enterprise with separate financial information.  The component engages in business activitiesfrom which it derives revenues and incurs expenses and the operating results ofwhich management relies on for decision-making and performance assessment.Bankshares has two reportable segments – Banking and Investment and WealthManagement  (“IWM”).

 

The following tables present selected segment information for the threeand nine months ended September 30, 2005 and 2004. The components in the “Other”column consist of amounts for the nonbank affiliates, unallocated corporateexpenses including income taxes and intercompany eliminations. Certain expenseamounts such as operations overhead have been reclassified in order to providefor full cost absorption. These reclassifications are shown on the “Adjustments”line.  Results of the CBNV acquisitionhave been included in the “Banking” column from its acquisition date in thesecond quarter of 2005.

 
| ** **                         | ** ** | **For the 9 months ended September 30, 2005** | ** **     | **For the 9 months ended September 30, 2004** | ** ** |
|------------------------------------|------------|-----------------------------------------------|----------------|-----------------------------------------------|------------|
| **(Dollars in thousands)**         | ** ** | **Banking**                                   | ** **     | **IWM**                                       | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income                | ** ** | **$**                                         | **455,013**    | ** **                                    | **$**      | **—** | ** ** | **$** | **(321** | **)** | **$** | **454,692** |   | $ | 401,781 |   | $ | — |   | $ | 290 |   | $ | 402,071 |   |
| Provision for loan losses          | ** ** | **(1,576**                                    | **)**          | **—**                                    | ** ** | **—** | ** ** | **(1,576** | **)** | (7,221 | ) | — |   | — |   | (7,221 | ) |
| Noninterest income                 | ** ** | **98,733**                                    | ** **     | **71,635**                                    | ** ** | **10,641** | ** ** | **181,009** |   | 85,650 |   | 67,548 |   | 5,003 |   | 158,201 |   |
| Noninterest expenses               | ** ** | **(254,629**                                  | **)**          | **(52,784**                                   | **)**      | **(5,035** | **)** | **(312,448** | **)** | (233,583 | ) | (50,748 | ) | (1,639 | ) | (285,970 | ) |
| Adjustments                        | ** ** | **14,261**                                    | ** **     | **(2,598**                                    | **)**      | **(11,663** | **)** | **—** |   | 14,251 |   | (3,070 | ) | (11,181 | ) | — |   |
| Income (loss) before income  taxes | ** ** | **311,802**                                   | ** **     | **16,253**                                    | ** ** | **(6,378** | **)** | **321,677** |   | 260,878 |   | 13,730 |   | (7,527 | ) | 267,081 |   |
| Income tax (expense) benefit       | ** ** | **(108,707**                                  | **)**          | **(6,501**                                    | **)**      | **(5,013** | **)** | **(120,221** | **)** | (90,979 | ) | (5,492 | ) | (1,815 | ) | (98,286 | ) |
| Net income (loss)                  | ** ** | **$**                                         | **203,095**    | ** **                                    | **$**      | **9,752** | ** ** | **$** | **(11,391** | **)** | **$** | **201,456** |   | $ | 169,899 |   | $ | 8,238 |   | $ | (9,342 | ) | $ | 168,795 |   |
| Average loans                      | ** ** | **$**                                         | **10,871,333** | ** **                                    | ** ** | ** ** | **$** | **391** | ** ** | **$** | **10,871,724** |   | $ | 9,596,686 |   |   |   | $ | 189 |   | $ | 9,596,875 |   |
| Average earning assets             | ** ** | **13,850,301**                                | ** **     | ** **                                    | ** ** | **5,328** | ** ** | **13,855,629** |   | 12,595,524 |   |   |   | 28,040 |   | 12,623,564 |   |
| Average assets                     | ** ** | **15,131,318**                                | ** **     | ** **                                    | ** ** | **143,413** | ** ** | **15,274,731** |   | 13,335,183 |   |   |   | 550,375 |   | 13,885,558 |   |
| Average deposits                   | ** ** | **11,465,466**                                | ** **     | ** **                                    | ** ** | **(213,685** | **)** | **11,251,781** |   | 10,400,049 |   |   |   | (75,173 | ) | 10,324,876 |   |
| Average equity                     | ** ** | **1,899,294**                                 | ** **     | ** **                                    | ** ** | **158,830** | ** ** | **2,058,124** |   | 1,380,857 |   |   |   | 477,720 |   | 1,858,577 |   |

 

13

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| ** **                         | ** ** | **For the 3 months ended September 30, 2005** | ** **     | **For the 3 months ended September 30, 2004** | ** ** |
|------------------------------------|------------|-----------------------------------------------|----------------|-----------------------------------------------|------------|
| **(Dollars in thousands)**         | ** ** | **Banking**                                   | ** **     | **IWM**                                       | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income                | ** ** | **$**                                         | **159,347**    | ** **                                    | **$**      | **—** | ** ** | **$** | **(105** | **)** | **$** | **159,242** |   | $ | 138,041 |   | $ | — |   | $ | 141 |   | $ | 138,182 |   |
| Provision for loan losses          | ** ** | **(820**                                      | **)**          | **—**                                    | ** ** | **—** | ** ** | **(820** | ) | (2,442 | ) | — |   | — |   | (2,442 | ) |
| Noninterest income                 | ** ** | **36,254**                                    | ** **     | **23,794**                                    | ** ** | **3,026** | ** ** | **63,074** |   | 29,496 |   | 22,319 |   | 2,106 |   | 53,921 |   |
| Noninterest expenses               | ** ** | **(90,009**                                   | **)**          | **(17,481**                                   | **)**      | **(892** | **)** | **(108,382** | ) | (80,819 | ) | (16,939 | ) | (1,459 | ) | (99,217 | ) |
| Adjustments                        | ** ** | **6,161**                                     | ** **     | **(1,155**                                    | **)**      | **(5,006** | **)** | **—** |   | 5,865 |   | (1,144 | ) | (4,721 | ) | — |   |
| Income (loss) before income  taxes | ** ** | **110,933**                                   | ** **     | **5,158**                                     | ** ** | **(2,977** | **)** | **113,114** |   | 90,141 |   | 4,236 |   | (3,933 | ) | 90,444 |   |
| Income tax (expense) benefit       | ** ** | **(38,784**                                   | **)**          | **(2,063**                                    | **)**      | **(1,311** | **)** | **(42,158** | ) | (30,997 | ) | (1,695 | ) | (967 | ) | (33,659 | ) |
| Net income (loss)                  | ** ** | **$**                                         | **72,149**     | ** **                                    | **$**      | **3,095** | ** ** | **$** | **(4,288** | **)** | **$** | **70,956** |   | $ | 59,144 |   | $ | 2,541 |   | $ | (4,900 | ) | $ | 56,785 |   |
| Average loans                      | ** ** | **$**                                         | **11,389,356** | ** **                                    | ** ** | ** ** | **$** | **375** | ** ** | **$** | **11,389,731** |   | $ | 9,825,607 |   |   |   | $ | 186 |   | $ | 9,825,793 |   |
| Average earning assets             | ** ** | **14,506,648**                                | ** **     | ** **                                    | ** ** | **(15,912** | **)** | **14,490,736** |   | 12,800,070 |   |   |   | 31,542 |   | 12,831,612 |   |
| Average assets                     | ** ** | **15,944,404**                                | ** **     | ** **                                    | ** ** | **120,764** | ** ** | **16,065,168** |   | 13,551,016 |   |   |   | 548,472 |   | 14,099,488 |   |
| Average deposits                   | ** ** | **12,010,432**                                | ** **     | ** **                                    | ** ** | **(258,442** | **)** | **11,751,990** |   | 10,599,179 |   |   |   | (91,463 | ) | 10,507,716 |   |
| Average equity                     | ** ** | **1,992,175**                                 | ** **     | ** **                                    | ** ** | **187,240** | ** ** | **2,179,415** |   | 1,377,283 |   |   |   | 500,561 |   | 1,877,844 |   |

 

11. Derivative Instruments and Hedging Activities

 

SFAS No. 133, *Accounting for DerivativeInstruments and Hedging Activities,*SFAS No. 138, *Accounting for Certain Derivative Instruments and Certain HedgingActivities – an amendment to FASB Statement No. 133*and**SFAS No. 149, *Amendment of Statement No.133 on Derivative Instruments and Hedging Activities*(collectivelyreferred to as “derivatives”), establish accounting and reporting standards forderivative instruments and for hedging activities. Bankshares maintains anoverall interest rate risk management strategy that incorporates the use ofderivative instruments to minimize significant unplanned fluctuations inearnings that are caused by interest rate volatility.  Currently, derivative instruments that areused as part of the interest rate risk management strategy have been restrictedto interest rate swaps.  Interest rateswaps generally involve the exchange of fixed-rate and variable-rate interestpayments between two parties, based on a common notional principal amount andmaturity date. As of September 30, 2005, Bankshares had interest rate swaps toconvert a portion of its nonprepayable fixed-rate debt to floating-ratedebt.  Bankshares also arranges interestrate swaps, caps and swaptions for commercial loan customers through itscapital markets group.  Derivativetransactions done with loan customers are hedged by means of an off-settingderivative trade with a third party.  Inthis way, Bankshares manages the market risk arising from capitalmarkets-related derivative activity.

 

The fair value of derivative instruments relating tohedging activities recorded in other assets was $10.9 million (notional $421.6million) and $7.1 million (notional $294.5 million) at September 30, 2005 andDecember 31, 2004, respectively.  Thefair value of derivative instruments relating to hedging activities recorded inother liabilities was $11.3 million (notional $233.5 million) and $6.8 million(notional $136.0 million) at September 30, 2005 and December 31, 2004,respectively.

 

Changes in the fair value of a derivative that isdesignated and qualifies as a fair value hedge, along with the gain or loss onthe hedged asset or liability that is attributable to the hedged risk, arerecorded as other noninterest income in the results of operations. For allhedge relationships, ineffectiveness resulting from differences between thechanges in fair values or cash flows of the hedged item and changes in fairvalue of the derivative are recognized as other noninterest income in theresults of operations. The net interest settlement on derivatives designated asfair value or cash flow hedges is treated as an adjustment of the interestincome or interest expense of the hedged assets or liabilities. The fair-valuehedges of nonprepayable fixed-rate debt were effective for the reported periods.The impact of the hedges decreased interest expense $3.5 million in the firstnine months of 2005 and $8.2 million for the same period in 2004.

 

14

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The following tables summarize the gross position ofderivatives relating to hedging activities at September 30, 2005 and December31, 2004.

 
| ** **                           | ** ** | **September 30, 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                                | ** ** | **$**                  | **350,000** | ** **            | **$**      | **4,302** | ** ** | **$** | **(2,085** | **)** | $ | 350,000 |   | $ | 6,297 |   | $ | (143 | ) |
|                                 |       |                   |        |                  |       |   |   |   |   |   |   |   |   |
| *Customer Accommodations*            |       |                   |        |                  |       |   |   |   |   |   |   |   |   |
| Interest Rate Contracts:             |       |                   |        |                  |       |   |   |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                  | **293,384** | ** **            | **$**      | **2,183** | ** ** | **$** | **1,748** |   | $ | 68,575 |   | $ | 684 |   | $ | 398 |   |
| Swaptions/Caps Purchased             | ** ** | **5,881**              | ** **  | **56**                | ** ** | **56** |   | 5,971 |   | 80 |   | 80 |   |
| Swaptions/Caps Sold                  | ** ** | **5,881**              | ** **  | **—**            | ** ** | **(56** | **)** | 5,971 |   | — |   | (80 | ) |

 

----

(1)          Credit risk amountsreflect the replacement cost for those contracts in a gain position in theevent of nonperformance by all counterparties.

 

Mortgage loans held-for-sale have inherent forwardcontract (agreements to sell or purchase loans at a specific rate or yield)characteristics. Risk may arise from the corresponding parties’ inability tomeet the terms of their contracts and from movement in interest rates.Bankshares had forward commitments to sell and fund individual fixed-rate andvariable-rate mortgage loans that are reported at fair value. The fair value ofthe forward contracts was recorded as other assets of $0.9 million at September30, 2005 and other liabilities of $1.2 million at December 31, 2004.

 

12. Stock-based Compensation Expense

 

Bankshares has several stock-based compensationprograms for its directors, management and employees. Compensation costs forstock options and restricted stock awards are measured under the fair valuemethod and are included in salary expense. At the Annual Shareholders’ Meetingheld on May 10, 2005, Bankshares’ stockholders approved the MercantileBankshares’ Corporation Stock Retainer and Deferred Compensation Plan forNon-Employee Directors (the “Plan”). The Plan provides for an annual stockretainer of 500 shares of Bankshares’ common stock to each non-employeedirector of Bankshares. The Plan permits non-employee directors of Banksharesand its affiliates to elect to defer voluntarily their annual stock and cashretainers and some or all of their fees. The initial annual stock retainerunder the Plan was paid on June 1, 2005 to non-employee directors. See CurrentReport on Form 8-K filed with the SEC on May 16, 2005 for more details on thePlan. Another form of stock-based compensation is phantom stock, which is usedfor a portion of the Bankshares’ Directors’ Deferred Compensation Plan. Thisplan requires that substantially all deferred fees be valued based onBankshares’ stock and paid out in cash and/or stock at retirement. Thecompensation cost for the phantom stock is included in other expenses.  Employee stock-based compensation amounts,included in salaries expense, for the nine months and quarters ended September30, 2005 and 2004, respectively, are summarized in the following table:

 
| ** **                         | ** ** | **For the 9 months ended  September 30,** | ** ** | **For the 3 months ended  September 30,** | ** ** |
|------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| **(Dollars  in thousands)**        | ** ** | **2005**                                  | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Stock options expense              | ** ** | **$**                                     | **1,660**  |                                      | $          | 1,996 | ** ** | **$** | **248** |   | $ | 796 |   |
| Restricted stock awards  expense   | ** ** | **1,965**                                 |       | 1,516                                     | ** ** | **685** |   | 509 |   |
| Total included in salaries expense | ** ** | **$**                                     | **3,625**  |                                      | $          | 3,512 | ** ** | **$** | **933** |   | $ | 1,305 |   |

 

15

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# **13. Pension& Other Postretirement Benefit Plans**

 

Bankshares sponsors qualified and nonqualified pensionplans and other postretirement benefit plans for its employees.  The following table summarizes the componentsof the net periodic benefit cost for the pension plans for the nine months andquarters ended September 30, 2005 and 2004, respectively.

 
| ** **                           | ** ** | **For the 9 months ended  September 30, 2005** | ** ** | **For the 9 months ended  September 30, 2004** | ** ** |
|--------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| **(Dollars  in thousands)**          | ** ** | **Qualified**                                  | ** ** | **Nonqualified**                               | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                         | ** ** | **$**                                          | **5,640**  | ** **                                     | **$**      | **455** | ** ** | **$** | **6,095** |   | $ | 4,716 |   | $ | 423 |   | $ | 5,139 |   |
| Interest cost                        | ** ** | **8,457**                                      | ** ** | **121**                                        | ** ** | **8,578** |   | 7,647 |   | 303 |   | 7,950 |   |
| Expected return on plan assets       | ** ** | **(12,430**                                    | **)**      | **—**                                     | ** ** | **(12,430** | **)** | (11,535 | ) | — |   | (11,535 | ) |
| Amortization of prior service cost   | ** ** | **877**                                        | ** ** | **17**                                         | ** ** | **894** |   | 585 |   | 18 |   | 603 |   |
| Recognized net actuarial (gain) loss | ** ** | **1,096**                                      | ** ** | **(139**                                       | **)**      | **957** |   | 661 |   | 87 |   | 748 |   |
| Amortization of transition asset     | ** ** | **—**                                     | ** ** | **—**                                     | ** ** | **—** |   | — |   | 72 |   | 72 |   |
| Net periodic benefit cost            | ** ** | **$**                                          | **3,640**  | ** **                                     | **$**      | **454** | ** ** | **$** | **4,094** |   | $ | 2,074 |   | $ | 903 |   | $ | 2,977 |   |
|                                 |       |                                           |       |                                           |       |   |   |   |   |   |   |   |   |
| ** **                           | ** ** | **For the 3 months ended  September 30, 2005** | ** ** | **For the 3 months ended September  30, 2004** | ** ** |
| **(Dollars  in thousands)**          | ** ** | **Qualified**                                  | ** ** | **Nonqualified**                               | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                         | ** ** | **$**                                          | **1,980**  | ** **                                     | **$**      | **151** | ** ** | **$** | **2,131** |   | $ | 1,572 |   | $ | 141 |   | $ | 1,713 |   |
| Interest cost                        | ** ** | **2,819**                                      | ** ** | **41**                                         | ** ** | **2,860** |   | 2,549 |   | 101 |   | 2,650 |   |
| Expected return on plan assets       | ** ** | **(4,143**                                     | **)**      | **—**                                     | ** ** | **(4,143** | **)** | (3,845 | ) | — |   | (3,845 | ) |
| Amortization of prior service cost   | ** ** | **292**                                        | ** ** | **5**                                          | ** ** | **297** |   | 195 |   | 6 |   | 201 |   |
| Recognized net actuarial (gain) loss | ** ** | **365**                                        | ** ** | **(46**                                        | **)**      | **319** |   | 307 |   | 29 |   | 336 |   |
| Amortization of transition asset     | ** ** | **—**                                     | ** ** | **—**                                     | ** ** | **—** |   | — |   | 24 |   | 24 |   |
| Net periodic benefit cost            | ** ** | **$**                                          | **1,313**  | ** **                                     | **$**      | **151** | ** ** | **$** | **1,464** |   | $ | 778 |   | $ | 301 |   | $ | 1,079 |   |

 

The following table summarizes the components of thenet periodic benefit cost for the other postretirement benefit plans for thenine months and quarters ended September 30, 2005 and 2004, respectively.

 
| ** **                          | ** ** | **For the 9 months ended  September 30,** | ** ** | **For the 3 months ended  September 30,** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| **(Dollars  in thousands)**         | ** ** | **2005**                                  | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Service cost                        | ** ** | **$**                                     | **400**    |                                      | $          | 195 | ** ** | **$** | **133** |   | $ | 65 |   |
| Interest cost                       | ** ** | **747**                                   |       | 642                                       | ** ** | **249** |   | 214 |   |
| Expected return on plan assets      | ** ** | **—**                                |       | —                                    | ** ** | **—** |   | — |   |
| Amortization of prior service  cost | ** ** | **—**                                |       | —                                    | ** ** | **—** |   | — |   |
| Recognized net actuarial loss       | ** ** | **264**                                   |       | 125                                       | ** ** | **88** |   | 44 |   |
| Amortization of transition  asset   | ** ** | **—**                                |       | —                                    | ** ** | **—** |   | — |   |
| Net periodic benefit cost           | ** ** | **$**                                     | **1,411**  |                                      | $          | 962 | ** ** | **$** | **470** |   | $ | 323 |   |

 

In May 2004, the FASB issued FSP FAS 106-2, “Accountingand Disclosure Requirements Related to the Medicare Prescription Drug,Improvement and Modernization Act of 2003,” which provides guidance onaccounting for the impact of the Medicare Prescription Drug, Improvement andModernization Act of 2003. Bankshares is currently reviewing the potentialeffect of the benefit that is at least actuarially equivalent to Medicare partD on its postretirement benefit plans.

 

As previously disclosed in its financial statementsfor the year ended December 31, 2004, Bankshares generally makes cashcontributions to the pension plan in amounts permitted by guidelinesestablished under employee benefit and tax laws.  Bankshares currently estimates it will beable to contribute up to approximately $19 million to the pension plan for2005.  Cash contributions are normallymade after valuations have been finalized for the plan year and prior to thetax return filing date.  As of September30, 2005, no contributions had been made.

 

16

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# **14.**         Recent Accounting Standards

 

In May 2005, the Financial Accounting Standards Board (“FASB”) issuedStatement No. 154, (“SFAS No. 154”) “Accounting Changes and Error Corrections -A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” This newstandard replaces Accounting Principles Board (“APB”) Opinion No. 20, “AccountingChanges”, and FASB Statement No. 3, “Reporting Accounting Changes in InterimFinancial Statements.” Among other changes, SFAS No. 154 requires that avoluntary change in accounting principle be applied retrospectively with allprior period financial statements presented on the new accounting principle,unless it is impracticable to do so. SFAS No. 154 also provides that (1) achange in method of depreciating or amortizing a long-lived nonfinancial assetbe accounted for as a change in estimate (prospectively) that was effected by achange in accounting principle, and (2) correction of errors in previously issuedfinancial statements should be termed a “restatement. “ The new standard iseffective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005. Bankshares does not anticipate this revisionwill have a material effect on its financial statements.

 

In December 2004, the FASB issued Statement No. 123 (Revised 2004) (“SFASNo. 123R”) “Share-Based Payment,” which requires that the compensation costrelating to share-based payment transactions be recognized in financialstatements.  SFAS No. 123R replaces SFASNo. 123, “Accounting for Stock-Based Compensation,” and supersedes APB OpinionNo. 25, “Accounting for Stock Issued to Employees.” Share-based compensationarrangements include share options, restricted share plans, performance-basedawards, share appreciation rights and employee share purchase plans. SFAS No.123R requires all share-based payments to employees to be valued using a fairvalue method on the date of grant and expensed based on that fair value overthe applicable vesting period. Bankshares adopted the cost recognitionprovision of SFAS No. 123 in 1995 and has been expensing compensation costrelated to options.  SFAS No. 123R alsoamends SFAS No. 95 “Statement of Cash Flows,” requiring the benefits of taxdeductions in excess of recognized compensation cost be reported as financinginstead of operating cash flows.  TheSecurities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No.107 (“SAB No. 107”), which expresses the SEC’s views regarding the interactionbetween SFAS No. 123R and certain SEC rules and regulations. Additionally, SABNo. 107 provides guidance related to share-based payment transactions forpublic companies. Bankshares will be required to apply SFAS No. 123R as of theannual reporting period that begins after September 15, 2005. Bankshares doesnot anticipate this revision will have a material effect on its financialstatements.

 

In November 2004, the Emerging Issues Task Force (“EITF”)published Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments.” The Task Force discussed the meaning ofother-than-temporary impairment and its application to certain investmentscarried at cost. The Task Force requested that the FASB staff consider otherimpairment models within U.S. Generally Accepted Accounting Principles (“GAAP”)when developing its views. The Task Force also requested that the scope of theimpairment issue be expanded to include equity investments and investmentssubject to FASB Statement No. 115, “Accounting for Certain Investments in Debtand Equity Securities,” and that the issue be addressed by the Task Force as aseparate EITF issue. At the EITF meeting, the Task Force reached a consensus onone issue that certain quantitative and qualitative disclosures should berequired for securities accounted for under Statement 115 that are impaired atthe balance sheet date but for which an other-than-temporary impairment has notbeen recognized. The Board ratified the consensus on that one issue at itsNovember 25, 2004 meeting. In September 2004, the FASB directed the staff toissue two proposed FASB Staff Positions (“FSP”): Proposed FSP EITF Issue03-1-a, which provides guidance for the application of paragraph 16 of EITFIssue 03-1 to debt securities that are impaired because of interest rate and/orsector spread increases, and Proposed FSP EITF Issue 03-1-b, which delays theeffective date of Issue 03-1 for debt securities that are impaired because ofinterest rate and/or sector spread increases. In September 2005, the FASB reacha decision whereby they declined to provide additional guidance on the meaningof other-than-temporary impairment. The FASB directed the staff to issue EITF03-1a as final and to draft a new FSP that will replace EITF 03-01. Banksharesdoes not anticipate this revision will have a material effect on its financialstatements.

 

17

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**Item 2.   Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

**MERCANTILE BANKSHARES CORPORATION**

 

HIGHLIGHTS

 

**Consolidated Financial Results**

 

Net income for the quarter ended September 30, 2005 was $71.0 million,a 25.0% increase over net income of $56.8 million for the same period in 2004and a 4.5% increase over the $67.9 million reported for the second quarter of2005.  For the quarter ended September30, 2005, diluted net income per share was $0.86, an increase of 21.1% over the$0.71 reported for the same period of last year and a 2.4% increase over the$0.84 reported for the second quarter of this year.  Adjusted weighted average shares outstandingincreased from 79.6 million for the quarter ended September 30, 2004, to 82.6million for the quarter ended September 30, 2005.  The results of operations for Community Bank of Northern Virginia (“CBNV”)are included from the merger dates forward.

 

Net interest income for the quarter ended September 30, 2005 increased15.2% to $159.2 million from $138.2 million for the same period of last year.The growth in net interest income was attributable to a 15.9% growth in averageloans and a seven (7) basis point improvement in the net interest margin, whichwas driven by a twenty-three basis point improvement in the effect ofnoninterest-bearing funds, which consist primarily of demand deposits andshareholders’ equity.

 

At September 30, 2005, nonperforming assets amounted to $27.8 million,or 0.24% of period-end loans and other real estate owned, a decline from $39.3million at September 30, 2004. Nonperforming assets were $27.7 million at June30, 2005. The comparable nonperforming ratios were 0.39% and 0.24% at September30, 2004 and June 30, 2005, respectively.

 

Noninterest income for the quarter ended September 30, 2005 increased17.0% to $63.1 million from $53.9 million for the same period last year, whilenoninterest expenses increased 9.2% to $108.4 million from $99.2 million.

 

Bankshares also reports cash operating earnings,defined as “GAAP” (Generally Accepted Accounting Principles) earnings excludingthe amortization of intangible assets associated with purchase accounting forbusiness combinations; securities gains and losses; and other significantgains, losses or expenses (such as those associated with integrating acquiredentities’ operations into Bankshares) unrelated to Bankshares’ coreoperations.  Cash operating earningstotaled $72.9 million for the third quarter of 2005, an increase of 23.1% overthe $59.2 million for the same period in 2004 and an 8.6% increase over the$67.1 million for the second quarter of 2005. Diluted cash operating earnings per share for the third quarter of 2005and 2004 were $0.89 and $0.74, respectively and $0.83 per share for the secondquarter of 2005.  A reconciliationof net income (GAAP basis) to cash operating earnings can be found on page 37of this filing.

 

Management believes that reporting several key measures based on cashoperating earnings and tangible equity (equity less intangible assets and theirrelated amortization expense) is important, as this is the general basis formeasuring the adequacy of capital for regulatory purposes.  For the quarter ended September 30, 2005,return on average assets was 1.75%, return on average tangible equity was 19.62%and average tangible equity to average tangible assets was 9.53%.  Comparable ratios for the three months endedSeptember 30, 2004 were 1.60%, 17.63% and 9.67%, respectively.  A reconciliation of these ratios to theirrespective GAAP basis ratios can be found on page 37 of this filing.

 

For the first nine months of 2005, net income was $201.5 million, anincrease of 19.3% over the $168.8 million reported for the same period in 2004.Diluted net income per share was $2.48, an increase of 17.5% over the $2.11reported for the same period last year. For the nine months ended September 30,2005, compared to the same period in 2004, cash operating earnings were $203.1million versus $173.3 million.  Dilutedcash operating earnings per share for these periods were $2.51 and $2.17,respectively.  The ratios of return onaverage assets, return on average tangible equity and average tangible equityto average tangible assets for year-to-date 2005 were 1.76%, 19.29% and 9.73%respectively.  These ratios for the sameperiod last year were 1.62%, 17.94%, and 9.65%, respectively.

 

18

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SEGMENT REPORTING

 

As noted in Footnote No. 10 “Segment Reporting”, Bankshares reports twodistinct business segments for which financial information is segregated foruse in assessing performance and allocating resources when reporting to theBoard of Directors. Segment financial information is subjective and, unlikefinancial accounting, is not necessarily based on GAAP. As a result, thefinancial information of the reporting segments is not necessarily comparablewith similar information reported by others and may not be comparable withBankshares’ consolidated results.

 

**Banking**

 

The Banking segment consists of 11 affiliate banks andmortgage banking activities.

 

In the second quarter of 2005, Bankshares consolidatedFidelity Bank into Farmers & Mechanics. The consolidation of these banksallows the surviving bank, Farmers & Mechanics, to serve its localcustomers with greater size and expertise. Also, in the second quarter of 2005,Mercantile Potomac Bank merged into Mercantile-Safe Deposit and Trust Company (“MSD&T”).This combination allows Bankshares to provide the resources necessary forexpansion into the Washington, D.C. and Northern Virginia markets. Further theacquisition of CBNV into the Mercantile Potomac Division of Mercantile-SafeDeposit and Trust Company was completed in the second quarter. MercantilePotomac Bank and Fidelity Bank will continue to serve their respective marketsunder their own names with local leadership and decision-making.

 

Net income for the nine months ended September 30, 2005 was $203.1million. This represented a $33.2 million, or 19.5%, increase over the sameperiod last year. The Banking segment was the primary beneficiary of the CBNVacquisition. For the first nine months of 2005 compared to the same period lastyear, net interest income increased by $53.2 million, or 13.2%, to $455.0million. Growth in average earning assets of $1.3 billion was largelyattributable to growth in average loans of 13.3% to which the CBNV acquisitioncontributed less than 1%. Banking had a smaller provision for loan lossescompared to the same period in 2004 as credit quality remained strong.

 

Noninterest income increased year-over-year by $13.1 million due to a $3.1million increase from nonmarketable investments, a $2.0 million increase inmortgage banking related fees, a $1.7 million increase in loan charges andfees, a $1.4 million increase in insurance revenue and a $1.7 million increasein electronic banking fees.

 

Noninterest expenses increased by $21.0 million for the first ninemonths of 2005 compared with the same period in 2004. Salaries and benefitsgrew by $9.9 million, with $2.3 million of additional personnel expense fromCBNV, incentive compensation linked to improved operating performance increased$9.0 million and higher pension expense increased $1.4 million. Occupancyexpense increased by $2.3 million, promotional expenses increased by $1.0million and outsourcing expense increased by $4.1 million over the same periodin 2004.

 

**Investment & Wealth Management**

 

Net income increased $1.5 million or 18.4% to $9.8 million for the ninemonths ended September 30, 2005 compared to the same period last year.

 

At September 30, 2005, assets under administration in IWM were $46.4billion, a decrease of $0.1 billion from the same period last year. IWM hadassets under management of $21.9 billion at September 30, 2005, an increase of$0.5 billion from September 30, 2004.

 

Revenues for the first nine months of 2005 increased$4.1 million, or 6.1%, over the same period last year. Stronger equity marketsand net new sales across both mutual funds and separately managed accountsfavorably affected IWM revenues. Noninterest expenses increased by $2.0 million or 4.0% to $52.8 millionfor the first nine months of 2005 from $50.7 million for the same period lastyear. The increase in noninterest expense was related primarily to salaries andbenefits.

 

**Other**

 

The components in the “Other” column consist ofamounts for the nonbanking affiliates, unallocated corporate expenses andintercompany eliminations.

 

For the first nine months of 2005 compared to the sameperiod in 2004, noninterest income increased $5.6 million due primarily toincome from nonmarketable investments. Noninterest expense increased $3.4million. The “adjustments” line represents corporate allocations from the leadbank (MSD&T).

 

19

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BANKSHARES EARNINGS PERFORMANCE

 

**Analysis of Interest Rates and InterestDifferentials**

The following table presents the distribution of the averageconsolidated balance sheet, interest income/expense and annualized yieldsearned and rates paid through the nine months ended September 30, 2005 and2004.

 
| ** **                                        | ** ** | **For the 9 months ended September 30,** | ** **     |
|---------------------------------------------------|------------|------------------------------------------|----------------|
| ** **                                        | ** ** | **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 and leasing                            | ** ** | **$**                                    | **2,896,725**  |   | **$** | **136,123** | ** ** | **6.28** | **%** | $ | 2,695,949 |   | $ | 105,371 |   | 5.22 | % |
| Commercial real estate                            | ** ** | **3,370,926**                            |           | **163,681** | ** ** | **6.49** |   | 2,875,824 |   | 126,425 |   | 5.87 |   |
| Construction                                      | ** ** | **1,439,235**                            |           | **72,480** | ** ** | **6.73** |   | 1,120,125 |   | 44,398 |   | 5.29 |   |
| Residential real estate                           | ** ** | **1,749,577**                            |           | **77,867** | ** ** | **5.95** |   | 1,630,638 |   | 73,526 |   | 6.02 |   |
| Home equity lines                                 | ** ** | **505,630**                              |           | **22,016** | ** ** | **5.82** |   | 438,836 |   | 14,287 |   | 4.35 |   |
| Consumer                                          | ** ** | **909,631**                              |           | **39,435** | ** ** | **5.80** |   | 835,503 |   | 38,844 |   | 6.21 |   |
| Total loans                                       | ** ** | **10,871,724**                           |           | **511,602** | ** ** | **6.29** |   | 9,596,875 |   | 402,851 |   | 5.61 |   |
| Federal funds sold, et al                         | ** ** | **43,658**                               |           | **1,544** | ** ** | **4.73** |   | 64,391 |   | 1,088 |   | 2.26 |   |
| Securities:                                       |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| Taxable securities                                |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and government agencies             | ** ** | **1,413,240**                            |           | **35,747** | ** ** | **3.38** |   | 1,557,396 |   | 43,653 |   | 3.74 |   |
| Mortgage-backed                                   | ** ** | **1,375,285**                            |           | **41,305** | ** ** | **4.02** |   | 1,253,440 |   | 35,961 |   | 3.83 |   |
| Other investments (3)                             | ** ** | **63,765**                               |           | **1,763** | ** ** | **3.70** |   | 53,642 |   | 1,172 |   | 2.92 |   |
| Tax-exempt securities                             |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| States and political subdivisions                 | ** ** | **87,760**                               |           | **3,885** | ** ** | **5.92** |   | 97,662 |   | 4,135 |   | 5.66 |   |
| Total securities                                  | ** ** | **2,940,050**                            |           | **82,700** | ** ** | **3.76** |   | 2,962,140 |   | 84,921 |   | 3.83 |   |
| Interest-bearing deposits in other banks          | ** ** | **197**                                  |           | **2** | ** ** | **1.15** |   | 158 |   | 1 |   | 1.08 |   |
| Total earning assets                              | ** ** | **13,855,629**                           |           | **595,848** | ** ** | **5.75** |   | 12,623,564 |   | 488,861 |   | 5.17 |   |
| Cash and due from banks                           | ** ** | **306,434**                              |           |   |   |   |   | 293,399 |   |   |   |   |   |
| Bank premises and equipment, net                  | ** ** | **144,362**                              |           |   |   |   |   | 141,641 |   |   |   |   |   |
| Other assets                                      | ** ** | **1,121,574**                            |           |   |   |   |   | 985,243 |   |   |   |   |   |
| Less: allowance for loan losses                   | ** ** | **(153,268**                             | **)**          |   |   |   |   | (158,289 | ) |   |   |   |   |
| Total assets                                      | ** ** | **$**                                    | **15,274,731** |   |   |   |   |   | $ | 13,885,558 |   |   |   |   |   |
| Interest-bearing liabilities                      |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                         |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| Savings                                           | ** ** | **$**                                    | **1,447,797**  |   | **3,983** | ** ** | **0.37** |   | $ | 1,418,775 |   | 3,107 |   | 0.29 |   |
| Checking plus interest accounts                   | ** ** | **1,399,352**                            |           | **1,719** | ** ** | **0.16** |   | 1,276,945 |   | 1,407 |   | 0.15 |   |
| Money market                                      | ** ** | **1,606,528**                            |           | **14,653** | ** ** | **1.22** |   | 1,570,271 |   | 6,625 |   | 0.56 |   |
| Time deposits $100,000 and over                   | ** ** | **1,574,236**                            |           | **35,254** | ** ** | **2.99** |   | 1,300,907 |   | 18,534 |   | 1.90 |   |
| Other time deposits                               | ** ** | **2,088,820**                            |           | **39,671** | ** ** | **2.54** |   | 1,950,974 |   | 31,109 |   | 2.13 |   |
| Total interest-bearing deposits                   | ** ** | **8,116,733**                            |           | **95,280** | ** ** | **1.57** |   | 7,517,872 |   | 60,782 |   | 1.08 |   |
| Short-term borrowings                             | ** ** | **1,069,792**                            |           | **17,228** | ** ** | **2.15** |   | 924,411 |   | 4,889 |   | 0.71 |   |
| Long-term debt                                    | ** ** | **743,381**                              |           | **23,634** | ** ** | **4.25** |   | 646,281 |   | 16,035 |   | 3.31 |   |
| Total interest-bearing funds                      | ** ** | **9,929,906**                            |           | **136,142** | ** ** | **1.83** |   | 9,088,564 |   | 81,706 |   | 1.20 |   |
| Noninterest-bearing deposits                      | ** ** | **3,135,048**                            |           |   |   |   |   | 2,807,004 |   |   |   |   |   |
| Other liabilities and accrued expenses            | ** ** | **151,653**                              |           |   |   |   |   | 131,413 |   |   |   |   |   |
| Total liabilities                                 | ** ** | **13,216,607**                           |           |   |   |   |   | 12,026,981 |   |   |   |   |   |
| Shareholders’ equity                         | ** ** | **2,058,124**                            |           |   |   |   |   | 1,858,577 |   |   |   |   |   |
| Total liabilities & shareholders’ equity | ** ** | **$**                                    | **15,274,731** |   |   |   |   |   | $ | 13,885,558 |   |   |   |   |   |
| Net interest rate spread                          | ** ** | ** **                               |           | **$** | **459,706** |   | **3.92** | **%** |   |   | $ | 407,155 |   | 3.97 | % |
| Effect of noninterest-bearing funds               | ** ** | ** **                               |           | ** ** |   | **0.52** |   |   |   |   |   | 0.34 |   |
| Net interest margin on earning assets             | ** ** | ** **                               |           | ** ** |   | **4.44** | **%** |   |   |   |   | 4.31 | % |
| Tax-equivalent adjustment included in:            |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| Loan income                                       | ** ** | ** **                               |           | **$** | **3,467** |   |   |   |   |   | $ | 3,434 |   |   |   |
| Investment securities income                      | ** ** | ** **                               |           | **1,547** |   |   |   |   |   | 1,650 |   |   |   |
| Total                                             | ** ** | ** **                               |           | **$** | **5,014** |   |   |   |   |   | $ | 5,084 |   |   |   |

 

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

(2)          Average investmentsecurities are reported at amortized cost; excludes unrealized gains (losses)on securities available-for-sale. Nonaccrual loans are included in averageloans.

(3)          Investments in hedgefunds and other nonmarketable investments were reclassified in the prior periodfrom securities available-for-sale into other assets to conform to the currentpresentation.

 

20

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**Analysis of Interest Rates and InterestDifferentials**

The following table presents the distribution of the averageconsolidated balance sheet, interest income/expense and annualized yieldsearned and rates paid for the third quarters of 2005 and 2004.

 
| ** **                                        | ** ** | **For the 3 months ended September 30,** | ** **     |
|---------------------------------------------------|------------|------------------------------------------|----------------|
| ** **                                        | ** ** | **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 and leasing                            | ** ** | **$**                                    | **2,914,761**  | ** ** | **$** | **48,635** | ** ** | **6.62** | **%** | $ | 2,744,195 |   | $ | 36,848 |   | 5.34 | % |
| Commercial real estate                            | ** ** | **3,610,170**                            | ** **     | **60,538** | ** ** | **6.65** |   | 2,969,515 |   | 44,121 |   | 5.91 |   |
| Construction                                      | ** ** | **1,544,082**                            | ** **     | **28,077** | ** ** | **7.21** |   | 1,142,921 |   | 15,775 |   | 5.49 |   |
| Residential real estate                           | ** ** | **1,775,023**                            | ** **     | **26,771** | ** ** | **5.98** |   | 1,687,813 |   | 25,017 |   | 5.90 |   |
| Home equity lines                                 | ** ** | **517,798**                              | ** **     | **8,126** | ** ** | **6.23** |   | 460,044 |   | 5,111 |   | 4.42 |   |
| Consumer                                          | ** ** | **1,027,897**                            | ** **     | **14,797** | ** ** | **5.71** |   | 821,305 |   | 12,400 |   | 6.01 |   |
| Total loans                                       | ** ** | **11,389,731**                           | ** **     | **186,944** | ** ** | **6.51** |   | 9,825,793 |   | 139,272 |   | 5.64 |   |
| Federal funds sold, et al                         | ** ** | **57,932**                               | ** **     | **759** | ** ** | **5.20** |   | 50,035 |   | 449 |   | 3.57 |   |
| Securities:                                       |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| Taxable securities                                |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and government agencies             | ** ** | **1,431,397**                            | ** **     | **12,078** | ** ** | **3.35** |   | 1,571,102 |   | 14,190 |   | 3.59 |   |
| Mortgage-backed                                   | ** ** | **1,455,475**                            | ** **     | **14,608** | ** ** | **3.98** |   | 1,228,539 |   | 11,858 |   | 3.84 |   |
| Other investments (3)                             | ** ** | **62,318**                               | ** **     | **526** | ** ** | **3.35** |   | 65,264 |   | 476 |   | 2.90 |   |
| Tax-exempt securities                             |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| States and political subdivisions                 | ** ** | **93,683**                               | ** **     | **1,390** | ** ** | **5.89** |   | 90,721 |   | 1,328 |   | 5.82 |   |
| Total securities                                  | ** ** | **3,042,873**                            | ** **     | **28,602** | ** ** | **3.73** |   | 2,955,626 |   | 27,852 |   | 3.75 |   |
| Interest-bearing deposits in other banks          | ** ** | **200**                                  | ** **     | **1** | ** ** | **1.02** |   | 158 |   | — |   | 1.08 |   |
| Total earning assets                              | ** ** | **14,490,736**                           | ** **     | **216,306** | ** ** | **5.92** |   | 12,831,612 |   | 167,573 |   | 5.20 |   |
| Cash and due from banks                           | ** ** | **326,515**                              |           |   |   |   |   | 296,203 |   |   |   |   |   |
| Bank premises and equipment, net                  | ** ** | **147,248**                              |           |   |   |   |   | 141,536 |   |   |   |   |   |
| Other assets                                      | ** ** | **1,257,846**                            |           |   |   |   |   | 990,468 |   |   |   |   |   |
| Less: allowance for loan losses                   | ** ** | **(157,177**                             | **)**          |   |   |   |   | (160,331 | ) |   |   |   |   |
| Total assets                                      | ** ** | **$**                                    | **16,065,168** |   |   |   |   |   | $ | 14,099,488 |   |   |   |   |   |
| Interest-bearing liabilities                      |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                         |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| Savings                                           | ** ** | **$**                                    | **1,420,283**  | ** ** | **1,519** | ** ** | **0.42** |   | $ | 1,457,432 |   | 1,080 |   | 0.29 |   |
| Checking plus interest accounts                   | ** ** | **1,428,344**                            | ** **     | **626** | ** ** | **0.17** |   | 1,291,808 |   | 472 |   | 0.15 |   |
| Money market                                      | ** ** | **1,692,684**                            | ** **     | **6,566** | ** ** | **1.54** |   | 1,556,212 |   | 2,168 |   | 0.55 |   |
| Time deposits $100,000 and over                   | ** ** | **1,674,265**                            | ** **     | **13,939** | ** ** | **3.30** |   | 1,299,918 |   | 6,214 |   | 1.90 |   |
| Other time deposits                               | ** ** | **2,295,608**                            | ** **     | **15,941** | ** ** | **2.76** |   | 1,918,216 |   | 10,208 |   | 2.12 |   |
| Total interest-bearing deposits                   | ** ** | **8,511,184**                            | ** **     | **38,591** | ** ** | **1.80** |   | 7,523,586 |   | 20,142 |   | 1.07 |   |
| Short-term borrowings                             | ** ** | **1,185,142**                            | ** **     | **7,702** | ** ** | **2.58** |   | 942,789 |   | 1,990 |   | 0.84 |   |
| Long-term debt                                    | ** ** | **797,527**                              | ** **     | **8,990** | ** ** | **4.47** |   | 641,264 |   | 5,575 |   | 3.46 |   |
| Total interest-bearing funds                      | ** ** | **10,493,853**                           | ** **     | **55,283** | ** ** | **2.09** |   | 9,107,639 |   | 27,707 |   | 1.21 |   |
| Noninterest-bearing deposits                      | ** ** | **3,240,806**                            |           |   |   |   |   | 2,984,130 |   |   |   |   |   |
| Other liabilities and accrued expenses            | ** ** | **151,094**                              |           |   |   |   |   | 129,875 |   |   |   |   |   |
| Total liabilities                                 | ** ** | **13,885,753**                           |           |   |   |   |   | 12,221,644 |   |   |   |   |   |
| Shareholders’ equity                         | ** ** | **2,179,415**                            |           |   |   |   |   | 1,877,844 |   |   |   |   |   |
| Total liabilities & shareholders’ equity | ** ** | **$**                                    | **16,065,168** |   |   |   |   |   | $ | 14,099,488 |   |   |   |   |   |
| Net interest rate spread                          | ** ** | ** **                               | ** **     | **$** | **161,023** |   | **3.83** | **%** |   |   | $ | 139,866 |   | 3.99 | % |
| Effect of noninterest-bearing funds               | ** ** | ** **                               |           | ** ** |   | **0.58** | ** ** |   |   |   |   | 0.35 |   |
| Net interest margin on earning assets             | ** ** | ** **                               |           | ** ** |   | **4.41** | **%** |   |   |   |   | 4.34 | % |
| Tax-equivalent adjustment included in:            |       |                                     |           |   |   |   |   |   |   |   |   |   |   |
| Loan income                                       | ** ** | ** **                               |           | **$** | **1,230** |   |   |   |   |   | $ | 1,155 |   |   |   |
| Investment securities income                      | ** ** | ** **                               |           | **551** |   |   |   |   |   | 529 |   |   |   |
| Total                                             | ** ** | ** **                               |           | **$** | **1,781** |   |   |   |   |   | $ | 1,684 |   |   |   |

 

----

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

(2)          Average investmentsecurities are reported at amortized cost; excludes unrealized gains (losses)on securities available-for-sale. Nonaccrual loans are included in averageloans.

(3)          Investments in hedgefunds and other nonmarketable investments were reclassified in the prior periodfrom securities available-for-sale into other assets to conform to the currentpresentation.

 

21

----

 

**Rate / Volume Analysis**

A rate/volume analysis, which demonstrates changes in interest incomeand expense for significant assets and liabilities, appears below.

 
| ** **                               | ** ** | **For the 9 months ended  September 30,  2005 vs. 2004** | ** ** | **For the 3 months ended  September 30,  2005 vs. 2004** | ** ** |
|------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                               | ** ** | **Due to variances in**                                  | ** ** | **Due to variances in**                                  | ** ** |
| **(Dollars  in thousands)**              | ** ** | **Total**                                                | ** ** | **Rates**                                                | ** ** | **Volumes (5)** | ** ** | **Total** | ** ** | **Rates** | ** ** | **Volumes (5)** | ** ** |
| Interest earned on:                      |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Loans:                                   |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Commercial and leasing (1)               |       | $                                                        | 30,052     |                                                     | $          | 21,414 |   | $ | 9,338 |   | $ | 11,787 |   | $ | 8,840 |   | $ | 2,947 |   |
| Commercial real estate (2)               |       | 37,256                                                   |       | 13,332                                                   |       | 23,924 |   | 16,417 |   | 5,553 |   | 10,864 |   |
| Construction (3)                         |       | 28,082                                                   |       | 12,052                                                   |       | 16,030 |   | 12,302 |   | 4,964 |   | 7,338 |   |
| Residential real estate                  |       | 4,341                                                    |       | (885                                                     | )          | 5,226 |   | 1,754 |   | 370 |   | 1,384 |   |
| Home equity lines                        |       | 7,729                                                    |       | 4,834                                                    |       | 2,895 |   | 3,015 |   | 2,095 |   | 920 |   |
| Consumer                                 |       | 591                                                      |       | (2,587                                                   | )          | 3,178 |   | 2,397 |   | (611 | ) | 3,008 |   |
| Taxable securities (4)                   |       | (1,971                                                   | )          | (1,560                                                   | )          | (411 | ) | 688 |   | (162 | ) | 850 |   |
| Tax-exempt securities (4)                |       | (250                                                     | )          | 192                                                      |       | (442 | ) | 62 |   | 14 |   | 48 |   |
| Federal funds sold, et al                |       | 457                                                      |       | 1,191                                                    |       | (734 | ) | 311 |   | 206 |   | 105 |   |
| Interest-bearing deposits in other banks |       | —                                                   |       | —                                                   |       | — |   | — |   | — |   | — |   |
| Total interest income                    |       | 106,987                                                  |       | 47,983                                                   |       | 59,004 |   | 48,733 |   | 21,269 |   | 27,464 |   |
|                                     |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Interest paid on:                        |       |                                                     |       |                                                     |       |   |   |   |   |   |   |   |   |
| Savings deposits                         |       | 876                                                      |       | 799                                                      |       | 77 |   | 439 |   | 476 |   | (37 | ) |
| Checking plus interest deposits          |       | 312                                                      |       | 163                                                      |       | 149 |   | 154 |   | 93 |   | 61 |   |
| Money market accounts                    |       | 8,028                                                    |       | 7,703                                                    |       | 325 |   | 4,398 |   | 3,863 |   | 535 |   |
| Time deposit $100,000 and over           |       | 16,720                                                   |       | 10,616                                                   |       | 6,104 |   | 7,725 |   | 4,591 |   | 3,134 |   |
| Other time deposits                      |       | 8,562                                                    |       | 5,973                                                    |       | 2,589 |   | 5,733 |   | 3,084 |   | 2,649 |   |
| Short-term borrowings                    |       | 12,339                                                   |       | 10,002                                                   |       | 2,337 |   | 5,712 |   | 4,132 |   | 1,580 |   |
| Long-term debt                           |       | 7,599                                                    |       | 4,527                                                    |       | 3,072 |   | 3,415 |   | 1,638 |   | 1,777 |   |
| Total interest expense                   |       | 54,436                                                   |       | 39,783                                                   |       | 14,653 |   | 27,576 |   | 17,877 |   | 9,699 |   |
| Net interest earned                      |       | $                                                        | 52,551     |                                                     | $          | 8,200 |   | $ | 44,351 |   | $ | 21,157 |   | $ | 3,392 |   | $ | 17,765 |   |

 

----

(1)          Interest year-to-date tax-equivalent adjustment of $2.3 million and $2.3million for 2005 and 2004, respectively, and quarter-to-date tax-equivalentadjustment of $0.8 million and $0.7 million for 2005 and 2004, respectively,are included in the commercial loan rate variances.

(2)          Interest year-to-date tax-equivalent adjustment of $0.4 million and $0.4million for 2005 and 2004, respectively, and quarter-to-date tax-equivalentadjustment of $0.2 million and $0.1 million for 2005 and 2004, respectively,are included in the commercial real estate loan rate variances.

(3)          Interest year-to-date tax-equivalent adjustment of $0.7 million and $0.7million for 2005 and 2004, respectively, and quarter-to-date tax-equivalentadjustment of $0.3 and $0.2 million for 2005 and 2004, respectively, areincluded in the construction loan rate variances.

(4)          Interest year-to-date tax-equivalent adjustment of $1.5 million and $1.7million for 2005 and 2004, respectively, and quarter-to-date tax-equivalentadjustment of $0.6 and $0.5 million for 2005 and 2004, respectively, areincluded in the investment securities rate variances.

(5)          Changes attributable to mix (rate and volume) are included in volumevariance.

 

22

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**Net Interest Income and Net Interest Margin**

 

In the third quarter of 2005 net interest income, on a tax-equivalentbasis, was $161.0 million, compared with $139.9 million in the third quarter of2004. This represented a $21.2 million, or 15.1% increase over the same periodin 2004. The increase was due primarily to strong loan growth and a higher netinterest margin.  Net interest income isaffected by both changes in the amount and composition of interest-earningassets and interest-bearing liabilities and by changes in the level of interestrates.

 

The net interest margin increased to 4.41% in thethird quarter of 2005 from 4.34% in the third quarter of 2004.  The increase was attributable to the benefitderived from the investment of noninterest-bearing funds. This benefitincreased 23 basis points for the three months ended September 30, 2005 fromthe same period in 2004 to 58 basis points due primarily to a $272.9 millionincrease in net noninterest-bearing funds and the rising rate environment. Thenet interest spread decreased 16 basis point due to the average cost ofinterest-bearing liabilities increasing more than earning asset yields dueprimarily to declines in the yield on the securities and consumer loanportfolios. The net interest margin decreased five (5) basis points from thesecond quarter of 2005 due primarily to the inclusion of CBNV for a fullquarter, the funding of $50 million in bank-owned life insurance during thequarter, the earnings from which are reported in noninterest income, and adecline in the yield on the investment securities portfolio.

 

Average earning assets for the three months endedSeptember 30, 2005 increased $1.7 billion, or 12.9%, from the same period in2004. The increase in average earning assets was driven primarily by a $1.6billion increase, or 15.9%, in average loans of which CBNV contributed 6.8%based on $670.7 million of average acquired loans. During the third quarter of2005, total average loan growth was driven by growth in commercial real estateof $640.7 million (up 21.6% year-over-year), construction of $401.2 million (up35.1% year-over-year), commercial of $170.6 million (up 6.2% year-over-year),residential mortgage of $87.2 million (up 5.2% year-over-year), home equity of$57.8 million (up 12.6% year-over-year) and consumer of $206.6 million (up25.2% year-over-year.)

 

Average investment securities for the third quarter of2005 increased by $87.2 million, or 3.0%, from the same period of 2004,reflecting the acquisition of approximately $163.0 million in securities fromCBNV. Bankshares utilizes the investment portfolio as part of its overallasset/liability management practices to minimize structural interest rate andmarket valuation risks associated with changes in interest rates. In connectionwith changing interest rates and its risk management activities, Banksharesmade the decision to adjust the composition of the investment portfolio toinclude a greater proportion of short-term mortgage-backed securities, agencyand asset-backed securities and a lesser proportion of U.S. Treasurysecurities. As a result, U.S. Treasury securities declined $265.3 million(35.6% year-over-year), while agency securities increased $125.6 million (15.2%year-over-year) and mortgage-backed securities increased $226.9 million (18.5%year-over-year). Refer to the “Interest Rate Risk” section for furtherinformation on the sensitivity of net interest income to changes in interestrates.

 

Average core deposits (total deposits lesscertificates of deposit of $100,000 and over) are an important contributor togrowth in net interest income and in the net interest margin. This low-coststable funding source increased 9.4% from the prior year with the CBNVacquisition contributing 5.3% of that growth based on $474.2 million in averageacquired core deposits. Average core deposits were $10.1 billion and $9.2billion for the three months ended September 30, 2005 and 2004, respectively.Average noninterest-bearing deposits for the third quarter of 2005 increased by$256.7 million, or 8.6%, compared with the same period in 2004. Total averageinterest-bearing deposits increased by $987.6 million, or 13.1%, for the thirdquarter of 2005 compared with the same period in 2004. The year-over-yearincrease in average interest-bearing deposits included increases in checkingplus interest accounts of $136.5 million, or 10.6%, time deposits greater than$100,000 of $374.3 million, or 28.8%, other time deposits of $377.4 million, or19.7%, and money market accounts of $136.5 million, or 8.8%, slightly offset bya decline in savings accounts of $37.1 million, or 2.6%.

 

Based on current market conditions, with ananticipation of a continued measured increase in the overall rate environment,management believes we are well-positioned, as pricing pressure oninterest-bearing liabilities will partially offset an improvement in earningasset yields and the value of noninterest-bearing funds.

 

Taxableequivalent net interest income for the first nine months of 2005 increased to$459.7 million, or 12.9%, over the $407.2 million for the first nine months oflast year due principally to 13.3% growth in average loans and a 13 basis pointimprovement in the net interest margin. The net interest margin increased from4.31% to 4.44%. The increase in the net interest margin was largelyattributable to the benefit derived from the investment of noninterest-bearing funds.  This benefit grew from 34 basis points in2004 to 52 basis points in 2005.

 

23

----

 

**Noninterest Income**

 
| ** **                                 | ** ** | **For the 9 months ended  September 30,** | ** **  | **% Change** | ** ** | **For the 3 months ended  September 30,** | ** ** | **% Change** | ** ** |
|--------------------------------------------|------------|-------------------------------------------|-------------|--------------|------------|-------------------------------------------|------------|--------------|------------|
| **(Dollars  in thousands)**                | ** ** | **2005**                                  | ** **  | **2004**     | ** ** | **2005/2004**                             | ** ** | **2005**     | ** ** | **2004** | ** ** | **2005/2004** | ** ** |
| Investment and wealth management           | ** ** | **$**                                     | **71,505**  |         | $          | 67,315                                    |       | 6.2          | %          | **$** | **23,668** |   | $ | 22,396 |   | 5.7 | % |
| Service charges on deposit accounts        | ** ** | **32,992**                                |        | 32,951       |       | 0.1                                       | ** ** | **11,478**   |       | 11,278 |   | 1.8 |   |
| Mortgage banking-related fees:             |       |                                      |        |         |       |                                      |       |         |       |   |   |   |   |
| Commercial                                 | ** ** | **8,016**                                 |        | 5,878        |       | 36.4                                      | ** ** | **4,086**    |       | 2,395 |   | 70.6 |   |
| Residential                                | ** ** | **2,313**                                 |        | 2,418        |       | (4.3                                      | )          | **1,065**    |       | 668 |   | 59.4 |   |
| Total mortgage banking-related fees        | ** ** | **10,329**                                |        | 8,296        |       | 24.5                                      | ** ** | **5,151**    |       | 3,063 |   | 68.2 |   |
| Net investment securities gains / (losses) | ** ** | **458**                                   |        | 534          |       | (14.2                                     | )          | **(32**      | **)**      | (1 | ) |   |   |
| Nonmarketable investments:                 |       |                                      |        |         |       |                                      |       |         |       |   |   |   |   |
| Private equity and other investments       | ** ** | **7,069**                                 |        | 2,391        |       | 195.7                                     | ** ** | **39**       |       | 1,628 |   | (97.6 | ) |
| Hedge funds                                | ** ** | **3,616**                                 |        | 2,653        |       | 36.3                                      | ** ** | **2,897**    |       | 341 |   | 749.6 |   |
| Bank-owned life insurance                  | ** ** | **2,998**                                 |        | 2,377        |       | 26.1                                      | ** ** | **1,254**    |       | 798 |   | 57.1 |   |
| Total nonmarketable investments            | ** ** | **13,683**                                |        | 7,421        |       | 84.4                                      | ** ** | **4,190**    |       | 2,767 |   | 51.4 |   |
| Other income:                              |       |                                      |        |         |       |                                      |       |         |       |   |   |   |   |
| Electronic banking fees                    | ** ** | **18,137**                                |        | 16,454       |       | 10.2                                      | ** ** | **7,010**    |       | 6,029 |   | 16.3 |   |
| Charges and fees on loans                  | ** ** | **9,601**                                 |        | 7,941        |       | 20.9                                      | ** ** | **3,786**    |       | 2,647 |   | 43.0 |   |
| Insurance                                  | ** ** | **11,578**                                |        | 10,312       |       | 12.3                                      | ** ** | **3,480**    |       | 3,218 |   | 8.1 |   |
| All other income                           | ** ** | **12,726**                                |        | 6,977        |       | 82.4                                      | ** ** | **4,343**    |       | 2,524 |   | 72.1 |   |
| Total other income                         | ** ** | **52,042**                                |        | 41,684       |       | 24.8                                      | ** ** | **18,619**   |       | 14,418 |   | 29.1 |   |
| Total                                      | ** ** | **$**                                     | **181,009** |         | $          | 158,201                                   |       | 14.4         | ** ** | **$** | **63,074** |   | $ | 53,921 |   | 17.0 |   |

 

Noninterest income for the quarter ended September 30, 2005 increasedby $9.2 million, or 17.0%, to $63.1 million compared with $53.9 million for thesame period in 2004.  Noninterest incomeincreased 5.0% from the second quarter of 2005. The table above shows the majorcomponents of noninterest income.

 

Investment and wealth management revenue, representing the largestsource of noninterest income, increased $1.3 million, or 5.7%, over the thirdquarter of 2004.  Stronger equity marketsand net new sales across both mutual funds and separately managed accountsfavorably affected IWM revenues.  Servicecharges on deposit accounts increased modestly for the third quarter of 2005compared to both the third quarter of 2004 and the second quarter of 2005, withmost of the increase coming from non-sufficient funds and overdraft fees.  Mortgagebanking-related fees were $2.1 million or 68.2% higher than the third quarterof 2004 due to higher volumes in both the commercial and residentialbusinesses.

 

Nonmarketable investment incomerepresents revenues derived from investing in private equities, hedgefunds-of-funds (“hedge funds”), securities acquired to meet various regulatoryrequirements and bank-owned life insurance (“BOLI”).  Nonmarketable investment income for the thirdquarter of 2005 increased $1.4 million over the third quarter of 2004.  The increase in nonmarketable investmentincome was due primarily to better performance by the hedge funds, which offseta decline in income from priviate equity and other investments.

 

Other income was $18.6 millionfor the third quarter of 2005, a $4.2 million, or 29.1%, increase over the$14.4 million for the same quarter last year. The increase was due primarily to a $1.0 million increase in electronicbanking fees, a $1.1 million increase in charges and fees on loans and a $1.3million increase in capital markets-related revenues, which are reported in allother income.

 

For the nine months endedSeptember 30, 2005, noninterest income increased by $22.8 million, or 14.4%, to$181.0 million compared with $158.2 million for the same period in 2004. Thisincrease was due largely to a $4.2 million increase in investment and wealthmanagement revenues, a $2.0 million increase in mortgage banking related fees,a $4.7 million increase in earnings from private equity investments and a $1.0million increase from the hedge funds. Other income increased by $10.4 million.The largest contributors were a $2.7 million increase in gains from the salesof branches and an office building, a $1.7 million increase in electronicbanking fees, a $1.7 million increase in charges and fees on loans, a $1.3million increase from insurance-related fees and a $1.6 million increase incapital markets-related revenues.

 

24

----

 

**NoninterestExpenses**

 
| ** **                             | ** ** | **For the 9  months ended** | ** **  | ** **   | ** ** | **For the 3  months ended** | ** ** | ** **   | ** ** |
|----------------------------------------|------------|-----------------------------|-------------|--------------|------------|-----------------------------|------------|--------------|------------|
| ** **                             | ** ** | **September 30,**      | ** **  | **% Change** | ** ** | **September 30,**      | ** ** | **% Change** | ** ** |
| **(Dollars in thousands)**             | ** ** | **2005**                    | ** **  | **2004**     | ** ** | **2005/2004**               | ** ** | **2005**     | ** ** | **2004** | ** ** | **2005/2004** | ** ** |
| Salaries                               | ** ** | **$**                       | **148,482** |         | $          | 138,173                     |       | 7.5          | %          | **$** | **51,748** |   | $ | 48,696 |   | 6.3 | % |
| Employee benefits                      | ** ** | **35,490**                  |        | 33,998       |       | 4.4                         | ** ** | **11,637**   |       | 10,557 |   | 10.2 |   |
| Net occupancy expense of bank premises | ** ** | **20,918**                  |        | 18,007       |       | 16.2                        | ** ** | **7,139**    |       | 6,128 |   | 16.5 |   |
| Furniture and equipment expenses       | ** ** | **23,168**                  |        | 22,873       |       | 1.3                         | ** ** | **7,965**    |       | 7,936 |   | 0.4 |   |
| Communications and supplies            | ** ** | **11,992**                  |        | 12,610       |       | (4.9                        | )          | **3,933**    |       | 4,111 |   | (4.3 | ) |
| Other expenses:                        |       |                        |        |         |       |                        |       |         |       |   |   |   |   |
| Professional services                  | ** ** | **16,047**                  |        | 15,987       |       | 0.4                         | ** ** | **6,040**    |       | 7,157 |   | (15.6 | ) |
| Advertising and promotional  expenses  | ** ** | **6,550**                   |        | 5,585        |       | 17.3                        | ** ** | **2,162**    |       | 1,747 |   | 23.7 |   |
| Electronic banking expense             | ** ** | **10,443**                  |        | 8,458        |       | 23.5                        | ** ** | **4,025**    |       | 3,299 |   | 22.0 |   |
| Amortization of intangible  assets     | ** ** | **6,482**                   |        | 6,132        |       | 5.7                         | ** ** | **2,231**    |       | 2,044 |   | 9.2 |   |
| Outsourcing expense                    | ** ** | **8,166**                   |        | 4,037        |       | 102.3                       | ** ** | **3,093**    |       | 1,351 |   | 128.9 |   |
| All other expenses                     | ** ** | **24,710**                  |        | 20,110       |       | 22.9                        | ** ** | **8,409**    |       | 6,191 |   | 35.8 |   |
| Total other expenses                   | ** ** | **72,398**                  |        | 60,309       |       | 20.0                        | ** ** | **25,960**   |       | 21,789 |   | 19.1 |   |
| Total                                  | ** ** | **$**                       | **312,448** |         | $          | 285,970                     |       | 9.3          | ** ** | **$** | **108,382** |   | $ | 99,217 |   | 9.2 |   |

 

Noninterestexpenses for the three months ended September 30, 2005 increased by $9.2million, or 9.2%, to $108.4 million compared with $99.2 million for the threemonths ended September 30, 2004. The table above shows the majorcomponents of noninterest expenses. This increase was due, in part, to theacquisition of CBNV.  CBNV added $2.9million to noninterest expenses for the third quarter of 2005 of which $1.2million was salary-related.

 

The efficiencyratio, a key measure of expense management, improved in the third 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 was48.36% for the three months ended September 30, 2005 compared with 51.20%for the three months ended September 30, 2004. On a non-GAAP basis, thecash operating 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 46.97% and 48.96% forthe three months ended September 30, 2005 and 2004, respectively. For thereconciliation of GAAP to non-GAAP measures, see page 37 of this filing.

 

Salary expenseincreased $3.1 million or 6.3% from the third quarter of 2004. The acquisitionof CBNV added $1.2 million to this expense category.  Salary expense also increased due to higherincentive compensation of $3.0 million, which is related to improved operatingperformance, and normal merit and staff increases of approximately $1.8million, offset by a $2.2 million severance charge in the third quarter of 2004related to the consolidation of eleven bank affiliates into four. Employeebenefits increased $1.1 million, or 10.2%, primarily due to increases inpayroll taxes, pension expense and medical premiums.

 

Net occupancyexpense, which includes premises depreciation, rents, maintenance andutilities, increased $1.0 million, or 16.5%, over the prior year. This increasewas related to the loss of outside tenant income of $1.2 million due to thesale of Bankshares’ headquarters building in December 2004.

 

Total otherexpenses were $4.2 million, or 19.1% higher than the same period lastyear.  This increase was due largely to a$1.7 million in outsourcing fees, which is mostly attributable to the IWMsystems and back office conversion to SunGard. The remaining increase was due to the acquisition of CBNV and higheraccruals for external audit fees, charitable giving and advertising andpromotional expenses.

 

Noninterest expense forthe nine months ended September 30, 2005 increased to $312.4 million or9.3% over the $286.0 million for the nine months ended September 30, 2004.The increase was partially due to the acquisition of CBNV.  CBNV added $5.1 million to noninterestexpenses for the nine months ended September 30, 2005. Salary expensesincreased $10.3 million. This increase was primarily due to $2.3 millionrelated to the CBNV acquisition and higher incentive compensation accruals of$6.5 million related to better year-over-year performance with the remainingincrease due to normal merit and staff increases. Employee benefits increased$1.5 million due to higher pension expense. Net occupancy expense increased $2.9 million and was related to the lossof outside tenant income of $3.9 million due to the sale of Bankshares’headquarters building in December 2004. Finally, other expenses were $12.1million, or 20.0%, higher than the prior year. This increase was primarilyattributable to a $1.0 million increase in advertising and promotion, a $2.0million increase in volume-related electronic banking fees, a $4.1 millionincrease in outsourcing fees primarily related to the IWM systems and backoffice conversion to SunGard, a $1.3 million settlement related to a previouslyannounced litigation matter, $1.2 million in higher charitable contributionsand approximately $1.1 million in merger-related charges in connection with theCBNV acquisition.

 

25

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ANALYSIS OFFINANCIAL CONDITION

 

At September 30,2005 compared with September 30, 2004, total assets increased $2.1billion, or 14.7%. At September 30, 2005 compared with December 31,2004, total assets increased $2.0 billion, or 13.7%.  This increase is attributable to organic loangrowth of  $546.9 million year-over-yearand the acquisition of CBNV on May 18, 2005, which had total assets ofapproximately $888.2 million, loans of $671.0 million, investment securities of$168.8 million, deposits of $626.9 million and borrowings of $193.5 million.

 

A comparative schedule ofaverage balances is included in the table on pages 20 and 21.

 

**SecuritiesAvailable-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 quality federalagency-backed debt securities. At September 30, 2005, the portfoliototaled $3.1 billion of debt securities available-for-sale, compared with $2.9billion at December 31, 2004. The increase in the investment portfolio wasdue primarily to additional investment securities from the CBNV acquisition,which at acquisition totaled $168.8 million. There were 88 securities in acontinuous loss position for 12 months or more at September 30, 2005,which consisted primarily of mortgage-backed securities. Because the declinesin fair value were due to changes in market interest rates, not in estimatedcash flows, no other-than-temporary impairment was recorded at September 30,2005. There was a net unrealized loss on debt securities available-for-sale of$39.8 million and $4.1 million at September 30, 2005 and December 31,2004, respectively.

 

Theweighted-average expected maturity of debt securities available-for-sale was2.0 years at September 30, 2005 compared with 2.4 years at December 31,2004.  Since approximately 49% of thisportfolio is mortgage-backed securities, the expected remaining maturity maydiffer from contractual maturity because borrowers may have the right to prepayobligations before the underlying mortgages mature.  See Note No. 4 “Investment Securities”to the Financial Statements for securities available-for-sale by security type.

 

**LoanPortfolio**

 

Total loans at September 30,2005 were $11.4 billion, compared with $10.2 billion at December 31, 2004,an increase of 11.9%. The CBNV acquisition and strong organic growth incommercial real estate and construction lending drove the increase in totalloans.  The CBNV acquisition added $671.0million in loans and contributed approximately 6.6% of the loan growth.  Construction loans totaled $1.5 billion at September 30,2005, compared with $1.3 billion at December 31, 2004, an increase of$275.3 million ($144.2 million from CBNV) or 21.7%.  Commercial real estate loans increased $515.5million ($275.9 million from CBNV) or 16.5% from the beginning of theyear.  Residential loans increased $100.8million ($10.1 million from CBNV) or 6.0% from the beginning of the year.  Home equity loans increased $24.8 million($4.5 million from CBNV).  Consumer loansincreased $242.6 million ($169.0 million from CBNV of primarily indirectautomobile loans) or 30.4% from December 31, 2004.  Commercial loans increased $58.8 million(67.3 million from CBNV) or 2.0%.  Totalloans at September 30, 2005 increased $1.4 billion or 14.3% over September 30,2004.

 

The table belowpresents the composition of the loan portfolio at September 30, 2005, December 31,2004 and September 30, 2004.

 
| ** **                   | ** ** | ** **             | ** **     | **% of**   | ** ** | ** **            | ** ** | **% of**   | ** ** | ** **             | ** ** | **% of**  | ** ** |
|------------------------------|------------|------------------------|----------------|------------|------------|-----------------------|------------|------------|------------|------------------------|------------|-----------|------------|
| ** **                   | ** ** | **September 30,** | ** **     | **Total**  | ** ** | **December 31,** | ** ** | **Total**  | ** ** | **September 30,** | ** ** | **Total** | ** ** |
| **(Dollars in thousands)**   | ** ** | **2005**               | ** **     | **Loans**  | ** ** | **2004**              | ** ** | **Loans**  | ** ** | **2004**               | ** ** | **Loans** | ** ** |
| Commercial and leasing       | ** ** | **$**                  | **2,925,445**  | ** ** | **25.6**   | **%**                 | $          | 2,866,693  |       | 28.0                   | %          | $         | 2,841,088  |   | 28.4 | % |
| Commercial real estate       | ** ** | **3,638,238**          | ** **     | **31.8**   | ** ** | 3,122,701             |       | 30.5       |       | 3,022,463              |       | 30.2      |       |
| Construction                 | ** ** | **1,543,633**          | ** **     | **13.5**   | ** ** | 1,268,350             |       | 12.4       |       | 1,170,704              |       | 11.7      |       |
| Residential real estate      | ** ** | **1,778,684**          | ** **     | **15.5**   | ** ** | 1,677,932             |       | 16.4       |       | 1,692,700              |       | 16.9      |       |
| Home equity lines            | ** ** | **520,214**            | ** **     | **4.5**    | ** ** | 495,462               |       | 4.9        |       | 473,089                |       | 4.7       |       |
| Consumer                     | ** ** | **1,039,845**          | ** **     | **9.1**    | ** ** | 797,295               |       | 7.8        |       | 814,270                |       | 8.1       |       |
| Total loans at end of period | ** ** | **$**                  | **11,446,059** | ** ** | **100.0**  | **%**                 | $          | 10,228,433 |       | 100.0                  | %          | $         | 10,014,314 |   | 100.0 | % |

 

26

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**Deposits**

 

Deposits, whichrepresent Bankshares’ primary source of funds, are offered through 238 branchesprimarily in Maryland, Virginia, Delaware, and Washington, D.C.  At September 30, 2005, total depositsincreased 12.3% or $1.3 billion compared to the year-earlier period with theCBNV acquisition contributing 5.9% of that growth based on $626.9 million inacquired deposits. Organic growth in deposits was in core deposits fromcustomers in the local markets. The affiliate banking model positionsBankshares to compete not only with the large national and regional bankingcompanies in the gathering of these funds, but also with local community banks.Based on historical experience, Bankshares expects to retain these deposits ina rising interest rate environment although pricing pressure is expected topersist.

 

The table belowpresents the composition of deposits at September 30, 2005, December 31,2004 and September 30, 2004.

 
| ** **                       | ** ** | ** **             | ** **     | ** **            | ** ** | ** **             | ** ** | **% change**                   | ** ** |
|----------------------------------|------------|------------------------|----------------|-----------------------|------------|------------------------|------------|--------------------------------|------------|
| ** **                       | ** ** | **September 30,** | ** **     | **December 31,** | ** ** | **September 30,** | ** ** | **September 30,  2005 /** | ** ** | **September 30,  2005 /** | ** ** |
| **(Dollars in thousands)**       | ** ** | **2005**               | ** **     | **2004**              | ** ** | **2004**               | ** ** | **December 31,  2004**    | ** ** | **September 30,  2004** | ** ** |
| Noninterest bearing deposits     | ** ** | **$**                  | **3,329,331**  |                  | $          | 3,049,031              |       | $                              | 3,167,398  |   | 9.2 | % | 5.1 | % |
| Savings                          | ** ** | **1,385,106**          |           | 1,449,313             |       | 1,445,978              |       | (4.4                           | )          | (4.2 | ) |
| Checking plus interest           | ** ** | **1,454,488**          |           | 1,377,981             |       | 1,310,415              |       | 5.6                            |       | 11.0 |   |
| Money market                     | ** ** | **1,830,111**          |           | 1,588,445             |       | 1,613,362              |       | 15.2                           |       | 13.4 |   |
| Time deposits $100,000 and over  | ** ** | **1,766,250**          |           | 1,393,907             |       | 1,325,049              |       | 26.7                           |       | 33.3 |   |
| Other time deposits              | ** ** | **2,274,620**          |           | 1,940,522             |       | 1,859,881              |       | 17.2                           |       | 22.3 |   |
| Total deposits at end of  period | ** ** | **$**                  | **12,039,906** |                  | $          | 10,799,199             |       | $                              | 10,722,083 |   | 11.5 |   | 12.3 |   |

 

Total deposits at September 30,2005, were $12.0 billion, an increase of $1.2 billion, or 11.5%, over December 31,2004. The increase in total deposits was primarily attributable to the $626.9million of deposits from CBNV with the main account concentration being in timecertificates of deposit.  Non-interestbearing checking accounts grew to $3.3 billion at September 30, 2005 anincrease of $280.3 million, or 9.2%, over December 31, 2004 of which CBNVcontributed $107.8 million. Interest-bearing deposits, which represent approximately 73% of totaldeposits, were $8.7 billion at September 30, 2005, compared to $7.8billion at December 31, 2004, an increase of $960.4 million, or 12.4% ofwhich CBNV contributed $519.1 million. Checking plus interest accounts increased  $76.5 million, or 5.6%, of which CBNVcontributed $19.7 million.  Savingsaccounts declined by  $64.2 million, or4.4%, as the $11.2 million in additional savings accounts from CBNV were offsetby a $75.4 million decline in existing deposits as customers sought the higherrates offered by premium money market and certificate of deposit accounts.  Money market accounts increased $241.7million, or 15.2%, of which CBNV contributed $56.8 million.  Time deposits greater than $100,000 increasedby $372.3 million, or 26.7%, of which CBNV contributed $152.7 million.  Other time deposits increased by $334.1million, or 17.2%, of which CBNV contributed $278.7 million.

 

**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 $1.3 billion at September 30, 2005,compared with $887.9 million at December 31, 2004.  Short-term funding is managed to levelsdeemed appropriate given alternative funding sources.  The increase of  $378.8 million, or 42.7%, in short-termborrowings reflected an increase in customer securities sold under agreementsto repurchase as well as increased usage of the overnight funding markets tosupport loan growth and fund the $82.9 million cash portion of the CBNV acquisition.  Long-term debt was $780.1 million at September 30,2005, an increase of $89.1 million, or 12.9%, compared with $691.0 million at December 31,2004.  The increase in long-term debt wasprimarily the result of $116.2 million of additional FHLB advances andsubordinated debt assumed in the CBNV acquisition.

 

**Capital**

 

Shareholders’equity at September 30, 2005 was $2.2 billion, an increase of $233.7million from December 31, 2004. This increase reflected the shares issuedin the CBNV acquisition that were valued at $124.3 million. Bankshares hasauthorization enabling it to repurchase up to approximately 0.5 millionadditional shares.  For more informationon capital adequacy see Footnote No. 9 “Capital Adequacy.”

 

27

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RISK MANAGEMENT

 

**CreditRisk Analysis**

 

Bankshares’ loans andcommitments are substantially to borrowers located within our immediate region.Bankshares has set an internal limit for each affiliate bank that is well belowthe regulatory limit, on the maximum amount of credit that may be extended to asingle borrower.  For more information oncredit risk see “Risk Management – Credit Risk Analysis” in the MercantileBankshares Corporation’s 2004 Annual Report on Form 10-K.

 

**NonperformingAssets**

 

Nonperforming assetsconsist of nonaccrual loans, renegotiated loans and other real estate owned(i.e., real estate acquired in foreclosure or in lieu of foreclosure).  With respect to nonaccrual loans, Bankshares’policy is that, regardless of the value of the underlying collateral and/orguarantees, no interest is accrued on the entire balance once either principalor interest payments on any loan become 90 days past due at the end of acalendar quarter.  All accrued anduncollected interest on such loans is charge against interest income and isrecognized only as collected.  If a loanis impaired and has a specific loss allocation based on an analysis under SFAS No. 114,“**Accounting by Creditors for Impairment of a Loan –****An Amendment of FASB Statements No. 5 and 15,**”all payments are then applied against the loan’s principal.  A loan may be put on nonaccrual status soonerthan this standard if, in management’s judgment, such action is warranted.

 

During the nine monthsended September 30, 2005, nonperforming assets decreased $3.3million to$27.8 million from $31.1 million at December 31, 2004.  Nonaccrual loans were $27.0 million at September 30,2005 and other real estate owned, the other component of nonperforming assets,was $0.8 million.  Nonperforming assetsas a percent of period-end loans and other real estate owned were 0.24% at September 30,2005 and 0.30% at December 31, 2004, respectively.  The decrease in nonperforming loans was dueprimarily to improvement in credit quality at the lead bank, MSD&T.

 

At September 30,2005 and December 31, 2004, monitored loans, or loans with characteristicssuggesting that they could be classified as nonperforming in the near future,were $3.4 million and $6.4 million, respectively.  Contributing to this decrease was theelimination of the one remaining loan secured by a commercial aircraft. Theamount of loans past due 30-89 days increased from $51.5 million at December 31,2004 to $57.3 million at September 30, 2005.  At the acquisition date, Banksharesdetermined that two loans at CBNV came under the scope of SOP 03-3, “Accountingfor Certain Loans or Debt Securities Acquired in a Transfer.”  These loans have a $4.9 million contractualbalance and a $3.5 million carrying value at September 30, 2005.  The accretable yield on these loans for thequarter was $96 thousand.  For additionalinformation on these loans see Note No.5 “Impaired Loans”

 

The table below presentsa comparison of nonperforming assets at September 30, 2005, December 31,2004 and September 30, 2004.

 
| ** **                                                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|------------------------|------------|
| **(Dollars in thousands)**                                                | ** ** | **2005**               | ** ** | **2004**              | ** ** | **2004**               | ** ** |
| Nonaccrual loans*(1)*                                                     |       |                   | ** ** |                  |       |                   |       |
| Commercial and leasing                                                    | ** ** | **$**                  | **21,065** | ** **            | $          | 25,510                 |       | $ | 32,401 |   |
| Commercial real estate                                                    | ** ** | **3,240**              | ** ** | 1,959                 |       | 2,925                  |       |
| Construction                                                              | ** ** | **377**                | ** ** | 9                     |       | 25                     |       |
| Residential real estate                                                   | ** ** | **1,845**              | ** ** | 2,748                 |       | 2,675                  |       |
| Home equity lines                                                         | ** ** | **89**                 | ** ** | 300                   |       | 256                    |       |
| Consumer                                                                  | ** ** | **406**                | ** ** | 372                   |       | 620                    |       |
| Total                                                                     | ** ** | **27,022**             | ** ** | 30,898                |       | 38,902                 |       |
| Renegotiated loans*(1)*                                                   | ** ** | **—**             | ** ** | —                |       | —                 |       |
| Loans contractually past due  90 days or more and still accruing interest | ** ** | **—**             | ** ** | **—**            | ** ** | **—**             | ** ** |
| Total nonperforming loans                                                 | ** ** | **27,022**             | ** ** | 30,898                |       | 38,902                 |       |
| Other real estate owned                                                   | ** ** | **777**                | ** ** | 212                   |       | 388                    |       |
| Total nonperforming assets                                                | ** ** | **$**                  | **27,799** | ** **            | $          | 31,110                 |       | $ | 39,290 |   |
| Nonperforming loans as a percent of                                       |       |                   | ** ** |                  |       |                   |       |
| period-end loans                                                          | ** ** | **0.24**               | **%**      | 0.30                  | %          | 0.39                   | %          |
| Nonperforming assets as a percent of                                      |       |                   | ** ** |                  |       |                   |       |
| period-end loans and other  real estate owned                             | ** ** | **0.24**               | **%**      | 0.30                  | %          | 0.39                   | %          |

 

----

(1)          Aggregategross interest income of $1.9 million, $2.5 million and $2.0 million for thefirst nine months of 2005, the year 2004 and the first nine months of 2004,respectively, on nonaccrual and renegotiated loans, would have been recorded ifthese loans had been accruing on their original terms throughout the period orsince origination if held for part of the period.  The amount of interest income on thenonaccrual and renegotiated loans that was recorded totaled $0.5 million, $0.8million and $0.6 million for the first nine months of 2005, the year 2004 andthe first nine months of 2004, respectively.

 

28

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**Allowanceand Provision for Loan Losses**

 

Each Bankshares affiliateis required to maintain an allowance for loan losses adequate to absorb lossesinherent in the loan portfolio. Each affiliate’s reserve is dedicated to thataffiliate only and is not available to absorb losses from anotheraffiliate.  Management at each affiliate,along with Bankshares’ management, conducts a regular review to assureadequacy.  On a periodic basis,significant credit exposures, nonperforming loans, impaired loans, historicallosses by loan type and various statistical measurements of asset quality areexamined to assure the adequacy of the allowance for loan losses. Managementbelieves that the allowance for loan losses is adequate to absorb lossesinherent in the portfolio.

 

The allowance for loanlosses has been established through provisions for loan losses charged againstincome. Loans deemed uncollectible are charged against the allowance for loanlosses and any subsequent recoveries are credited to the allowance.  Intensive collection efforts continue aftercharge-off in order to maximize recovery amounts.  A $1.6 million provision for possible loanlosses was taken for the nine months ended September 30, 2005. Thiscompares with a $7.2 million provision for the nine months ended September 30,2004. The decline in the provision reflects the charge-off of severalnonperforming loans during the fourth quarter of 2004, an improved economy andimproved credit quality measures within Bankshares’ Affiliate Banks. Netcharge-offs were $0.5 million for the nine month ended September 30, 2005,compared with $1.1 for the nine months ended September 30, 2004. Theallowance for loan losses increased between December 31, 2004 and September 30,2005 primarily as a result of the acquired allowance of CBNV, which after theapplication of SOP 03-3, was approximately $7.1 million. The allowance for loanlosses as a percent of period-end loans decreased to 1.37% at September 30,2005 from 1.46% at December 31, 2004 and 1.61% at September 30, 2004.The reduction in the allowance as a percentage of total loans is attributableto improved credit quality as well as the acquired loan portfolio, whichresulted in a lower required allowance as a percentage of loans.

 

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

 
| ** **                                                                 | ** ** | **For the 9  months ended September 30,** |           | **For the 3  months ended September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------|----------------|------------------------------------------------|------------|
| **(Dollars in thousands)**                                                 | ** ** | **2005**                                       | ** **     | **2004**                                       |       | **2005** | ** ** | **2004** | ** ** |
| Allowance balance - beginning                                              | ** ** | **$**                                          | **149,002**    | ** **                                     | $          | 155,337 |   | **$** | **157,101** | ** ** | $ | 158,431 |   |
| Allowance of acquired bank                                                 | ** ** | **7,086**                                      | ** **     |                                           |       |   | ** ** |   |   |
| Charge-offs:                                                               |       |                                           | ** **     |                                           |       |   | ** ** |   |   |
| Commercial and leasing                                                     | ** ** | **(2,252**                                     | **)**          | (1,092                                         | )          | **(570** | **)** | (147 | ) |
| Commercial real estate                                                     | ** ** | **(32**                                        | **)**          | (67                                            | )          | **—** | ** ** | (39 | ) |
| Construction                                                               | ** ** | **—**                                     | ** **     | —                                         |       | **—** | ** ** | — |   |
| Residential real estate                                                    | ** ** | **(42**                                        | **)**          | (377                                           | )          | **(28** | **)** | (255 | ) |
| Home equity lines                                                          | ** ** | **(69**                                        | **)**          | (46                                            | )          | **—** | ** ** | — |   |
| Consumer                                                                   | ** ** | **(2,430**                                     | **)**          | (3,419                                         | )          | **(1,112** | **)** | (1,081 | ) |
| Total                                                                      | ** ** | **(4,825**                                     | **)**          | (5,001                                         | )          | **(1,710** | **)** | (1,522 | ) |
| Recoveries:                                                                |       |                                           | ** **     |                                           |       |   | ** ** |   |   |
| Commercial and leasing                                                     | ** ** | **1,813**                                      | ** **     | 1,515                                          |       | **233** | ** ** | 1,178 |   |
| Commercial real estate                                                     | ** ** | **151**                                        | ** **     | 51                                             |       | **27** | ** ** | 25 |   |
| Construction                                                               | ** ** | **446**                                        | ** **     | 4                                              |       | **445** | ** ** | — |   |
| Residential real estate                                                    | ** ** | **232**                                        | ** **     | 358                                            |       | **167** | ** ** | 167 |   |
| Home equity lines                                                          | ** ** | **—**                                     | ** **     | 95                                             |       | **—** | ** ** | 94 |   |
| Consumer                                                                   | ** ** | **1,695**                                      | ** **     | 1,861                                          |       | **93** | ** ** | 626 |   |
| Total                                                                      | ** ** | **4,337**                                      | ** **     | 3,884                                          |       | **965** | ** ** | 2,090 |   |
| Net (charge-offs) / recoveries                                             | ** ** | **(488**                                       | **)**          | (1,117                                         | )          | **(745** | **)** | 568 |   |
| Provision for loan losses                                                  | ** ** | **1,576**                                      | ** **     | 7,221                                          |       | **820** | ** ** | 2,442 |   |
| Allowance balance - ending                                                 | ** ** | **$**                                          | **157,176**    | ** **                                     | $          | 161,441 |   | **$** | **157,176** | ** ** | $ | 161,441 |   |
| Average loans                                                              | ** ** | **$**                                          | **10,871,724** | ** **                                     | $          | 9,596,875 |   | **$** | **11,389,731** | ** ** | $ | 9,825,793 |   |
| Percent of net charge-offs /  (recoveries), (annualized), to average loans | ** ** | **0.01**                                       | **%**          | 0.02                                           | %          | **0.03** | **%** | (0.02 | )% |
| Period-end loans                                                           | ** ** | **$**                                          | **11,446,059** | ** **                                     | $          | 10,014,314 |   |   | ** ** |   |   |
| Percent of allowance for loan  losses to period-end loans                  | ** ** | **1.37**                                       | **%**          | 1.61                                           | %          |   | ** ** |   |   |

 

**InterestRate Risk**

 

The objective ofinterest rate risk management is to contain the risks associated with interestrate fluctuations. 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.

 

29

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EARNINGS SIMULATION MODELPROJECTIONS

 

Banksharesassesses interest rate risk by comparing projected net interest income in thecurrent rate environment with various interest rate scenarios that differ inthe direction of interest rate changes, the degree of change over time, thespeed of the change and the projected shape of the yield curve.  This analysis incorporates substantially allof Bankshares’ assets and liabilities and off-balance sheet instruments as of September 30,2005.  Through these simulations,management estimates the impact on net interest income of a 200 basis pointupward and 100 basis point downward change in interest rates. The followingtable summarizes the effect a positive 100 and 200 basis point parallel changeand a negative 100 basis point parallel change in interest rates would have onBankshares’ net interest income over the next 12 months.

 
| ** **                   | ** ** | **Calculated  increase / (decrease) in** | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| ** **                   | ** ** | **projected  net interest income**       | ** ** |
| **Change in interest rates** | ** ** | **September 30,**                   | ** ** | **December 31,** | ** ** |
| **(basis points)**           | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| +200                         | ** ** | **3.3**                                  | **%**      | 5.5 | % |
| +100                         | ** ** | **1.7**                                  | **%**      | 2.8 | % |
| -100                         | ** ** | **(2.2**                                 | **)%**     | (2.9 | )% |

 

At September 30,2005, Bankshares’ interest sensitivity position remained asset sensitive.  Based on its most recent simulation model,Bankshares’ net interest income would increase by $10.9 million or 1.7% and$21.0 million or 3.3% 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 $13.8 million or 2.2%.  Bankshares manages the interest rate riskprofile within policy limits.  During thethird quarter of 2005, Bankshares’ Asset/Liability Management Committee (“ALCO”)began measuring interest rate risk in a down 200 basis point scenario.  As of September 30, 2005 Bankshares wasslightly outside of the policy guidelines. Given the rising rate environment,Bankshares’ ALCO has elected to measure the risk for decrease in interest ratesat 100 basis points as a more probable scenario.  In response to action by the Federal Reserveto increase short-term interest rates, Bankshares’ prime interest ratecontinues to rise.  Bankshares hasapproximately $4.7 billion in loans that will reprice within the nextquarter.  The effects of a rising rateenvironment on interest expense are less predictable due to customer behaviorthat may shift the mix of deposit products. Approximately $1.6 billion in short and long-term debt will also besubject to rate increases within the next quarter.  As rates continue to rise, managementexpects, based on Bankshares’ interest sensitivity position, that the netinterest margin and net interest income will expand modestly.

 

Bankshares alsoutilizes interest rate derivatives to hedge interest rate risk exposures. Thecredit risk amount and estimated net fair values of these derivatives as of September 30,2005 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:

•                  To convert long-term fixed-rate debtto floating-rate payments by entering into receive-fixed swaps at issuance;

•                  To convert the cash flows fromselected asset and/or liability instruments/portfolios from fixed to floatingpayments or vice versa; and

•                  To hedge the mortgage originationpipeline by utilizing forward rate commitments for loans held-for-sale.

 

MARKET VALUE OFEQUITY MODELING

 

Bankshares alsoutilizes the market value of equity as a measurement tool in managing interestrate sensitivity.  The market value ofequity measures the degree to which the market values of Bankshares’ assets andliabilities and off-balance sheet instruments will change given a change ininterest rates.  ALCO guidelines limitthe change in market value of equity in a 200 basis point parallel rate shockto 25% of the market value of equity assuming interest rates at September 30,2005.  The up 200 basis point scenarioresulted in a 2.7% decrease at September 30, 2005 and a 2.2% increase at December 31,2004.  The down 200 basis point scenarioresulted in an 2.1% decrease at September 30, 2005 and an 8.6% decrease atDecember 31, 2004.  At September 30,2005 and December 31, 2004, Bankshares was within its policy guidelines.

 

The valuationanalysis is dependent upon certain key assumptions about the nature ofindeterminate maturities of assets and liabilities. Management estimates theaverage life and rate characteristics of asset and liability accounts based onhistorical analysis and management’s expectation of rate behavior.  These assumptions are periodically validatedand updated.

 

30

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**MarketRisk – Trading Activities**

 

Banksharesprovides capital market products to its customers. From a market riskperspective, Bankshares’ net income is exposed to changes in interest rates,credit spreads, and equities and their implied volatilities.  The primary purpose of Bankshares’ tradingbusiness is to accommodate customers in the management of their market pricerisks.  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 ALCO establishes and monitors counterparty risk limits.  The notional amount, exposure amount andestimated net fair value of all customer accommodation derivatives at September 30,2005 are included in Note No. 11 (Derivative Instruments and HedgingActivities) to the Financial Statements.

 

**MarketRisk – Equity Markets**

 

Bankshares isdirectly and indirectly affected by changes in the equity markets.  Bankshares has made investments in privateequities and hedge funds. These investments are made within capital allocationsapproved by management.  Managementreviews these investments at least quarterly and assesses them for possibleother-than-temporary impairment.  Privateequity and hedge funds investments totaled $32.2 million and $61.7 million,respectively, at September 30, 2005 and $23.4 million and $74.8 million,respectively, at September 30, 2004.

 

Changes in equitymarket prices may also indirectly affect Bankshares’ net income:   (1) by affecting the value of thirdparty assets under management or administration within IWM and, hence, feeincome; (2) by affecting particular borrowers, whose ability to repayprincipal and/or interest may be affected by the stock market; or (3) byaffecting brokerage activity, related commission income and other business activities.

 

**LiquidityRisk**

 

Liquidity risk isthe possibility that Bankshares will not be able to fund present and futurefinancial obligations.  The objective ofliquidity management is to maintain the ability to meet commitments to fundloans, purchase securities and repay deposits and other liabilities inaccordance with their terms.  To achievethis objective, the ALCO establishes and monitors liquidity guidelines thatrequire sufficient asset-based liquidity to cover potential fundingrequirements and to avoid over-reliance on volatile, less reliable fundingmarkets.  Debt securities in theavailable-for-sale portfolio provide liquidity, in addition to the immediatelyliquid resources of cash and due from banks and federal funds sold andsecurities purchased under resale agreements. By limiting the maturity of securities and maintaining a conservativeinvestment posture, management can rely on the investment portfolio to helpmeet any short-term funding needs. U.S. Treasury and agency securities, whichprovide the greatest liquidity, averaged $1.4 billion for the third quarter of2005 and the second quarter of 2005, an 8.9% decrease from the average of $1.6billion for the third quarter of 2004.

 

Core customerdeposits have historically provided a substantial source of relatively stable,low-cost funds.  For the three monthsended September 30, 2005, core deposits (total deposits less certificatesof deposit of $100,000 and over) averaged $10.1 billion compared with $9.7billion for the second quarter of 2005 and $9.2 billion for the third quarterof 2004.  Although not viewed as coredeposits, a substantial portion of short-term borrowings comprised ofsecurities sold under agreements to repurchase and commercial paper originatefrom core deposit relationships tied to an overnight cash management programoffered to customers.  Long-term debt andshort-term borrowings funded the remaining assets.

 

In addition tothese sources, Bankshares has access to national markets for certificates ofdeposit, commercial paper and debt financing. Should it need to further supplement its liquidity, Bankshares has $1.8billion in lines with the FHLB Atlanta and back-up commercial paper lines of$40 million with commercial banks. Bankshares is required to obtain approval fromholders of Bankshares’ 6.72% and 6.80% unsecured senior notes if itincrementally borrows in excess of $150 million under these FHLB lines.

 

Liquidity is alsoavailable through Bankshares’ ability to raise funds in the capitalmarkets.  Bankshares accesses capitalmarkets for long-term funding by issuing registered debt and privateplacements.  As of September 2005,Moody’s Investors Service published their Mercantile Bankshares Corporation’scommercial paper rating of  “P-1” and theCorporation’s subordinated debt rating of “A2.” Also in September 2005, Standard & Poor’s Ratings Servicepublished their Bankshares’ rating of “A+/Stable/A-1” and counterparty ratingof “A+/Stable/A-1. ” Rating agencies base their ratings on many quantitativeand qualitative factors, including capital adequacy, liquidity, asset quality,quality of the management team, business mix and level and quality ofearnings.  For additional information see“Risk Management – Liquidity Risk” in the Mercantile Bankshares Corporation’s 2004Annual Report on Form 10-K.

 

31

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**ContractualObligations and Commitments**

 

In the normalcourse of business, Bankshares enters into certain contractual obligations andother commitments. Such obligations generally relate to funding operationsthrough debt 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.

 

**CautionaryStatement**

 

This reportcontains financial information determined by methods other than in accordance withGenerally Accepted Accounting Principles (“GAAP”).  Bankshares’ management uses these non-GAAPmeasures in their analysis of the Company’s performance. In particular, netinterest income, net interest margin and the cash operating efficiency ratioare 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.

 

This reportcontains forward-looking statements within the meaning of and pursuant to thesafe harbor provisions of the Private Securities Litigation Reform Act of1995.  A forward-looking statementencompasses any estimate, prediction, opinion or statement of belief containedin this report, and the underlying management assumptions.  Such statements in this report include:identification of trends; loan growth; deposit retention; comments on adequacyof the allowance for loan losses; credit quality; changes in leasingactivities; effects of asset sensitivity and interest rate changes; informationconcerning market risk referenced in Item 3; expected pro forma assets, loansand deposits of the banks resulting from the planned reorganization; and theanticipated effect of the proposed reorganization on operations, regulatorycompliance and service to banking customers. Forward-looking statements are based on current expectations andassessments of potential developments affecting market conditions, interestrates and other economic conditions, and results may ultimately vary from thestatements made in this report.  Inaddition, the following factors, among others, could cause actual results todiffer materially from the anticipated results or expectations expressed in theforward-looking statements: administrative and operational efficiencies may notimprove to the degree projected; and competitive pressures and regulatorycomplexities that affect our banks may be stronger than expected.

 

32

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**SupplementalInformation by Quarter**

**SelectFinancial Data**

(in thousands, except per share data)

 
| ** **                                                                            | ** ** | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **3Q 05**  | ** ** | **3Q 05** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|----------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|-----------|------------|
| ** **                                                                            | ** ** | ** **     | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**     | ** ** | **vs**    | ** ** |
| ** **                                                                            | ** ** | **3Q 05**      | ** **     | **2Q 05**  | ** ** | **1Q 05**  | ** ** | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 05**  | ** ** | **3Q 04** | ** ** |
| **OPERATING RESULTS**                                                                 |       |           | ** **     |       |       |       |       |       |       |       |       |       |       |      |       |
| Net interest income (1)                                                               | ** ** | **$**          | **159,242**    | ** ** | $          | 152,367    |       | $          | 143,083    |       | $          | 143,710    |       | $         | 138,182    |   | 4.5 | % | 15.2 | % |
| Net interest income - taxable  equivalent (1)                                         | ** ** | **161,023**    | ** **     | 154,023    |       | 144,660    |       | 145,370    |       | 139,866    |       | 4.5        |       | 15.1      |       |
| Provision for loan losses                                                             | ** ** | **820**        | ** **     | —     |       | 756        |       | —     |       | 2,442      |       |       |       | (66.4     | )          |
| Net income                                                                            | ** ** | **70,956**     | ** **     | 67,873     |       | 62,627     |       | 60,612     |       | 56,785     |       | 4.5        |       | 25.0      |       |
| **PER COMMON SHARE DATA**                                                             | ** ** | ** **     | ** **     |       |       |       |       |       |       |       |       |       |       |      |       |
| Basic net income                                                                      | ** ** | **$.87**       | ** **     | $.84       |       | $.79       |       | $.77       |       | $.72       |       | 3.6        | %          | 20.8      | %          |
| Diluted net income                                                                    | ** ** | **.86**        | ** **     | .84        |       | .78        |       | .76        |       | .71        |       | 2.4        |       | 21.1      |       |
| Dividends paid                                                                        | ** ** | **.38**        | ** **     | .38        |       | .35        |       | .35        |       | .35        |       | —     |       | 8.6       |       |
| Book value at period end                                                              | ** ** | **26.21**      | ** **     | 25.87      |       | 24.39      |       | 24.18      |       | 23.85      |       | 1.3        |       | 9.9       |       |
| Market value at period end                                                            | ** ** | **53.88**      | ** **     | 51.53      |       | 50.86      |       | 52.20      |       | 47.96      |       | 4.6        |       | 12.3      |       |
| Market range:                                                                         | ** ** | ** **     | ** **     |       |       |       |       |       |       |       |       |       |       |      |       |
| High                                                                                  | ** ** | **56.19**      | ** **     | 52.80      |       | 52.35      |       | 53.09      |       | 49.34      |       | 6.4        |       | 13.9      |       |
| Low                                                                                   | ** ** | **51.19**      | ** **     | 48.58      |       | 48.40      |       | 47.07      |       | 44.18      |       | 5.4        |       | 15.9      |       |
| **AVERAGE BALANCE SHEET DATA**                                                        | ** ** | ** **     | ** **     |       |       |       |       |       |       |       |       |       |       |      |       |
| Total loans                                                                           | ** ** | **$**          | **11,389,731** | ** ** | $          | 10,899,263 |       | $          | 10,314,361 |       | $          | 10,084,344 |       | $         | 9,825,793  |   | 4.5 | % | 15.9 | % |
| Total earning assets                                                                  | ** ** | **14,490,736** | ** **     | 13,840,991 |       | 13,221,167 |       | 13,056,972 |       | 12,831,612 |       | 4.7        |       | 12.9      |       |
| Total assets                                                                          | ** ** | **16,065,168** | ** **     | 15,233,571 |       | 14,508,344 |       | 14,310,894 |       | 14,099,488 |       | 5.5        |       | 13.9      |       |
| Total deposits                                                                        | ** ** | **11,751,990** | ** **     | 11,273,220 |       | 10,718,734 |       | 10,675,933 |       | 10,507,716 |       | 4.2        |       | 11.8      |       |
| Shareholders’ equity                                                             | ** ** | **2,179,415**  | ** **     | 2,042,104  |       | 1,950,276  |       | 1,911,151  |       | 1,877,844  |       | 6.7        |       | 16.1      |       |
| **STATISTICS AND RATIOS (Net  income annualized)**                                    | ** ** | ** **     | ** **     |       |       |       |       |       |       |       |       |       |       |      |       |
| Return on average assets                                                              | ** ** | **1.75**       | **%**          | 1.79       | %          | 1.75       | %          | 1.68       | %          | 1.60       | %          |       |       |      |       |
| Return on average equity (2)                                                          | ** ** | **12.92**      | ** **     | 13.33      |       | 13.02      |       | 12.62      |       | 12.03      |       |       |       |      |       |
| Return on average tangible  equity (2)                                                | ** ** | **19.62**      | ** **     | 19.64      |       | 18.57      |       | 18.16      |       | 17.63      |       |       |       |      |       |
| Average equity to average  assets (2)                                                 | ** ** | **13.57**      | ** **     | 13.41      |       | 13.44      |       | 13.35      |       | 13.32      |       |       |       |      |       |
| Average tangible equity to  average tangible assets (2)                               | ** ** | **9.53**       | ** **     | 9.67       |       | 10.00      |       | 9.84       |       | 9.67       |       |       |       |      |       |
| Net interest rate spread -  taxable equivalent                                        | ** ** | **3.83**       | ** **     | 3.95       |       | 3.99       |       | 4.02       |       | 3.99       |       |       |       |      |       |
| Net interest margin on earning  assets - taxable equivalent                           | ** ** | **4.41**       | ** **     | 4.46       |       | 4.44       |       | 4.43       |       | 4.34       |       |       |       |      |       |
| Efficiency ratio (1),(3)                                                              | ** ** | **48.36**      | ** **     | 48.54      |       | 49.45      |       | 52.70      |       | 51.20      |       |       |       |      |       |
| Operating efficiency ratio  (1),(3)                                                   | ** ** | **46.97**      | ** **     | 48.29      |       | 48.68      |       | 51.20      |       | 48.96      |       |       |       |      |       |
| Dividend payout ratio                                                                 | ** ** | **43.68**      | ** **     | 45.24      |       | 44.30      |       | 45.45      |       | 48.61      |       |       |       |      |       |
|                                                                                  | ** ** | ** **     | ** **     |       |       |       |       |       |       |       |       |       |       |      |       |
| Bank offices                                                                          | ** ** | **238**        | ** **     | 239        |       | 225        |       | 226        |       | 229        |       | (1         | )          | 9         |       |
| Employees                                                                             | ** ** | **3,607**      | ** **     | 3,630      |       | 3,423      |       | 3,479      |       | 3,418      |       | (23        | )          | 189       |       |
| **CREDIT QUALITY DATA AT PERIOD  END**                                                | ** ** | ** **     | ** **     |       |       |       |       |       |       |       |       |       |       |      |       |
| Net charge-offs / (recoveries)                                                        | ** ** | **$**          | **745**        | ** ** | $          | (998       | )          | $          | 741        |       | $          | 12,439     |       | $         | (568       | ) | 174.6 | % | 231.2 | % |
| Nonaccrual loans                                                                      | ** ** | **27,022**     | ** **     | 26,909     |       | 31,234     |       | 30,898     |       | 38,902     |       | 0.4        |       | (30.5     | )          |
| Restructured loans                                                                    |       | —         | ** **     | —     |       | —     |       | —     |       | —     |       | —     |       | —    |       |
| Total nonperforming loans                                                             | ** ** | **27,022**     | ** **     | 26,909     |       | 31,234     |       | 30,898     |       | 38,902     |       | 0.4        |       | (30.5     | )          |
| Other real estate owned, net                                                          | ** ** | **777**        | ** **     | 777        |       | 145        |       | 212        |       | 388        |       | —     |       | 100.3     |       |
| Total nonperforming assets                                                            | ** ** | **27,799**     | ** **     | 27,686     |       | 31,379     |       | 31,110     |       | 39,290     |       | 0.4        |       | (29.2     | )          |
| **CREDIT QUALITY RATIOS**                                                             | ** ** | ** **     | ** **     |       |       |       |       |       |       |       |       |       |       |      |       |
| Provision for loan losses  (annualized) as a percent of period-end loans              | ** ** | **.03**        | **%**          | —     | %          | .03        | %          | —     | %          | .10        | %          |       |       |      |       |
| Net charge-offs / (recoveries)  - annualized as a percent of period-end loans         | ** ** | **.03**        | ** **     | (.04       | )          | .03        |       | .48        |       | (.02       | )          |       |       |      |       |
| Nonperforming loans as a  percent of period-end loans                                 | ** ** | **.24**        | ** **     | .24        |       | .30        |       | .30        |       | .39        |       |       |       |      |       |
| Allowance for loan losses as a  percent of period-end loans                           | ** ** | **1.37**       | ** **     | 1.38       |       | 1.43       |       | 1.46       |       | 1.61       |       |       |       |      |       |
| Allowance for loan losses as a  percent of nonperforming loans                        | ** ** | **581.66**     | ** **     | 583.82     |       | 477.10     |       | 482.24     |       | 414.99     |       |       |       |      |       |
| Other real estate owned as a  percent of period-end loans and other real estate owned | ** ** | **.01**        | ** **     | .01        |       | —     |       | —     |       | —     |       |       |       |      |       |
| Nonperforming assets as a  percent of period-end loans and other real estate owned    | ** ** | **.24**        | ** **     | .24        |       | .30        |       | .30        |       | .39        |       |       |       |      |       |
| Nonperforming assets as a  percent of total assets                                    | ** ** | **.17**        | ** **     | .17        |       | .21        |       | .22        |       | .27        |       |       |       |      |       |

 

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(1),(2),(3) See Reconciliation of Non-GAAP measures on page 37 for additionalinformation.

 

33

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**Statementsof Consolidated Income**

(in thousands, except per share data)

 
| ** **                                               | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **3Q 05** | ** ** | **3Q 05** | ** ** |
|----------------------------------------------------------|------------|-------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|-----------|------------|-----------|------------|
| ** **                                               | ** ** | ** **  | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**    | ** ** | **vs**    | ** ** |
| ** **                                               | ** ** | **3Q 05**   | ** **  | **2Q 05**  | ** ** | **1Q 05**  | ** ** | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 05** | ** ** | **3Q 04** | ** ** |
| **INTEREST INCOME**                                      |       |        | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Interest and fees on loans                               | ** ** | **$**       | **185,714** | ** ** | $          | 169,877    |       | $          | 152,544    |       | $          | 147,114   |       | $         | 138,117    |   | 9.3 | % | 34.5 | % |
| Interest and dividends on investment securities:         | ** ** | ** **  | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Taxable interest income                                  | ** ** | **26,686**  | ** **  | 25,374     |       | 24,992     |       | 25,809     |       | 26,048     |       | 5.2       |       | 2.4       |       |
| Tax-exempt interest income                               | ** ** | **839**     | ** **  | 788        |       | 721        |       | 766        |       | 803        |       | 6.5       |       | 4.5       |       |
| Other investment income                                  | ** ** | **526**     | ** **  | 583        |       | 644        |       | 1,157      |       | 472        |       | (9.8      | )          | 11.4      |       |
|                                                     | ** ** | **28,051**  | ** **  | 26,745     |       | 26,357     |       | 27,732     |       | 27,323     |       | 4.9       |       | 2.7       |       |
| Other interest income                                    | ** ** | **760**     | ** **  | 442        |       | 344        |       | 414        |       | 449        |       | 71.9      |       | 69.3      |       |
| Total interest income                                    | ** ** | **214,525** | ** **  | 197,064    |       | 179,245    |       | 175,260    |       | 165,889    |       | 8.9       |       | 29.3      |       |
| **INTEREST EXPENSE**                                     | ** ** | ** **  | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Interest on deposits                                     | ** ** | **38,591**  | ** **  | 31,384     |       | 25,305     |       | 22,621     |       | 20,142     |       | 23.0      |       | 91.6      |       |
| Interest on short-term borrowings                        | ** ** | **7,702**   | ** **  | 5,484      |       | 4,042      |       | 2,955      |       | 1,990      |       | 40.4      |       | 287.0     |       |
| Interest on long-term debt                               | ** ** | **8,990**   | ** **  | 7,829      |       | 6,815      |       | 5,974      |       | 5,575      |       | 14.8      |       | 61.3      |       |
| Total interest expense                                   | ** ** | **55,283**  | ** **  | 44,697     |       | 36,162     |       | 31,550     |       | 27,707     |       | 23.7      |       | 99.5      |       |
|                                                     | ** ** | ** **  | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| **NET INTEREST INCOME**                                  | ** ** | **159,242** | ** **  | 152,367    |       | 143,083    |       | 143,710    |       | 138,182    |       | 4.5       |       | 15.2      |       |
| Provision for loan losses                                | ** ** | **820**     | ** **  | —     |       | 756        |       | —     |       | 2,442      |       |      |       | (66.4     | )          |
| **NET INTEREST INCOME AFTER  PROVISION FOR LOAN LOSSES** | ** ** | **158,422** | ** **  | 152,367    |       | 142,327    |       | 143,710    |       | 135,740    |       | 4.0       |       | 16.7      |       |
| **NONINTEREST INCOME**                                   | ** ** | ** **  | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Investment and wealth management                         | ** ** | **23,668**  | ** **  | 23,780     |       | 24,057     |       | 22,735     |       | 22,396     |       | (0.5      | )          | 5.7       |       |
| Service charges on deposit accounts                      | ** ** | **11,478**  | ** **  | 11,088     |       | 10,426     |       | 11,312     |       | 11,278     |       | 3.5       |       | 1.8       |       |
| Mortgage banking-related fees                            | ** ** | **5,151**   | ** **  | 2,895      |       | 2,283      |       | 3,199      |       | 3,063      |       | 77.9      |       | 68.2      |       |
| Investment securities gains and (losses)                 | ** ** | **(32**     | **)**       | 76         |       | 414        |       | 705        |       | (1         | )          | (142..1   | )          |      |       |
| Nonmarketable investments                                | ** ** | **4,190**   | ** **  | 4,222      |       | 5,271      |       | 4,001      |       | 2,767      |       | (3.4      | )          | 51.4      |       |
| Other income                                             | ** ** | **18,619**  | ** **  | 18,005     |       | 15,418     |       | 13,776     |       | 14,418     |       | 3.5       |       | 29.1      |       |
| Total noninterest income                                 | ** ** | **63,074**  | ** **  | 60,066     |       | 57,869     |       | 55,728     |       | 53,921     |       | 5.0       |       | 17.0      |       |
| **NONINTEREST EXPENSES**                                 | ** ** | ** **  | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Salaries                                                 | ** ** | **51,748**  | ** **  | 50,180     |       | 46,554     |       | 49,448     |       | 48,696     |       | 3.1       |       | 6.3       |       |
| Employee benefits                                        | ** ** | **11,637**  | ** **  | 11,956     |       | 11,897     |       | 10,678     |       | 10,557     |       | (2.7      | )          | 10.2      |       |
| Net occupancy expense of bank premises                   | ** ** | **7,139**   | ** **  | 6,857      |       | 6,922      |       | 6,300      |       | 6,128      |       | 4.1       |       | 16.5      |       |
| Furniture and equipment expenses                         | ** ** | **7,965**   | ** **  | 7,924      |       | 7,279      |       | 8,566      |       | 7,936      |       | 0.5       |       | 0.4       |       |
| Communications and supplies                              | ** ** | **3,933**   | ** **  | 4,019      |       | 4,040      |       | 4,294      |       | 4,111      |       | (2.1      | )          | (4.3      | )          |
| Other expenses                                           | ** ** | **25,960**  | ** **  | 22,977     |       | 23,461     |       | 26,702     |       | 21,789     |       | 13.0      |       | 19.1      |       |
| Total noninterest expenses                               | ** ** | **108,382** | ** **  | 103,913    |       | 100,153    |       | 105,988    |       | 99,217     |       | 4.3       |       | 9.2       |       |
| Income before income taxes                               | ** ** | **113,114** | ** **  | 108,520    |       | 100,043    |       | 93,450     |       | 90,444     |       | 4.2       |       | 25.1      |       |
| Applicable income taxes                                  | ** ** | **42,158**  | ** **  | 40,647     |       | 37,416     |       | 32,838     |       | 33,659     |       | 3.7       |       | 25.3      |       |
| **NET INCOME**                                           | ** ** | **$**       | **70,956**  | ** ** | $          | 67,873     |       | $          | 62,627     |       | $          | 60,612    |       | $         | 56,785     |   | 4.5 |   | 25.0 |   |
|                                                     | ** ** | ** **  | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Weighted average shares outstanding                      | ** ** | **81,865**  | ** **  | 80,514     |       | 79,228     |       | 79,075     |       | 78,965     |       | 1.7       |       | 3.7       |       |
| Adjusted weighted average shares outstanding             | ** ** | **82,635**  | ** **  | 81,161     |       | 79,875     |       | 79,800     |       | 79,611     |       | 1.8       |       | 3.8       |       |
| **NET INCOME PER COMMON SHARE:**                         | ** ** | ** **  | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Basic                                                    | ** ** | **$.87**    | ** **  | $.84       |       | $.79       |       | $.77       |       | $.72       |       | 3.6       |       | 20.8      |       |
| Diluted                                                  | ** ** | **$.86**    | ** **  | $.84       |       | $.78       |       | $.76       |       | $.71       |       | 2.4       |       | 21.1      |       |

 

34

----

 

**Statementsof Consolidated Noninterest Income and Noninterest Expenses**

(in thousands)

 
| ** **                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **3Q 05** | ** ** | **3Q 05** | ** ** |
|------------------------------------------|------------|------------|-------------|------------|------------|------------|------------|------------|------------|------------|------------|-----------|------------|-----------|------------|
| ** **                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**    | ** ** | **vs**    | ** ** |
| **Noninterest Income**                   | ** ** | **3Q 05**  | ** **  | **2Q 05**  | ** ** | **1Q 05**  | ** ** | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 05** | ** ** | **3Q 04** | ** ** |
| Investment and wealth management         | ** ** | **$**      | **23,668**  | ** ** | $          | 23,780     |       | $          | 24,057     |       | $          | 22,735    |       | $         | 22,396     |   | (0.5 | )% | 5.7 | % |
| Service charges on deposit accounts      | ** ** | **11,478** | ** **  | 11,088     |       | 10,426     |       | 11,312     |       | 11,278     |       | 3.5       |       | 1.8       |       |
| Mortgage banking-related fees:           | ** ** | ** ** | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Commercial                               | ** ** | **4,086**  | ** **  | 2,092      |       | 1,837      |       | 2,600      |       | 2,395      |       | 95.3      |       | 70.6      |       |
| Residential                              | ** ** | **1,065**  | ** **  | 803        |       | 446        |       | 599        |       | 668        |       | 32.6      |       | 59.4      |       |
| Total mortgage banking-related  fees     | ** ** | **5,151**  | ** **  | 2,895      |       | 2,283      |       | 3,199      |       | 3,063      |       | 77.9      |       | 68.2      |       |
| Investment securities gains and (losses) | ** ** | **(32**    | **)**       | 76         |       | 414        |       | 705        |       | (1         | )          | (142.1    | )          |      |       |
| Nonmarketable investments                | ** ** | ** ** | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Private equity and other  investments    | ** ** | **39**     | ** **  | 4,569      |       | 2,461      |       | 179        |       | 1,628      |       | (99.1     | )          | (97.6     | )          |
| Hedge funds                              | ** ** | **2,897**  | ** **  | (1,245     | )          | 1,964      |       | 2,875      |       | 341        |       | 332.7     |       | 749.6     |       |
| Bank-owned life insurance                | ** ** | **1,254**  | ** **  | 898        |       | 846        |       | 947        |       | 798        |       | 39.6      |       | 57.1      |       |
| Total nonmarketable investments          | ** ** | **4,190**  | ** **  | 4,222      |       | 5,271      |       | 4,001      |       | 2,767      |       | (0.8      | )          | 51.4      |       |
| Other income:                            | ** ** | ** ** | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Electronic banking fees                  | ** ** | **7,010**  | ** **  | 5,954      |       | 5,173      |       | 5,312      |       | 6,029      |       | 17.7      |       | 16.3      |       |
| Charges and fees on loans                | ** ** | **3,786**  | ** **  | 3,020      |       | 2,795      |       | 2,892      |       | 2,647      |       | 25.4      |       | 43.0      |       |
| Insurance                                | ** ** | **3,480**  | ** **  | 3,558      |       | 4,540      |       | 3,046      |       | 3,218      |       | (2.2      | )          | 8.1       |       |
| All other income                         | ** ** | **4,343**  | ** **  | 5,473      |       | 2,910      |       | 2,526      |       | 2,524      |       | (20.6     | )          | 72.1      |       |
| Total other income                       | ** ** | **18,619** | ** **  | 18,005     |       | 15,418     |       | 13,776     |       | 14,418     |       | 3.4       |       | 29.1      |       |
| Total                                    | ** ** | **$**      | **63,074**  | ** ** | $          | 60,066     |       | $          | 57,869     |       | $          | 55,728    |       | $         | 53,921     |   | 5.0 |   | 17.0 |   |
|                                     |       |       | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| ** **                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **3Q 05** | ** ** | **3Q 05** | ** ** |
| ** **                               | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **vs**    | ** ** | **vs**    | ** ** |
| **Noninterest Expenses**                 | ** ** | **3Q 05**  | ** **  | **2Q 05**  | ** ** | **1Q 05**  | ** ** | **4Q 04**  | ** ** | **3Q 04**  | ** ** | **2Q 05** | ** ** | **3Q 04** | ** ** |
| Salaries                                 | ** ** | **$**      | **51,748**  | ** ** | $          | 50,180     |       | $          | 46,554     |       | $          | 49,448    |       | $         | 48,696     |   | 3.1 | % | 6.3 | % |
| Employee benefits                        | ** ** | **11,637** | ** **  | 11,956     |       | 11,897     |       | 10,678     |       | 10,557     |       | (2.7      | )          | 10.2      |       |
| Net occupancy expense of bank premises   | ** ** | **7,139**  | ** **  | 6,857      |       | 6,922      |       | 6,300      |       | 6,128      |       | 4.1       |       | 16.5      |       |
| Furniture and equipment expenses         | ** ** | **7,965**  | ** **  | 7,924      |       | 7,279      |       | 8,566      |       | 7,936      |       | 0.5       |       | 0.4       |       |
| Communications and supplies              | ** ** | **3,933**  | ** **  | 4,019      |       | 4,040      |       | 4,294      |       | 4,111      |       | (2.1      | )          | (4.3      | )          |
| Other expenses:                          | ** ** | ** ** | ** **  |       |       |       |       |       |       |       |       |      |       |      |       |
| Professional services                    | ** ** | **6,040**  | ** **  | 4,882      |       | 5,125      |       | 9,315      |       | 7,157      |       | 23.7      |       | (15.6     | )          |
| Advertising and promotional  expenses    | ** ** | **2,162**  | ** **  | 2,677      |       | 1,711      |       | 2,833      |       | 1,747      |       | (19.2     | )          | 23.8      |       |
| Electronic banking expenses              | ** ** | **4,025**  | ** **  | 3,177      |       | 3,241      |       | 3,051      |       | 3,299      |       | 26.7      |       | 22.0      |       |
| Amortization of intangible  assets       | ** ** | **2,231**  | ** **  | 2,179      |       | 2,072      |       | 2,009      |       | 2,044      |       | 2.4       |       | 9.1       |       |
| Outsourcing expenses                     | ** ** | **3,093**  | ** **  | 2,383      |       | 2,690      |       | 1,305      |       | 1,351      |       | 29.8      |       | 128.9     |       |
| All other expenses                       | ** ** | **8,409**  | ** **  | 7,679      |       | 8,622      |       | 8,189      |       | 6,191      |       | 9.5       |       | 35.8      |       |
| Total other expenses                     | ** ** | **25,960** | ** **  | 22,977     |       | 23,461     |       | 26,702     |       | 21,789     |       | 13.0      |       | 19.1      |       |
| Total                                    | ** ** | **$**      | **108,382** | ** ** | $          | 103,913    |       | $          | 100,153    |       | $          | 105,988   |       | $         | 99,217     |   | 4.3 |   | 9.2 |   |

 

35

----

 

**ConsolidatedAverage Balance Sheets**

(in thousands)

 
| ** **                                              | ** ** | ** **     | ** **     | ** **   | ** ** | ** **  | ** ** | ** **   | ** ** | ** **  | ** ** | ** **   | ** ** | ** **  | ** ** | ** **   | ** ** | ** **  | ** ** | ** **   | ** ** | **Average Balance** | ** ** |
|---------------------------------------------------------|------------|----------------|----------------|--------------|------------|-------------|------------|--------------|------------|-------------|------------|--------------|------------|-------------|------------|--------------|------------|-------------|------------|--------------|------------|---------------------|------------|
| ** **                                              | ** ** | **3Q 05**      | ** **     | **2Q 05**    | ** ** | **1Q 05**   | ** ** | **4Q 04**    | ** ** | **3Q 04**   | ** ** | **3Q 05**    | ** ** | **3Q 05**   | ** ** |
| ** **                                              | ** ** | **Average**    | ** **     | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** | ** ** | **vs**              | ** ** | **vs** | ** ** |
| ** **                                              | ** ** | **Balance**    | ** **     | **/ Rate**   | ** ** | **Balance** | ** ** | **/ Rate**   | ** ** | **Balance** | ** ** | **/ Rate**   | ** ** | **Balance** | ** ** | **/ Rate**   | ** ** | **Balance** | ** ** | **/ Rate**   | ** ** | **2Q 05**           | ** ** | **3Q 04** | ** ** |
| Earning assets                                          |       |           |           |         | ** ** |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |       |                |       |   |   |
| Loans:                                                  |       |           |           |         | ** ** |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |       |                |       |   |   |
| Commercial and leasing                                  | ** ** | **$**          | **2,914,761**  | ** **   | **6.62**   | **%**       | $          | 2,926,234    |       | 6.31        | %          | $            | 2,848,452  |        | 5.90       | %            | $          | 2,813,318   |       | 5.63         | %          | $                   | 2,744,195  |   | 5.34 | % | (0.4 | )% | 6.2 | % |
| Commercial real estate                                  | ** ** | **3,610,170**  | ** **     | **6.65**     | ** ** | 3,363,924   |       | 6.51         |       | 3,133,446   |       | 6.28         |       | 3,083,266   |       | 6.09         |       | 2,969,515   |       | 5.91         |       | 7.3                 |       | 21.6 |   |
| Construction                                            | ** ** | **1,544,082**  | ** **     | **7.21**     | ** ** | 1,442,621   |       | 6.66         |       | 1,328,633   |       | 6.24         |       | 1,215,282   |       | 5.93         |       | 1,142,921   |       | 5.49         |       | 7.0                 |       | 35.1 |   |
| Residential real estate                                 | ** ** | **1,775,023**  | ** **     | **5.98**     | ** ** | 1,762,991   |       | 5.95         |       | 1,710,003   |       | 5.92         |       | 1,681,823   |       | 5.93         |       | 1,687,813   |       | 5.90         |       | 0.7                 |       | 5.2 |   |
| Home equity lines                                       | ** ** | **517,798**    | ** **     | **6.23**     | ** ** | 502,917     |       | 5.85         |       | 495,935     |       | 5.36         |       | 484,222     |       | 4.88         |       | 460,044     |       | 4.42         |       | 3.0                 |       | 12.6 |   |
| Consumer                                                | ** ** | **1,027,897**  | ** **     | **5.71**     | ** ** | 900,576     |       | 5.77         |       | 797,892     |       | 5.94         |       | 806,433     |       | 5.97         |       | 821,305     |       | 6.01         |       | 14.1                |       | 25.2 |   |
| Total loans                                             | ** ** | **11,389,731** | ** **     | **6.51**     | ** ** | 10,899,263  |       | 6.29         |       | 10,314,361  |       | 6.04         |       | 10,084,344  |       | 5.85         |       | 9,825,793   |       | 5.64         |       | 4.5                 |       | 15.9 |   |
| Federal funds sold, et al                               | ** ** | **57,932**     | ** **     | **5.20**     | ** ** | 40,904      |       | 4.33         |       | 31,854      |       | 4.37         |       | 44,113      |       | 3.72         |       | 50,035      |       | 3.57         |       | 41.6                |       | 15.8 |   |
| Securities: (2)                                         | ** ** | ** **     | ** **     | ** **   | ** ** |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |       |                |       |   |   |
| Taxable securities                                      | ** ** | ** **     |           |         | ** ** |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |       |                |       |   |   |
| U.S. Treasury and gov. agencies                         | ** ** | **1,431,397**  | ** **     | **3.35**     | ** ** | 1,382,037   |       | 3.37         |       | 1,426,230   |       | 3.43         |       | 1,532,514   |       | 3.53         |       | 1,571,102   |       | 3.59         |       | 3.6                 |       | (8.9 | ) |
| Mortgage-backed                                         | ** ** | **1,455,475**  | ** **     | **3.98**     | ** ** | 1,365,012   |       | 4.05         |       | 1,303,700   |       | 4.02         |       | 1,243,520   |       | 3.90         |       | 1,228,539   |       | 3.84         |       | 6.6                 |       | 18.5 |   |
| Other investments                                       | ** ** | **62,318**     | ** **     | **3.35**     | ** ** | 65,051      |       | 3.63         |       | 63,943      |       | 4.12         |       | 68,004      |       | 7.12         |       | 65,264      |       | 2.90         |       | (4.2                | )          | (4.5 | ) |
| Tax-exempt securities                                   | ** ** | ** **     | ** **     | ** **   | ** ** |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |       |                |       |   |   |
| States and political  subdivisions                      | ** ** | **93,683**     | ** **     | **5.89**     | ** ** | 88,537      |       | 5.90         |       | 80,921      |       | 5.97         |       | 84,319      |       | 5.99         |       | 90,721      |       | 5.82         |       | 5.8                 |       | 3.3 |   |
| Total securities                                        | ** ** | **3,042,873**  | ** **     | **3.73**     | ** ** | 2,900,637   |       | 3.77         |       | 2,874,794   |       | 3.79         |       | 2,928,357   |       | 3.84         |       | 2,955,626   |       | 3.75         |       | 4.9                 |       | 3.0 |   |
| Interest-bearing deposits in  other banks               | ** ** | **200**        | ** **     | **1.02**     | ** ** | 187         |       | 1.31         |       | 158         |       | 1.47         |       | 158         |       | 1.45         |       | 158         |       | 1.08         |       | 7.0                 |       | 26.6 |   |
| Total earning assets                                    | ** ** | **14,490,736** | ** **     | **5.92**     | ** ** | 13,840,991  |       | 5.76         |       | 13,221,167  |       | 5.55         |       | 13,056,972  |       | 5.39         |       | 12,831,612  |       | 5.20         |       | 4.7                 |       | 12.9 |   |
| Cash and due from banks                                 | ** ** | **326,515**    | ** **     | ** **   | ** ** | 301,484     |       |         |       | 290,911     |       |         |       | 285,742     |       |         |       | 296,203     |       |         |       | 8.3                 |       | 10.2 |   |
| Bank premises and equipment,  net                       | ** ** | **147,248**    | ** **     | ** **   | ** ** | 144,347     |       |         |       | 141,426     |       |         |       | 140,556     |       |         |       | 141,536     |       |         |       | 2.0                 |       | 4.0 |   |
| Other assets                                            | ** ** | **1,257,846**  | ** **     | ** **   | ** ** | 1,099,607   |       |         |       | 1,004,526   |       |         |       | 985,411     |       |         |       | 990,468     |       |         |       | 14.4                |       | 27.0 |   |
| Less: allowance for loan losses                         | ** ** | **(157,177**   | **)**          | ** **   | ** ** | (152,858    | )          |         |       | (149,686    | )          |         |       | (157,787    | )          |         |       | (160,331    | )          |         |       | 2.8                 |       | (2.0 | ) |
| Total assets                                            | ** ** | **$**          | **16,065,168** | ** **   | ** ** | ** **  | $          | 15,233,571   |       |        |       | $            | 14,508,344 |        |       |         | $          | 14,310,894  |       |         |       | $                   | 14,099,488 |   |   |   | 5.5 |   | 13.9 |   |
|                                                    | ** ** | ** **     |           |         | ** ** |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |       |                |       |   |   |
| Interest-bearing liabilities                            | ** ** | ** **     |           |         | ** ** |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |       |                |       |   |   |
| Deposits:                                               | ** ** | ** **     |           |         | ** ** |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |       |                |       |   |   |
| Savings                                                 | ** ** | **$**          | **1,420,283**  | ** **   | **.42**    | ** **  | $          | 1,463,960    |       | .36         |       | $            | 1,459,580  |        | .32        |         | $          | 1,445,223   |       | .30          |       | $                   | 1,457,432  |   | .29 |   | (3.0 | ) | (2.5 | ) |
| Checking plus interest                                  | ** ** | **1,428,344**  | ** **     | **.17**      | ** ** | 1,418,337   |       | .16          |       | 1,350,521   |       | .15          |       | 1,326,074   |       | .15          |       | 1,291,808   |       | .15          |       | 0.7                 |       | 10.6 |   |
| Money market                                            | ** ** | **1,692,684**  | ** **     | **1.54**     | ** ** | 1,574,422   |       | 1.15         |       | 1,550,919   |       | .94          |       | 1,572,997   |       | .75          |       | 1,556,212   |       | .55          |       | 7.5                 |       | 8.8 |   |
| Time deposits $100,000 and over                         | ** ** | **1,674,265**  | ** **     | **3.30**     | ** ** | 1,618,161   |       | 2.97         |       | 1,427,571   |       | 2.66         |       | 1,354,677   |       | 2.22         |       | 1,299,918   |       | 1.90         |       | 3.5                 |       | 28.8 |   |
| Other time deposits                                     | ** ** | **2,295,608**  | ** **     | **2.76**     | ** ** | 2,060,974   |       | 2.54         |       | 1,905,548   |       | 2.28         |       | 1,882,646   |       | 2.22         |       | 1,918,216   |       | 2.12         |       | 11.4                |       | 19.7 |   |
| Total interest-bearing deposits                         | ** ** | **8,511,184**  | ** **     | **1.80**     | ** ** | 8,135,854   |       | 1.55         |       | 7,694,139   |       | 1.33         |       | 7,581,617   |       | 1.19         |       | 7,523,586   |       | 1.07         |       | 4.6                 |       | 13.1 |   |
| Short-term borrowings                                   | ** ** | **1,185,142**  | ** **     | **2.58**     | ** ** | 1,021,281   |       | 2.15         |       | 1,000,929   |       | 1.64         |       | 956,368     |       | 1.23         |       | 942,789     |       | .84          |       | 16.0                |       | 25.7 |   |
| Long-term debt                                          | ** ** | **797,527**    | ** **     | **4.47**     | ** ** | 742,056     |       | 4.23         |       | 689,372     |       | 4.01         |       | 642,675     |       | 3.70         |       | 641,264     |       | 3.46         |       | 7.5                 |       | 24.4 |   |
| Total interest-bearing funds                            | ** ** | **10,493,853** | ** **     | **2.09**     | ** ** | 9,899,191   |       | 1.81         |       | 9,384,440   |       | 1.56         |       | 9,180,660   |       | 1.37         |       | 9,107,639   |       | 1.21         |       | 6.0                 |       | 15.2 |   |
| Noninterest-bearing deposits                            | ** ** | **3,240,806**  |           |         | ** ** | 3,137,366   |       |         |       | 3,024,595   |       |         |       | 3,094,316   |       |         |       | 2,984,130   |       |         |       | 3.3                 |       | 8.6 |   |
| Other liabilities and accrued  expenses                 | ** ** | **151,094**    |           |         | ** ** | 154,910     |       |         |       | 149,033     |       |         |       | 124,767     |       |         |       | 129,875     |       |         |       | (2.5                | )          | 16.3 |   |
| Total liabilities                                       | ** ** | **13,885,753** |           |         | ** ** | 13,191,467  |       |         |       | 12,558,068  |       |         |       | 12,399,743  |       |         |       | 12,221,644  |       |         |       | 5.3                 |       | 13.6 |   |
| Shareholders’ equity                               | ** ** | **2,179,415**  |           |         | ** ** | 2,042,104   |       |         |       | 1,950,276   |       |         |       | 1,911,151   |       |         |       | 1,877,844   |       |         |       | 6.7                 |       | 16.1 |   |
| Total liabilities &  shareholders’ equity | ** ** | **$**          | **16,065,168** |         |       | ** **  | $          | 15,233,571   |       |        |       | $            | 14,508,344 |        |       |         | $          | 14,310,894  |       |         |       | $                   | 14,099,488 |   |   |   | 5.5 |   | 13.9 |   |
|                                                    |       |           |           |         | ** ** |        |       |         |       |        |       |         |       |        |       |         |       |        |       |         |       |                |       |   |   |
| Net interest rate spread                                |       |           | ** **     | **3.83**     | **%**      |        |       | 3.95         | %          |        |       | 3.99         | %          |        |       | 4.02         | %          |        |       | 3.99         | %          |                |       |   |   |
| Effect of noninterest-bearing  funds                    |       |           | ** **     | **.58**      | ** ** |        |       | .51          |       |        |       | .45          |       |        |       | .41          |       |        |       | .35          |       |                |       |   |   |
| Net interest margin on earning  assets                  |       |           | ** **     | **4.41**     | **%**      |        |       | 4.46         | %          |        |       | 4.44         | %          |        |       | 4.43         | %          |        |       | 4.34         | %          |                |       |   |   |

 

----

(1)          Presentedon a tax-equivalent basis using the statutory federal corporate income tax rateof 35% (see reconciliation of non-GAAP measures on page 37)

(2)          Nonaccrualloans are included in average loans

(3)          Balancesreported at amortized cost; excludes pretax unrealized gains (losses) onsecurities available-for-sale

 

36

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**Reconciliation of Non-GAAPMeasures**

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | ** ** | **YTD**    | ** **  | **YTD**    | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|-------------|------------|------------|------------|------------|------------|-------------|------------|------------|------------|------------|------------|------------|
| **(in thousands, except per share  data)**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | ** ** | **2005**   | ** **  | **2004**   | ** ** | **3Q 05**  | ** ** | **2Q 05**  | ** **  | **1Q 05**  | ** ** | **4Q 04**  | ** ** | **3Q 04**  | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| (1)   The  net interest margin and efficiency ratios are presented on a fully  tax-equivalent (“FTE”) and annualized basis. The FTE basis adjusts for the  tax-favored status of income from certain loans and investments.  Management believes this measure to be the  preferred industry measurement of the net interest income and provides a  relevant comparison between taxable and non-taxable investments.                                                                                                                                                                         | ** ** |
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net interest income (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | ** ** | **$**      | **454,692** |       | $          | 402,071    | ** ** | **$**      | **159,242** |       | $          | 152,367    |       | $          | 143,083    |   | $ | 143,710 |   | $ | 138,182 |   |
| Taxable-equivalent adjustment                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **5,014**  |        | 5,084      | ** ** | **1,781**  |       | 1,656      |        | 1,577      |       | 1,660      |       | 1,684      |       |
| Net interest income - taxable equivalent                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** ** | **$**      | **459,706** |       | $          | 407,155    | ** ** | **$**      | **161,023** |       | $          | 154,023    |       | $          | 144,660    |   | $ | 145,370 |   | $ | 139,866 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | ** ** |        |       | ** ** | ** ** |       |       |        |       |       |       |       |       |       |
| (2)   Management excludes the balance of  intangible assets and their related amortization expense from its calculation  of return on average tangible equity and average tangible equity to average  tangible assets. This adjustment allows management to review the core  operating results and core capital position of Bankshares. This is consistent  with the treatment by bank regulatory agencies which exclude goodwill and  other intangible assets from their calculation of risk-based capital ratios.                                                                                        |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | ** ** |        |       | ** ** | ** ** |       |       |        |       |       |       |       |       |       |
| Return on average equity (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** ** | **13.09**  | **%**       | 12.13      | %          | **12.92**  | **%**      | 13.33      | %           | 13.02      | %          | 12.62      | %          | 12.03      | %          |
| Impact of excluding average intangible assets and amortization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **6.20**   | ** **  | 5.81       |       | **6.70**   | ** ** | 6.31       |        | 5.55       |       | 5.54       |       | 5.60       |       |
| Return on average tangible equity                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | ** ** | **19.29**  | **%**       | 17.94      | %          | **19.62**  | **%**      | 19.64      | %           | 18.57      | %          | 18.16      | %          | 17.63      | %          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |       |       | ** **  |       |       |       | ** ** |       |        |       |       |       |       |       |       |
| Average equity to average assets (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **13.47**  | **%**       | 13.38      | %          | **13.57**  | **%**      | 13.41      | %           | 13.44      | %          | 13.35      | %          | 13.32      | %          |
| Impact of excluding average intangible assets and amortization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **(3.74**  | **)**       | (3.73      | )          | **(4.04**  | **)**      | (3.74      | )           | (3.44      | )          | (3.51      | )          | (3.65      | )          |
| Average tangible equity to average tangible assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** ** | **9.73**   | **%**       | 9.65       | %          | **9.53**   | **%**      | 9.67       | %           | 10.00      | %          | 9.84       | %          | 9.67       | %          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | ** ** | ** **  |       |       | ** ** | ** ** |       |        |       |       |       |       |       |       |
| When computing the cash operating efficiency ratio  and cash operating earnings, management excludes the amortization of  intangible assets, restructuring charges, merger-related expenses and gains  and losses on sales of premises and from sales of investment securities in  order to assess the core operating results of Bankshares and because of the  uncertainty as to timing and amount of gain or losses to be recognized.  

 

(3)   The efficiency ratio is measured by  dividing noninterest expenses by the sum of net interest income on a FTE  basis and noninterest income. |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | ** ** | ** **  |       |       | ** ** | ** ** |       |        |       |       |       |       |       |       |
| Efficiency ratio (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **48.77**  | **%**       | 50.58      | %          | **48.36**  | **%**      | 48.54      | %           | 49.45      | %          | 52.70      | %          | 51.20      | %          |
| Impact  of excluding:  Securities gains and  (losses)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | ** ** | **0.03**   | ** **  | 0.05       |       | **—** | ** ** | 0.02       |        | 0.10       |       | 0.18       |       | —     |       |
| Gains/(losses)  on sales of premises                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **0.33**   | ** **  | 0.14       |       | **(0.05**  | **)**      | 0.78       |        | 0.27       |       | 0.01       |       | 0.20       |       |
| Amortization  of deposit intangibles                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **(0.66**  | **)**       | (0.72      | )          | **(0.65**  | **)**      | (0.69      | )           | (0.67      | )          | (0.68      | )          | (0.71      | )          |
| Amortization  of other intangibles                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** ** | **(0.35**  | **)**       | (0.36      | )          | **(0.34**  | **)**      | (0.34      | )           | (0.35      | )          | (0.31      | )          | (0.35      | )          |
| Restructuring  charges                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | ** ** | **—** | ** **  | (0.55      | )          | **—** | ** ** | —     |        | —     |       | (0.70      | )          | (1.38      | )          |
| Merger-related  expenses                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** ** | **(0.18**  | **)**       | (0.07      | )          | **(0.35**  | **)**      | (0.02      | )           | (0.12      | )          | —     |       | —     |       |
| Cash  operating efficiency ratio                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | ** ** | **47.94**  | **%**       | 49.07      | %          | **46.97**  | **%**      | 48.29      | %           | 48.68      | %          | 51.20      | %          | 48.96      | %          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | ** ** | ** **  |       |       | ** ** | ** ** |       |        |       |       |       |       |       |       |
| (4)   Bankshares presents cash operating earnings  and diluted cash operating earnings per share in order to assess the core  operating results.                                                                                                                                                                                                                                                                                                                                                                                                                                                           |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | ** ** | ** **  |       |       | ** ** | ** ** |       |        |       |       |       |       |       |       |
| Net income (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **$**      | **201,456** | ** ** | $          | 168,795    |       | **$**      | **70,956**  | ** ** | $          | 67,873     |       | $          | 62,627     |   | $ | 60,612 |   | $ | 56,785 |   |
| Less: Securities (gains) and losses, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** ** | **(277**   | **)**       | (323       | )          | **19**     | ** ** | (60        | )           | (250       | )          | (426       | )          | 1          |       |
| (Gains)/losses  on sales of premises, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | ** ** | **(2,624** | **)**       | (979       | )          | **117**    | ** ** | (2,048     | )           | (693       | )          | (26        | )          | (442       | )          |
| Plus: Amortization of deposit intangibles, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** ** | **2,593**  | ** **  | 2,478      |       | **892**    | ** ** | 875        |        | 826        |       | 826        |       | 826        |       |
| Amortization  of other intangibles, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **1,326**  | ** **  | 1,228      |       | **458**    | ** ** | 442        |        | 426        |       | 388        |       | 409        |       |
| Restructuring  charges, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** ** | **—** | ** **  | 1,861      |       | **—** | ** ** | —     |        | —     |       | 850        |       | 1,610      |       |
| Merger-related  expenses, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **661**    | ** **  | 248        |       | **449**    | ** ** | 56         |        | 156        |       | —     |       | —     |       |
| Cash  operating earnings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** ** | **$**      | **203,135** | ** ** | $          | 173,308    |       | **$**      | **72,891**  | ** ** | $          | 67,138     |       | $          | 63,092     |   | $ | 62,224 |   | $ | 59,189 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |       |       | ** **  |       |       |       | ** ** |       |        |       |       |       |       |       |       |
| Diluted net income per share (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **$**      | **2.48**    | ** ** | $          | 2.11       |       | **$**      | **0.86**    | ** ** | $          | 0.84       |       | $          | 0.78       |   | $ | 0.76 |   | $ | 0.71 |   |
| Less: Securities (gains) and losses, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** ** | **—** | ** **  | —     |       | **—** | ** ** | —     |        | —     |       | (0.01      | )          | —     |       |
| (Gains)/losses  on sales of premises, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | ** ** | **(0.03**  | **)**       | (0.01      | )          | **—** | ** ** | (0.03      | )           | (0.01      | )          | —     |       | (0.01      | )          |
| Plus: Amortization of deposit intangibles, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** ** | **0.03**   | ** **  | 0.03       |       | **0.01**   | ** ** | 0.01       |        | 0.01       |       | 0.01       |       | 0.01       |       |
| Amortization  of other intangibles, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **0.02**   | ** **  | 0.02       |       | **0.01**   | ** ** | 0.01       |        | 0.01       |       | 0.01       |       | 0.01       |       |
| Restructuring  charges, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | ** ** | **—** | ** **  | 0.02       |       | **—** | ** ** | —     |        | —     |       | 0.01       |       | 0.02       |       |
| Merger-related  expenses, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **0.01**   | ** **  | —     |       | **0.01**   | ** ** | —     |        | —     |       | —     |       | —     |       |
| Diluted cash operating earnings per share                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **$**      | **2.51**    | ** ** | $          | 2.17       |       | **$**      | **0.89**    | ** ** | $          | 0.83       |       | $          | 0.79       |   | $ | 0.78 |   | $ | 0.74 |   |

 

37

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# **Item3. Quantitative and Qualitative Disclosures About Market Risk**

 

Information responsive tothis item as of December 31, 2004 appears under the captions “*Risk Management”, “Interest Rate Sensitivity Analysis (Static Gap)”*and*“Earnings Simulation Model Projections”*of the registrant’s Form 10-K for the year ended December 31, 2004.There was no material change in such information as of September 30, 2005.

 

# **Item4. Controls and Procedures**

# ** **

Bankshares’ management,under the supervision and with the participation of Bankshares’ principalexecutive officer and principal financial officer, evaluated the effectivenessof the design and operation of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the Securitiesand Exchange Act of 1934, as amended). Based on the evaluation, the principal executive officer and principalfinancial officer concluded that Bankshares’ disclosure controls and proceduresare effective over financial reporting as of the end of the period covered bythis report.

 

There have not been anychanges in Bankshares’ internal control over financial reporting (as defined inRules 13a-15(f) and 15d-15(f) under the Securities and ExchangeAct of 1934, as amended)) during the fiscal quarter to which this reportrelates that have materially affected, or are reasonably likely to materiallyaffect, Bankshares’ internal control over financial reporting.

 

# **PART II –OTHER INFORMATION**

# ** **

# **Item 1. LegalProceedings**

# ** **

Between 2001 and 2003, onbehalf of either individual plaintiffs or a putative class of plaintiffs, eightseparate actions were filed in state and federal court against Community Bankof Northern Virginia (“CBNV”) and other defendants challenging the validity ofsecond mortgage loans the defendants made to the plaintiffs.  All of the cases were either filed in orremoved to the federal district court for the Western District ofPennsylvania.  In June 2003, theparties to the various actions informed the court that they had reached anagreement in principle to settle the various actions.  On July 17, 2003, the courtconditionally certified a class for settlement purposes, preliminarily approvedthe class settlement, and directed the issuance of notice to the class.

 

Thereafter, certainplaintiffs who had initially opted out of the proposed settlement and otherobjectors challenged the validity of the settlement in the district court.  The district court denied their arguments andapproved the settlement.  These “opt out”plaintiffs and other objectors appealed the district court’s approval of thesettlement to the Third Circuit Court of Appeals.  In August 2005, the Third Circuitreversed the district court’s approval of the settlement and remanded the caseback to the district court with instructions to consider and address certainspecific issues when re-evaluating the settlement. Certain individuals who wereexcluded from the settlement class have filed two actions on behalf of aputative class of plaintiffs alleging claims similar to those raised in theinitial filing.  These actions recentlywere consolidated in the Western District of Pennsylvania.  Bankshares believes these actions are withoutmerit and intends to defend the actions vigorously.

 

**Item 6.    Exhibits**

 

Exhibits

 

31.1 Section 302Certification of Chief Executive Officer. Filed as an exhibit hereto andincorporated herein by reference

 

31.2 Section 302Certification of Chief Financial Officer. Filed as an exhibit hereto andincorporated herein by reference

 

32.1 Section 906Certification of Chief Executive Officer. Filed as an exhibit hereto andincorporated herein by reference

 

32.2 Section 906Certification of Chief Financial Officer. Filed as an exhibit hereto andincorporated herein by reference

 

38

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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)                             |
|                  |       |                                     |
| October 28, 2005 |       | /s/ Edward J.  Kelly, III           |
| Date                  |       | By: Edward J.  Kelly, III           |
|                  |       | Chairman of the Board,                   |
|                  |       | President and                            |
|                  |       | Chief Executive Officer                  |
|                  |       |                                     |
|                  |       |                                     |
| October 28, 2005 |       | /s/ Terry L. Troupe                      |
| Date                  |       | By: Terry L. Troupe                      |
|                  |       | Executive Vice  President and            |
|                  |       | Chief Financial Officer                  |
|                  |       |                                     |
|                  |       |                                     |
| October 28, 2005 |       | /s/ William T.  Skinner, Jr.        |
| Date                  |       | By: William T.  Skinner, Jr.        |
|                  |       | Controller                               |

 

39

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