**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 SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                          |
| **For the quarterly period  ended September 30, 2004**                                                                                                                                                        |
|                                                                                                                                                                                                          |
| **OR**                                                                                                                                                                                                        |
|                                                                                                                                                                                                          |
| **o**                                                                                                                                                                                                         | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                          |
| **For the transition period  from              to              ** |
|                                                                                                                                                                                                          |
| **Commission file number 0-5127**                                                                                                                                                                             |

 

**MERCANTILE BANKSHARES CORPORATION**

(Exact name of registrant as specified in itscharter)

 

| **Maryland**                                                                        | ** ** | **52-0898572**                        |
|-------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                     | * *   | (I.R.S. Employer  Identification No.) |
|                                                                                | * *   |                                  |
| **2 Hopkins Plaza  Baltimore, Maryland 21201**                                      |
| (Address of principal 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) |

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.  Yes ý  No o

 

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

 

As of October 31, 2004, 79,189,894 shares ofregistrant’s Common Stock, $2 par value per share, were outstanding.

 

 

----

 

**PART I – FINANCIAL INFORMATION**

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

 

**MERCANTILE BANKSHARES CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

 
| **(Dollars in thousands, except per share data)**                                                                                                                                                                                                     | ** ** | **September 30,  2004** | ** **     | **December 31,  2003** | ** ** | **September 30,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|----------------|------------------------|------------|-------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                            |       |                    |           |                   |       |                    |       |
| Cash and due  from banks                                                                                                                                                                                                                              | ** ** | **$**                   | **290,401**    |                   | $          | 321,882                 |       | $ | 375,627 |   |
| Interest-bearing  deposits in other banks                                                                                                                                                                                                             | ** ** | **158**                 |           | 14,583                 |       | 50,518                  |       |
| Federal funds  sold                                                                                                                                                                                                                                   | ** ** | **24,500**              |           | 26,236                 |       | 350,825                 |       |
| Total cash and  cash equivalents                                                                                                                                                                                                                      | ** ** | **315,059**             |           | 362,701                |       | 776,970                 |       |
| Investment  securities available-for-sale (Note 4)                                                                                                                                                                                                    | ** ** | **3,030,584**           |           | 3,123,514              |       | 3,128,594               |       |
| Investment  securities held-to-maturity (Note 4)                                                                                                                                                                                                      | ** ** | **49,659**              |           | 49,417                 |       | 56,057                  |       |
| Total  investment securities                                                                                                                                                                                                                          | ** ** | **3,080,243**           |           | 3,172,931              |       | 3,184,651               |       |
| Loans  held-for-sale                                                                                                                                                                                                                                  | ** ** | **15,984**              |           | 14,925                 |       | 26,288                  |       |
| Loans:                                                                                                                                                                                                                                                |       |                    |           |                   |       |                    |       |
| Commercial                                                                                                                                                                                                                                            | ** ** | **2,791,396**           |           | 2,577,021              |       | 2,534,519               |       |
| Commercial  real estate                                                                                                                                                                                                                               | ** ** | **3,014,104**           |           | 2,738,832              |       | 2,610,827               |       |
| Construction                                                                                                                                                                                                                                          | ** ** | **1,170,704**           |           | 1,064,021              |       | 1,043,522               |       |
| Residential  real estate                                                                                                                                                                                                                              | ** ** | **1,496,222**           |           | 1,335,375              |       | 1,299,665               |       |
| Consumer                                                                                                                                                                                                                                              | ** ** | **1,483,837**           |           | 1,482,860              |       | 1,445,004               |       |
| Lease  financing                                                                                                                                                                                                                                      | ** ** | **58,051**              |           | 74,051                 |       | 81,545                  |       |
| Total loans                                                                                                                                                                                                                                           | ** ** | **10,014,314**          |           | 9,272,160              |       | 9,015,082               |       |
| Less:  allowance for loan losses                                                                                                                                                                                                                      | ** ** | **(161,441**            | )              | (155,337               | )          | (155,754                | )          |
| Loans, net                                                                                                                                                                                                                                            | ** ** | **9,852,873**           |           | 9,116,823              |       | 8,859,328               |       |
| Bank premises  and equipment, less accumulated depreciation of $159,477 (2004), $152,771  (December 2003) and $161,720 (September 2003)                                                                                                               | ** ** | **140,411**             |           | 140,922                |       | 137,100                 |       |
| Other real  estate owned, net                                                                                                                                                                                                                         | ** ** | **388**                 |           | 191                    |       | 397                     |       |
| Goodwill, net  (Note 7)                                                                                                                                                                                                                               | ** ** | **507,791**             |           | 522,173                |       | 510,406                 |       |
| Other  intangible assets, net (Note 7)                                                                                                                                                                                                                | ** ** | **50,391**              |           | 56,223                 |       | 57,359                  |       |
| Other assets                                                                                                                                                                                                                                          | ** ** | **339,879**             |           | 308,583                |       | 323,649                 |       |
| Total assets                                                                                                                                                                                                                                          | ** ** | **$**                   | **14,303,019** |                   | $          | 13,695,472              |       | $ | 13,876,148 |   |
|                                                                                                                                                                                                                                                  |       |                    |           |                   |       |                    |       |
| **LIABILITIES**                                                                                                                                                                                                                                       |       |                    |           |                   |       |                    |       |
| Deposits:                                                                                                                                                                                                                                             |       |                    |           |                   |       |                    |       |
| Noninterest-bearing  deposits                                                                                                                                                                                                                         | ** ** | **$**                   | **3,167,398**  |                   | $          | 2,750,721               |       | $ | 2,698,277 |   |
| Interest-bearing  deposits                                                                                                                                                                                                                            | ** ** | **7,554,685**           |           | 7,511,832              |       | 7,597,565               |       |
| Total deposits                                                                                                                                                                                                                                        | ** ** | **10,722,083**          |           | 10,262,553             |       | 10,295,842              |       |
| Short-term  borrowings                                                                                                                                                                                                                                | ** ** | **923,447**             |           | 809,021                |       | 958,506                 |       |
| Accrued expenses  and other liabilities                                                                                                                                                                                                               | ** ** | **127,534**             |           | 134,735                |       | 140,913                 |       |
| Long-term debt                                                                                                                                                                                                                                        | ** ** | **642,510**             |           | 647,722                |       | 658,565                 |       |
| Total  liabilities                                                                                                                                                                                                                                    | ** ** | **12,415,574**          |           | 11,854,031             |       | 12,053,826              |       |
|                                                                                                                                                                                                                                                  |       |                    |           |                   |       |                    |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                         |       |                    |           |                   |       |                    |       |
| Preferred  stock, no par value; authorized 2,000,000 shares; issued and outstanding -  None                                                                                                                                                           |       |                    |           |                   |       |                    |       |
| Common stock,  $2 par value; authorized 130,000,000 shares; issued shares - 79,152,310  (2004), 79,772,705 (December 2003) and 79,602,236 (September 2003); restricted  shares - 136,467 (2004), 121,369 (December 2003) and 123,442 (September 2003) | ** ** | **158,305**             |           | 159,545                |       | 159,204                 |       |
| Capital  surplus                                                                                                                                                                                                                                      | ** ** | **525,011**             |           | 548,664                |       | 544,818                 |       |
| Retained  earnings                                                                                                                                                                                                                                    | ** ** | **1,198,039**           |           | 1,110,748              |       | 1,085,979               |       |
| Accumulated  other comprehensive income                                                                                                                                                                                                               | ** ** | **6,090**               |           | 22,484                 |       | 32,321                  |       |
| Total shareholders’  equity                                                                                                                                                                                                                      | ** ** | **1,887,445**           |           | 1,841,441              |       | 1,822,322               |       |
| Total  liabilities and shareholders’ equity                                                                                                                                                                                                      | ** ** | **$**                   | **14,303,019** |                   | $          | 13,695,472              |       | $ | 13,876,148 |   |

 

See notes to consolidatedfinancial statements

 

2

----

 

**MERCANTILE BANKSHARES CORPORATIONSTATEMENTS OF CONSOLIDATED INCOME**

 
| ** **                                              | ** ** | **For the 9 Months  Ended September 30,** | ** **  | **For the 3 Months  Ended September 30,** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------|-------------|-------------------------------------------|------------|
| **(Dollars  in thousands, except per share data)**      | ** ** | **2004**                                  | ** **  | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| **INTEREST INCOME**                                     |       |                                      |        |                                      |       |   |   |   |   |
| Interest and  fees on loans                             | ** ** | **$**                                     | **399,223** |                                      | $          | 343,091 | ** ** | **$** | **138,047** |   | $ | 120,137 |   |
| Interest and  dividends on investment securities:       |       |                                      |        |                                      |       |   |   |   |   |
| Taxable  interest income                                | ** ** | **79,614**                                |        | 81,107                                    | ** ** | **26,048** |   | 27,285 |   |
| Tax-exempt  interest income                             | ** ** | **2,500**                                 |        | 1,747                                     | ** ** | **803** |   | 783 |   |
| Dividends                                               | ** ** | **797**                                   |        | 640                                       | ** ** | **236** |   | 212 |   |
| Other  investment income                                | ** ** | **3,772**                                 |        | 4,390                                     | ** ** | **803** |   | 1,508 |   |
| Total interest  and dividends on investment securities  | ** ** | **86,683**                                |        | 87,884                                    | ** ** | **27,890** |   | 29,788 |   |
| Other interest  income                                  | ** ** | **1,283**                                 |        | 3,331                                     | ** ** | **519** |   | 1,291 |   |
| Total interest  income                                  | ** ** | **487,189**                               |        | 434,306                                   | ** ** | **166,456** |   | 151,216 |   |
| **INTEREST EXPENSE**                                    |       |                                      |        |                                      |       |   |   |   |   |
| Interest on  deposits                                   | ** ** | **60,782**                                |        | 70,892                                    | ** ** | **20,142** |   | 22,313 |   |
| Interest on  short-term borrowings                      | ** ** | **4,889**                                 |        | 4,317                                     | ** ** | **1,990** |   | 1,303 |   |
| Interest on  long-term debt                             | ** ** | **16,035**                                |        | 13,016                                    | ** ** | **5,575** |   | 5,368 |   |
| Total interest  expense                                 | ** ** | **81,706**                                |        | 88,225                                    | ** ** | **27,707** |   | 28,984 |   |
| **NET INTEREST INCOME**                                 | ** ** | **405,483**                               |        | 346,081                                   | ** ** | **138,749** |   | 122,232 |   |
| Provision for  loan losses                              | ** ** | **7,221**                                 |        | 9,072                                     | ** ** | **2,442** |   | 3,005 |   |
| **NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES** | ** ** | **398,262**                               |        | 337,009                                   | ** ** | **136,307** |   | 119,227 |   |
| **NONINTEREST INCOME**                                  |       |                                      |        |                                      |       |   |   |   |   |
| Investment and  wealth management                       | ** ** | **67,315**                                |        | 57,450                                    | ** ** | **22,396** |   | 20,577 |   |
| Service  charges on deposit accounts                    | ** ** | **31,107**                                |        | 26,072                                    | ** ** | **10,637** |   | 9,701 |   |
| Mortgage  banking related fees                          | ** ** | **8,296**                                 |        | 8,298                                     | ** ** | **3,063** |   | 3,403 |   |
| Investment  securities gains and (losses)               | ** ** | **534**                                   |        | 7,015                                     | ** ** | **(1** | ) | (336 | ) |
| Other income                                            | ** ** | **47,537**                                |        | 30,358                                    | ** ** | **17,259** |   | 12,558 |   |
| Total  noninterest income                               | ** ** | **154,789**                               |        | 129,193                                   | ** ** | **53,354** |   | 45,903 |   |
| **NONINTEREST EXPENSES**                                |       |                                      |        |                                      |       |   |   |   |   |
| Salaries                                                | ** ** | **138,173**                               |        | 114,602                                   | ** ** | **48,696** |   | 43,870 |   |
| Employee  benefits                                      | ** ** | **33,998**                                |        | 28,891                                    | ** ** | **10,557** |   | 10,144 |   |
| Net occupancy  expense of bank premises                 | ** ** | **18,007**                                |        | 13,451                                    | ** ** | **6,128** |   | 5,136 |   |
| Furniture and  equipment expenses                       | ** ** | **22,873**                                |        | 21,974                                    | ** ** | **7,936** |   | 8,432 |   |
| Communications  and supplies                            | ** ** | **12,610**                                |        | 10,506                                    | ** ** | **4,111** |   | 3,889 |   |
| Other expenses                                          | ** ** | **60,309**                                |        | 48,595                                    | ** ** | **21,789** |   | 19,718 |   |
| Total  noninterest expenses                             | ** ** | **285,970**                               |        | 238,019                                   | ** ** | **99,217** |   | 91,189 |   |
| Income before  income taxes                             | ** ** | **267,081**                               |        | 228,183                                   | ** ** | **90,444** |   | 73,941 |   |
| Applicable  income taxes                                | ** ** | **98,286**                                |        | 82,014                                    | ** ** | **33,659** |   | 26,768 |   |
| **NET INCOME**                                          | ** ** | **$**                                     | **168,795** |                                      | $          | 146,169 | ** ** | **$** | **56,785** |   | $ | 47,173 |   |
| **NET INCOME PER SHARE OF COMMON STOCK (Note 3):**      |       |                                      |        |                                      |       |   |   |   |   |
| Basic                                                   | ** ** | **$**                                     | **2.13**    |                                      | $          | 2.07 | ** ** | **$** | **0.72** |   | $ | 0.64 |   |
| Diluted                                                 | ** ** | **$**                                     | **2.11**    |                                      | $          | 2.05 | ** ** | **$** | **0.71** |   | $ | 0.63 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                     | ** ** | **$**                                     | **1.03**    |                                      | $          | 0.96 | ** ** | **$** | **0.35** |   | $ | 0.33 |   |

 

See notes to consolidated financial statements

 

3

----

 

**MERCANTILE BANKSHARES CORPORATIONSTATEMENTS OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY**

** **

**For The Nine Months Ended September 30, 2004and 2003**

 
| **(Dollars  in thousands, except per share data)**                                                              | ** ** | **Total** | ** **    | **Common  Stock** | ** ** | **Capital  Surplus** | ** ** | **Retained  Earnings** | ** **  | **Accumulated Other  Comprehensive  Income (Loss)** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-----------|---------------|-------------------|------------|----------------------|------------|------------------------|-------------|-----------------------------------------------------|------------|
| BALANCE,  DECEMBER 31, 2002                                                                                     |       | $         | 1,324,358     |              | $          | 137,672              |       | $                      | 120,577     |                                                | $          | 1,010,248 |   | $ | 55,861 |   |
|                                                                                                            |       |      |          |              |       |                 |       |                   |        |                                                |       |
| Net income                                                                                                      |       | 146,169   |          |              |       |                 |       | 146,169                |        |                                                |       |
| Unrealized  losses on securities available-for-sale, net of reclassification adjustment,  net of taxes          |       | (23,540   | )             |              |       |                 |       |                   |        | (23,540                                             | )          |
| Comprehensive  income                                                                                           |       | 122,629   |          |              |       |                 |       |                   |        |                                                |       |
| Cash dividends  paid:                                                                                           |       |      |          |              |       |                 |       |                   |        |                                                |       |
| Common stock  ($.96 per share)                                                                                  |       | (69,568   | )             |              |       |                 |       | (69,568                | )           |                                                |       |
| Issuance of  10,379,710 shares for bank acquisition                                                             |       | 428,059   |          | 20,759            |       | 407,300              |       |                   |        |                                                |       |
| Fair value of  322,528 converted options related to employee stock option plan of acquired  bank                |       | 5,944     |          |              |       | 5,944                |       |                   |        |                                                |       |
| Issuance of  95,070 shares for dividend reinvestment and stock purchase plan                                    |       | 3,427     |          | 190               |       | 3,237                |       |                   |        |                                                |       |
| Issuance of  17,815 shares for employee stock purchase dividend reinvestment plan                               |       | 675       |          | 35                |       | 640                  |       |                   |        |                                                |       |
| Issuance of  178,512 shares for employee stock option plan                                                      |       | 3,130     |          | 357               |       | 2,773                |       |                   |        |                                                |       |
| Restricted  stock awards:                                                                                       |       |      |          |              |       |                 |       |                   |        |                                                |       |
| Issuance of  100,537 shares                                                                                     |       | 3,561     |          | 202               |       | 3,359                |       |                   |        |                                                |       |
| Deferred  compensation, net                                                                                     |       | (870      | )             |              |       |                 |       | (870                   | )           |                                                |       |
| Purchase of  5,500 shares under stock repurchase plan                                                           |       | (212      | )             | (11               | )          | (201                 | )          |                   |        |                                                |       |
| Vested stock  options                                                                                           |       | 1,189     |          | —            |       | 1,189                |       | —                 |        | —                                              |       |
| BALANCE,  SEPTEMBER 30, 2003                                                                                    |       | $         | 1,822,322     |              | $          | 159,204              |       | $                      | 544,818     |                                                | $          | 1,085,979 |   | $ | 32,321 |   |
|                                                                                                            |       |      |          |              |       |                 |       |                   |        |                                                |       |   |   |   |   |   |
| 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 (Note 8) |       | (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, net                                                                                     |       | 206       |          |              |       |                 |       | 206                    |        |                                                |       |
| 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** | ** ** |

 

See notes to consolidated financial statements

 

4

----

 

**MERCANTILE BANKSHARES CORPORATIONSTATEMENTS OF CONSOLIDATED CASH FLOWS**

** **
| **Increase  (decrease) in cash and cash equivalents**                              | ** ** | **For the 9 Months Ended  September 30,** | ** **  |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|-------------|
| **(Dollars  in thousands)**                                                        | ** ** | **2004**                                  | ** **  | **2003** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                          |       |                                      |        |   |   |
| Net income                                                                         | ** ** | **$**                                     | **168,795** |   | $ | 146,169 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                                      |        |   |   |
| Provision for  loan losses                                                         | ** ** | **7,221**                                 |        | 9,072 |   |
| Depreciation and  amortization                                                     | ** ** | **11,732**                                |        | 10,028 |   |
| Amortization  of other intangible assets                                           | ** ** | **6,132**                                 |        | 3,097 |   |
| Investment  securities gains                                                       | ** ** | **(534**                                  | )           | (7,015 | ) |
| (Income)  write-downs of investments in private equity funds                       | ** ** | **(1,544**                                | )           | 78 |   |
| Write-downs of  other real estate owned                                            | ** ** | **14**                                    |        | 7 |   |
| Gains on sales  of other real estate owned                                         | ** ** | **(119**                                  | )           | (350 | ) |
| Gains on sales  of buildings                                                       | ** ** | **(1,620**                                | )           | (228 | ) |
| Net (increase)  decrease in assets:                                                |       |                                      |        |   |   |
| Interest  receivable                                                               | ** ** | **(3,049**                                | )           | 2,727 |   |
| Other  receivables                                                                 | ** ** | **704**                                   |        | (10,743 | ) |
| Bank-owned  life insurance                                                         | ** ** | **(2,606**                                | )           | (1,337 | ) |
| Other assets                                                                       | ** ** | **3,769**                                 |        | (16,485 | ) |
| Loans  held-for-sale                                                               | ** ** | **(1,059**                                | )           | 19,733 |   |
| Net increase  (decrease) in liabilities:                                           |       |                                      |        |   |   |
| Interest  payable                                                                  | ** ** | **5,031**                                 |        | 8,422 |   |
| Accrued  expenses                                                                  | ** ** | **7,582**                                 |        | (18,974 | ) |
| Taxes payable                                                                      | ** ** | **(8,582**                                | )           | (12,496 | ) |
| Net cash  provided by operating activities                                         | ** ** | **191,867**                               |        | 131,705 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                          |       |                                      |        |   |   |
| Proceeds from  maturities of investment securities held-to-maturity                | ** ** | **8,199**                                 |        | 8,406 |   |
| Proceeds from  maturities of investment securities available-for-sale              | ** ** | **727,003**                               |        | 772,637 |   |
| Proceeds from  sales of investment securities available-for-sale                   | ** ** | **47,182**                                |        | 558,481 |   |
| Purchases of  investment securities held-to-maturity                               | ** ** | **(8,441**                                | )           | (2,486 | ) |
| Purchases of  investment securities available-for-sale                             | ** ** | **(707,120**                              | )           | (1,274,441 | ) |
| Net increase  in customer loans                                                    | ** ** | **(745,923**                              | )           | (403,404 | ) |
| Proceeds from  sales of other real estate owned                                    | ** ** | **181**                                   |        | 748 |   |
| Capital  expenditures                                                              | ** ** | **(9,021**                                | )           | (9,311 | ) |
| Proceeds from  sales of buildings                                                  | ** ** | **3,813**                                 |        | 602 |   |
| Business  acquisitions net of cash received                                        | ** ** | **—**                                |        | (82,204 | ) |
| Other  investing activity                                                          | ** ** | **(5,119**                                | )           | (3,515 | ) |
| Net cash used  in investing activities                                             | ** ** | **(689,246**                              | )           | (434,487 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                          |       |                                      |        |   |   |
| Net increase  in noninterest-bearing deposits                                      | ** ** | **416,677**                               |        | 315,196 |   |
| Net increase  in checking plus interest and savings accounts                       | ** ** | **123,689**                               |        | 110,249 |   |
| Net decrease  in certificates of deposit                                           | ** ** | **(80,836**                               | )           | (82,637 | ) |
| Net increase  (decrease) in short-term borrowings                                  | ** ** | **114,426**                               |        | (37,889 | ) |
| Proceeds from  issuance of long-term debt                                          | ** ** | **—**                                |        | 300,000 |   |
| Repayment of  long-term debt                                                       | ** ** | **(7,745**                                | )           | (8,400 | ) |
| Proceeds from  issuance of shares                                                  | ** ** | **9,237**                                 |        | 7,232 |   |
| Repurchase of  common shares                                                       | ** ** | **(44,110**                               | )           | (212 | ) |
| Dividends paid                                                                     | ** ** | **(81,601**                               | )           | (69,568 | ) |
| Net cash  provided by financing activities                                         | ** ** | **449,737**                               |        | 533,971 |   |
| Net(decrease) increase  in cash and cash equivalents                               | ** ** | **(47,642**                               | )           | 231,189 |   |
| Cash and cash  equivalents at beginning of period                                  | ** ** | **362,701**                               |        | 545,781 |   |
| Cash and cash  equivalents at end of period                                        | ** ** | **$**                                     | **315,059** |   | $ | 776,970 |   |
| **SUPPLEMENTAL INFORMATION**                                                       |       |                                      |        |   |   |
| Cash payments  for interest                                                        | ** ** | **$**                                     | **76,675**  |   | $ | 102,609 |   |
| Cash payments  for income taxes                                                    | ** ** | **100,098**                               |        | 80,244 |   |

 

See notes to consolidated financial statements

 

5

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**MERCANTILE BANKSHARES CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

1. Basis ofPresentation

 

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

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and contingentassets and liabilities in the financial statements, and the disclosure ofrevenue and expenses during the reporting period.  These assumptions are based on informationavailable as of the date of the financial statements and could differ fromactual results.  See Annual Report onForm 10-K for more detail.

 

2. BusinessCombinations

 

The following providesinformation concerning acquisitions. These acquisitions were accounted for aspurchases. The results of operations of these acquisitions subsequent to theacquisition dates are included in Bankshares’ Statements of ConsolidatedIncome. Individually, the results of operations of these acquisitions prior tothe acquisition dates were not material to Bankshares’ results of operations.

 

In March and April 2003,Bankshares acquired in separate transactions, Boyd Watterson Asset ManagementLLC (“BW”), an investment management firm, and Peremel & Company, Inc. (“Peremel”),a directed and discount brokerage company, respectively.  In the aggregate, the companies werepurchased for approximately $29 million in cash.  The BW acquisition has a potential additionalcontingent payment of up to $8.6 million which, if paid, will be recorded asgoodwill.  The contingent payment will berecorded assuming certain metrics are met and becomes payable three years fromthe acquisition date.  Banksharesfinalized and recorded approximately $10.1 million of identified intangibles,mostly client relationships, as a result of these acquisitions.  These intangibles are being amortized on astraight-line basis over a range of three to eight years.  Goodwill recorded on these transactionstotaled approximately $18.0 million at September 30, 2004.

 

On August 12, 2003, Banksharescompleted its acquisition of F&M Bancorp (“F&M”), a bank holdingcompany headquartered in Frederick, Maryland. The total consideration paid to F&M shareholders in connection withthe acquisition was $124.1 million in cash and 10.4 million shares ofBankshares’ common stock.  F&Mtransactions have been included in Bankshares’ financial results since August13, 2003.  Acquired assets on August 12,2003 totaled $2.2 billion, including $1.4 billion of loans and leases;liabilities assumed were $2.0 billion, including $1.7 billion of deposits. Asof September 30, 2004, Bankshares had recorded $385.9 million of goodwill,$36.0 million of core deposit intangible, $5.8 million of mostly clientrelationship intangibles (relating to the two insurance subsidiaries) and $1.1million in a trademark intangible. Intangible assets subjected to amortizationare being amortized on a straight-line basis. The weighted average amortizationperiod for the newly-acquired core deposit intangible is nine years, and theclient-relationship identified intangible ranges from three to fifteen years.On October 24, 2003, certain assets and liabilities of F&M were transferredto other Bankshares’ affiliates in order to align customers’ accounts with theBankshares’ affiliate serving the geographic area where those customers reside.Prior to the merger, F&M recorded exit costs of $33.6 million relating toseverance, system conversions, branch consolidations and costs associated withterminating contracts (including leases). Management has determined that $3.2million of the estimated $33.6 million in exit costs will not be disbursed.This $3.2 million was reversed out of the accrued exit costs, withcorresponding decreases to deferred taxes ($1.2 million) and goodwill ($2.0million). As of September 30, 2004, $28.0 million of these exit costs werepaid, leaving $2.4 million unpaid.

 

In the third quarter of 2004,Bankshares initiated a significant reorganization within its Community Bankingnetwork.  In a move designed to createbanks of sufficient size and depth to compete more effectively today and in thefuture, Bankshares combined 11 affiliate banks to create four neworganizations, all with a more prominent Mercantile identity. Thisreorganization will enable Bankshares to operate more effectively andefficiently in the face of increased competitive and regulatory pressures.  Fewer, larger banks will better leverage ourbranch network, reduce administrative and operational redundancies and increasethe breadth and depth of expertise within our Community Banks. All banks thatwere combined are geographically contiguous, share increasingly common marketdynamics and offer the opportunity to create scale efficiencies. The totalrestructuring costs incurred through the nine months ended September 30, 2004amounted to $3.1 million. At September 30, 2004 $2.1 million was unpaid.

 

6

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3. Earnings Per Share

 

Basic earnings per share (“EPS”)are computed by dividing income available to common shareholders by weightedaverage common shares outstanding. Diluted EPS are computed using the same components as basic EPS with thedenominator adjusted for the dilutive effect of stock options, restricted stockawards and vested directors’ deferred compensation plan shares.  The following tables provide reconciliationbetween the computation of basic EPS and diluted EPS for the nine months andquarters ended September 30, 2004 and 2003, respectively.

 
| ** **                                                | ** ** | **For the 9 Months Ended  September 30,** | ** **  |
|-----------------------------------------------------------|------------|-------------------------------------------|-------------|
| ** **                                                | ** ** | **2004**                                  | ** **  | **2003** | ** ** |
| **(In thousands, except per share  data)**                | ** ** | **Net  Income**                           | ** **  | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** | **Net  Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                 | ** ** | **$**                                     | **168,795** | ** ** | **79,269** | ** ** | **$** | **2.13** |   | $ | 146,169 |   | 70,647 |   | $ | 2.07 |   |
| Dilutive effect of:                                       |       |                                      |        |   |   |   |   |   |   |   |   |   |   |
| Stock options and restricted  stock awards                | ** ** | ** **                                |        | **489** |   |   |   |   |   | 510 |   |   |   |
| Vested directors’ deferred compensation  plan shares | ** ** | ** **                                |        | **101** |   |   |   |   |   | — |   |   |   |
| Diluted EPS                                               | ** ** | **$**                                     | **168,795** | ** ** | **79,859** | ** ** | **$** | **2.11** |   | $ | 146,169 |   | 71,157 |   | $ | 2.05 |   |

 
| ** **                                                | ** ** | **For the 3 Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| **(In thousands, except per share  data)**                | ** ** | **Net  Income**                           | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** | **Net  Income** | ** ** | **Weighted Average  Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                 | ** ** | **$**                                     | **56,785** | ** ** | **78,965** | ** ** | **$** | **0.72** |   | $ | 47,173 |   | 74,253 |   | $ | 0.64 |   |
| Dilutive effect of:                                       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Stock options and restricted  stock awards                | ** ** | ** **                                |       | **491** |   |   |   |   |   | 587 |   |   |   |
| Vested directors’ deferred compensation  plan shares | ** ** | ** **                                |       | **155** |   |   |   |   |   | — |   |   |   |
| Diluted EPS                                               | ** ** | **$**                                     | **56,785** | ** ** | **79,611** | ** ** | **$** | **0.71** |   | $ | 47,173 |   | 74,840 |   | $ | 0.63 |   |

 

Antidilutive options and awardsexcluded from the computation of diluted earnings per share were 526,465 and238,838 for the nine months ended September 30, 2004 and 2003, respectively,and 57,388 and 170,313 for the third quarter of 2004 and 2003, respectively.

 

# **4. Investment Securities**

 

The amortized cost andfair value of investment securities at September 30, 2004, December 31, 2003and September 30, 2003 are shown below:

 
| ** **                         | ** ** | **September 30, 2004** | ** **    | **December 31, 2003** | ** ** | **September 30, 2003** | ** ** |
|------------------------------------|------------|------------------------|---------------|-----------------------|------------|------------------------|------------|
| **(Dollars  in thousands)**        | ** ** | **Amortized  Cost**    | ** **    | **Fair  Value**       | ** ** | **Amortized  Cost**    | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| Securities available-for-sale      |       |                   |          |                  |       |                   |       |   |   |   |   |   |   |
| U.S. Treasury                      | ** ** | **$**                  | **728,454**   | ** **            | **$**      | **737,144**            |       | $ | 823,356 |   | $ | 845,754 |   | $ | 869,760 |   | $ | 901,384 |   |
| U.S. Government agencies           | ** ** | **877,877**            | ** **    | **882,667**           |       | 778,916                |       | 793,611 |   | 752,861 |   | 773,894 |   |
| Mortgage-backed securities         | ** ** | **1,210,527**          | ** **    | **1,203,931**         |       | 1,288,109              |       | 1,283,630 |   | 1,243,745 |   | 1,240,215 |   |
| States and political  subdivisions | ** ** | **64,746**             | ** **    | **65,977**            |       | 77,897                 |       | 79,870 |   | 88,691 |   | 90,696 |   |
| Other investments                  | ** ** | **139,091**            | ** **    | **140,865**           |       | 118,948                |       | 120,649 |   | 121,377 |   | 122,405 |   |
| Total                              | ** ** | **$**                  | **3,020,695** | ** **            | **$**      | **3,030,584**          |       | $ | 3,087,226 |   | $ | 3,123,514 |   | $ | 3,076,434 |   | $ | 3,128,594 |   |
|                               |       |                   |          |                  |       |                   |       |   |   |   |   |   |   |
| Securities held-to-maturity        |       |                   |          |                  |       |                   |       |   |   |   |   |   |   |
| States and political  subdivisions | ** ** | **$**                  | **21,909**    | ** **            | **$**      | **23,000**             |       | $ | 28,213 |   | $ | 30,115 |   | $ | 33,421 |   | $ | 36,030 |   |
| Other investments                  | ** ** | **27,750**             | ** **    | **27,750**            |       | 21,204                 |       | 21,204 |   | 22,636 |   | 22,636 |   |
| Total                              | ** ** | **$**                  | **49,659**    | ** **            | **$**      | **50,750**             |       | $ | 49,417 |   | $ | 51,319 |   | $ | 56,057 |   | $ | 58,666 |   |
|                                    |            |                        |               |                       |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

At September 30, 2004, therewere $289.5 million of individual securities that had unrealized losses for aperiod greater than one year. At September 30, 2004, these securities had anunrealized loss of $7.5 million. Management has assessed the impairment ofthese securities and determined that the impairment is temporary.

 

7

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5. ImpairedLoans

 

Whenscheduled principal or interest payments are past due 90 days or more atquarter-end on any loan, the accrual of interest income is discontinued andsubsequent receipts on these loans are recorded as a reduction of principal,and interest income is recorded only once principal recovery is reasonablyassured. Previously accrued but uncollected interest on these loans is chargedagainst interest income. Generally, a loan may be restored to accruing statuswhen all past due principal, interest and late charges have been paid and thebank expects repayment of the remaining contractual principal and interest on atimely basis.

 

UnderStatements of Financial Accounting Standards (SFAS) Nos. 114 and 118, “Accountingby Creditors for Impairment of a Loan-an amendment of FASB Statements No. 5 and15,” a loan is considered impaired, based on current information and events, ifit is probable that Bankshares will not collect all principal and interestpayments according to the contractual terms of the loan agreement. Theimpairment of a loan is measured based on the present value of expected futurecash flows discounted at the loan’s effective interest rate, or the fair valueof the collateral if the repayment is expected to be provided predominantly bythe underlying collateral. A majority of Bankshares’ impaired loans aremeasured by reference to the fair value of the collateral. Informationwith respect to impaired loans and the related valuation allowance (if themeasure of the impaired loan is less than the recorded investment) at September30, 2004, December 31, 2003 and September 30, 2003 is shown below.  See Annual Report on Form 10-K for moredetail.

 
| **(Dollars  in thousands)**                                                      | ** ** | **September 30,  2004** | ** **  | **December 31,  2003** | ** ** | **September 30,  2003** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------|-------------|------------------------|------------|-------------------------|------------|
| Impaired loans with a specific  valuation allowance                              | ** ** | **$**                   | **25,045**  |                   | $          | 26,715                  |       | $ | 27,869 |   |
| All other impaired loans                                                         | ** ** | **10,306**              |        | 18,692                 |       | 18,609                  |       |
| Total impaired loans                                                             | ** ** | **$**                   | **35,351**  |                   | $          | 45,407                  |       | $ | 46,478 |   |
|                                                                             |       |                    |        |                   |       |                    |       |
| Specific allowance for loan  losses applicable to impaired loans                 | ** ** | **$**                   | **14,499**  |                   | $          | 14,925                  |       | $ | 14,766 |   |
| General allowance for loan  losses applicable to other than impaired loans       | ** ** | **146,942**             |        | 140,412                |       | 140,988                 |       |
| Total allowance for loan losses                                                  | ** ** | **$**                   | **161,441** |                   | $          | 155,337                 |       | $ | 155,754 |   |
|                                                                             |       |                    |        |                   |       |                    |       |
| Year-to-date interest income on  impaired loans recorded on the cash basis       | ** ** | **$**                   | **300**     |                   | $          | 443                     |       | $ | 220 |   |
| Year-to-date average recorded  investment in impaired loans during the period    | ** ** | **$**                   | **40,172**  |                   | $          | 31,241                  |       | $ | 29,194 |   |
| Quarter-to-date interest income  on impaired loans recorded on the cash basis    | ** ** | **$**                   | **88**      |                   | $          | 223                     |       | $ | 65 |   |
| Quarter-to-date average recorded  investment in impaired loans during the period | ** ** | **$**                   | **38,285**  |                   | $          | 37,382                  |       | $ | 34,707 |   |

 

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.

 

6. Commitments

 

Bankshares is a party tofinancial instruments that are not reflected in the balance sheet, whichinclude commitments to extend credit and standby letters of credit. Variouscommitments to extend credit (lines of credit) are made in the normal course ofbanking business. Letters of credit are issued for the benefit of customers byaffiliated banks. These commitments are subject to loan underwriting standardsand geographic boundaries consistent with Bankshares’ loans outstanding.Bankshares’ lending activities are concentrated in Maryland, Delaware andVirginia.

 

Commitments to extend creditare agreements to lend to a customer as long as there is no violation of anycondition established in the contract. Commitments generally have fixedexpiration dates or other termination clauses and may require payment of a fee.Since many of the commitments are expected to expire without being drawn upon,the total commitment amounts do not necessarily represent future cashrequirements. Total commitments to extend credit were $4.1 billion at September30, 2004, $3.6 billion at December 31, 2003, and $3.4 billion at September 30,2003.

 

Letters of credit arecommitments issued to guarantee the performance of a customer to a third party.Outstanding letters of credit were $347.5 million at September 30, 2004, $281.4million at December 31, 2003 and $284.3 million at September 30, 2003.  Fees received for issuing letters of creditare deferred and amortized over the life of the commitment.  The unamortized fees on letters of credit atSeptember 30, 2004, December 31, 2003, and September 30, 2003 had a carryingvalue of $1.3 million, $1.0 million and $0.7 million, respectively.

 

8

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Bankshares’ mortgage bankingsubsidiary is a Fannie Mae Delegated Underwriting and Servicing lender, and hasa loss sharing arrangement for loans originated on behalf of and sold to FannieMae.  The unamortized principal balanceof the underlying loans totaled $191.7 million, $149.4 million and $150.0million at September 30, 2004, December 31, 2003 and September 30, 2003,respectively.  No loss reserve has beenestablished for potential losses on loans originated and sold in the secondarymarket since there have been no losses recognized during the history of thisarrangement and no losses were incurred at September 30, 2004.  The mortgage subsidiary also has originatedand sold loans with recourse in the event of foreclosure on the underlying realestate.  The unamortized amount of principalbalance of loans sold with recourse totaled $1.8 million at September 30, 2004,$2.3 million at December 31, 2003 and $2.5 million at September 30, 2003.  These mortgages are generally in goodstanding, are well-collateralized and no loss has ensued and no future loss isexpected.

 

Bankshares has committed toinvest funds in third-party private equity investments. At September 30, 2004,December 31, 2003 and September 30, 2003, $21.9 million, $16.1 million and$17.8 million, respectively, remained unfunded.

 

7. Goodwilland Other Intangible Assets

 

Goodwill decreased by $9.8 millionduring the third quarter of 2004.  Thisdecrease was due to the finalization of F&M’s purchase accountingadjustments related to exit costs accrued by F&M prior to merger, sale of abranch and the finalization of deferred taxes.

 

The following table disclosesthe gross carrying amount and accumulated amortization of intangible assetssubject to amortization at September 30, 2004 and December 31, 2003:

 
| ** **                     | ** ** | **September 30, 2004**     | ** ** | **December 31, 2003**         | ** ** |
|--------------------------------|------------|----------------------------|------------|-------------------------------|------------|
| **(Dollars  in thousands)**    | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** |
| Deposit intangibles            | ** ** | **$**                      | **49,881** | ** **                    | **$**      | **(13,647** | **)** | **$** | **36,234** |   | $ | 49,881 |   | $ | (9,546 | ) | $ | 40,335 |   |
| Mortgage servicing intangibles | ** ** | **2,303**                  | ** ** | **(1,729**                    | **)**      | **574** |   | 2,351 |   | (1,790 | ) | 561 |   |
| Customer lists and other       | ** ** | **17,010**                 | ** ** | **(3,427**                    | **)**      | **13,583** |   | 17,010 |   | (1,683 | ) | 15,327 |   |
| Total                          | ** ** | **$**                      | **69,194** | ** **                    | **$**      | **(18,803** | **)** | **$** | **50,391** |   | $ | 69,242 |   | $ | (13,019 | ) | $ | 56,223 |   |

 

Identifiable intangible assetsare amortized based on estimated lives of 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. Forthose intangible assets subject to amortization, impairment is indicated if thesum of undiscounted estimated future net cash flows is less than the carryingamount of the asset. Impairment is recognized by writing down the carryingvalue of the asset. Any impairment recognized in a valuation account isreflected in the income statement in the corresponding period. Banksharesrecorded a write down of $43.9 thousand in the third quarter of 2004 formortgage servicing rights.

 

The following table shows thecurrent period and estimated future amortization expense for amortizedintangible assets. The projections of amortization expense shown for mortgageservicing rights are based on asset balances and the interest rate environmentas of September 30, 2004. Future amortization expense may be significantlydifferent depending upon changes in the mortgage servicing portfolio, mortgageinterest rates and market conditions.

 
| **(Dollars  in thousands)**                        | ** ** | **Core  deposit  intangibles** | ** ** | **Mortgage  servicing  intangibles** | ** ** | **Customer lists  and other  intangibles** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|--------------------------------|------------|--------------------------------------|------------|--------------------------------------------|------------|-----------|------------|
| Nine months ended September 30,  2004 (actual)     | ** ** | **$**                          | **4,101**  | ** **                           | **$**      | **274**                                    | ** ** | **$**     | **1,757**  | ** ** | **$** | **6,132** | ** ** |
| Three months ended December 31,  2004 (estimated)  |       | 1,366                          |       | 86                                   |       | 581                                        |       | 2,033     |       |
| Twelve months ended December  31, 2004 (estimated) |       | 5,467                          |       | 360                                  |       | 2,338                                      |       | 8,165     |       |
|                                               |       |                           |       |                                 |       |                                       |       |      |       |
| Estimate for year ended  December 31,              | 2005       |                           | 5,467      |                                 | 342        |                                       | 2,326      |      | 8,135      |   |
|                                               | 2006       |                           | 5,467      |                                 | 146        |                                       | 2,083      |      | 7,696      |   |
|                                               | 2007       |                           | 5,209      |                                 |       |                                       | 1,890      |      | 7,099      |   |
|                                               | 2008       |                           | 4,344      |                                 |       |                                       | 1,708      |      | 6,052      |   |
|                                               | 2009       |                           | 4,120      |                                 |       |                                       | 985        |      | 5,105      |   |
|                                                    |            |                                |            |                                      |            |                                            |            |           |            |  |  |  |  |  |

 

9

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8.Comprehensive Income

 

The following table summarizesthe market value change and related tax effect of unrealized gains (losses) onsecurities available-for-sale for the nine months ended and the quarters endedSeptember 30, 2004 and 2003, respectively. The total comprehensive income is included in the Statements of Changesin Consolidated Shareholders’ Equity.

 
| ** **                                                             | ** ** | **For the 9 Months Ended   September 30,** | ** **  | **For the 3 Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------|-------------|-------------------------------------------|------------|
| **(Dollars  in thousands)**                                            | ** ** | **2004**                                   | ** **  | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income                                                             | ** ** | **$**                                      | **168,795** |                                      | $          | 146,169 | ** ** | **$** | **56,785** |   | $ | 47,173 |   |
| Other comprehensive income, net  of taxes:                             |       |                                       |        |                                      |       |   |   |   |   |
| Unrealized holding (losses)  gains arising during the period           | ** ** | **(16,071**                                | **)**       | (19,299                                   | )          | **14,190** |   | (13,194 | ) |
| Reclassification adjustment for  (gains) losses included in net income | ** ** | **(323**                                   | **)**       | (4,241                                    | )          | **1** |   | 203 |   |
| Total comprehensive income                                             | ** ** | **$**                                      | **152,401** |                                      | $          | 122,629 | ** ** | **$** | **70,976** |   | $ | 34,182 |   |

 

9. CapitalAdequacy

 

Bankshares and its bankaffiliates are subject to various regulatory capital adequacy requirementsadministered by federal and state banking agencies.  These requirements include maintainingcertain capital ratios above minimum levels. These capital ratios include tier I capital and total risk-based capitalas percentages of net risk-weighted assets and tier I capital as a percentageof adjusted average total assets (leverage ratio).  The minimum ratios for capital adequacypurposes are 4.00%, 8.00% and 4.00%, for the tier I capital, total capital andleverage ratios, respectively.  To becategorized as *well capitalized,* a bank mustmaintain minimum ratios of 6.00%, 10.00% and 5.00%, for its tier I capital,total capital and leverage ratios, respectively.  As of September 30, 2004, Bankshares and eachof its bank affiliates exceeded all capital adequacy requirements to beconsidered well capitalized.

 

Capital ratios and the amountsused to calculate them are presented in the following table for Bankshares andMercantile-Safe Deposit & Trust Company (MSD&T), the lead bank, as ofSeptember 30, 2004 and December 31, 2003.

 
| *** ***                  | ** ** | **September 30, 2004** | ** **    | **December 31, 2003** | ** ** |
|-------------------------------|------------|------------------------|---------------|-----------------------|------------|
| **(Dollars  in thousands)**   | ** ** | **Bankshares**         | ** **    | **MSD&T**         | ** ** | **Bankshares** | ** ** | **MSD&T** | ** ** |
|                          |       |                   |          |                  |       |   |   |   |   |
| Tier I capital                | ** ** | **$**                  | **1,329,898** |                  | $          | 406,526 |   | $ | 1,248,492 |   | $ | 396,186 |   |
| Total risk-based capital      | ** ** | **1,759,611**          |          | 453,514               |       | 1,666,064 |   | 440,479 |   |
| Net risk-weighted assets      | ** ** | **10,817,560**         |          | 3,730,852             |       | 10,020,487 |   | 3,529,223 |   |
| Adjusted average total assets | ** ** | **13,465,769**         |          | 4,403,191             |       | 13,011,399 |   | 4,353,713 |   |
|                          |       |                   |          |                  |       |   |   |   |   |
| Tier I capital ratio          | ** ** | **12.29**              | **%**         | 10.90                 | %          | 12.46 | % | 11.23 | % |
| Total capital ratio           | ** ** | **16.27**              | **%**         | 12.16                 | %          | 16.63 | % | 12.48 | % |
| Leverage ratio                | ** ** | **9.88**               | **%**         | 9.23                  | %          | 9.60 | % | 9.10 | % |
|                               |            |                        |               |                       |            |  |  |  |  |  |  |  |  |

 

Bankshareshas an ongoing share repurchase program. At September 30, 2004, there were 476,327 shares remaining forrepurchase of the 2,000,000 shares previously authorized by the Board ofDirectors on December 11, 2001.  For thenine months ended September 30, 2004 and the twelve months ended December 31,2003, 1,000,000 and 5,500 shares, respectively, were repurchased byBankshares.  In April 2004, Banksharesentered into a privately negotiated agreement for the accelerated repurchase ofthe one million shares.  Sharesrepurchased in 2003 were acquired in open market transactions.

 

10

----

 

10. SegmentReporting

 

Operating segments as definedby SFAS No. 131, *Disclosures about Segments of an Enterpriseand Related Information,* are components of an enterprise withseparate financial information.  Thecomponent engages in business activities from which it derives revenues andincurs expenses and whose operating results management relies on fordecision-making and performance assessment. Bankshares has three reportablesegments – its 12 Community Banks, MSD&T Banking and Investment and Wealth Management  (IWM).

 

The following tables present selected segment information for the ninemonths and quarters ended September 30, 2004 and 2003, respectively.  The components in the “Other” column consistof amounts for the nonbanking affiliates, unallocated corporate expenses andintercompany eliminations.   Certainexpense amounts such as operations overhead have been reclassified frominternal financial reporting in order to provide for full cost absorption.  These reclassifications are shown in the “Adjustments”line.  F&M is included in the column “CommunityBanking” whereas BW and Peremel are included in the column “IWM”.

 
| ** **                         | ** ** | **For the 9 Months Ended  September 30, 2004** | ** **    |
|------------------------------------|------------|------------------------------------------------|---------------|
| ** **                         | ** ** | **Banking**                                    | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)**        | ** ** | **Community**                                  | ** **    | **MSD&T** | ** ** | **Total (1)** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income                | ** ** | **$**                                          | **292,546**   | ** ** | **$** | **110,004** | ** ** | **$** | **402,550** | ** ** | **$** | **—** | ** ** | **$** | **2,933** | ** ** | **$** | **405,483** | ** ** |
| Provision for loan losses          | ** ** | **81**                                         | ** **    | **(7,302** | **)** | **(7,221** | **)** | **—** | ** ** | **—** | ** ** | **(7,221** | **)** |
| Noninterest income                 | ** ** | **64,595**                                     | ** **    | **33,664** | ** ** | **84,881** | ** ** | **67,548** | ** ** | **2,360** | ** ** | **154,789** | ** ** |
| Noninterest expenses               | ** ** | **(168,444**                                   | **)**         | **(78,517** | **)** | **(233,583** | **)** | **(50,748** | **)** | **(1,639** | **)** | **(285,970** | **)** |
| Adjustments                        | ** ** | **(5,661**                                     | **)**         | **19,912** | ** ** | **14,251** | ** ** | **(3,070** | **)** | **(11,181** | **)** | **—** | ** ** |
| Income (loss) before income  taxes | ** ** | **183,117**                                    | ** **    | **77,761** | ** ** | **260,878** | ** ** | **13,730** | ** ** | **(7,527** | **)** | **267,081** | ** ** |
| Income tax (expense) benefit       | ** ** | **(62,959**                                    | **)**         | **(28,020** | **)** | **(90,979** | **)** | **(5,492** | **)** | **(1,815** | **)** | **(98,286** | **)** |
| Net income (loss)                  | ** ** | **$**                                          | **120,158**   | ** ** | **$** | **49,741** | ** ** | **$** | **169,899** | ** ** | **$** | **8,238** | ** ** | **$** | **(9,342** | **)** | **$** | **168,795** | ** ** |
| Average loans                      | ** ** | **$**                                          | **6,551,220** | ** ** | **$** | **3,045,466** | ** ** | **$** | **9,596,686** | ** ** | **—** | ** ** | **$** | **189** | ** ** | **$** | **9,596,875** | ** ** |
| Average earning assets             | ** ** | **8,859,644**                                  | ** **    | **4,069,343** | ** ** | **12,620,653** | ** ** | **—** | ** ** | **107,630** | ** ** | **12,728,283** | ** ** |
| Average assets                     | ** ** | **9,344,183**                                  | ** **    | **4,424,233** | ** ** | **13,335,183** | ** ** | **—** | ** ** | **550,375** | ** ** | **13,885,558** | ** ** |
| Average deposits                   | ** ** | **7,419,030**                                  | ** **    | **3,121,148** | ** ** | **10,400,049** | ** ** | **—** | ** ** | **(75,173** | **)** | **10,324,876** | ** ** |
| Average equity                     | ** ** | **935,872**                                    | ** **    | **444,985** | ** ** | **1,380,857** | ** ** | **—** | ** ** | **477,720** | ** ** | **1,858,577** | ** ** |

 
| ** **                         | ** ** | **For the 9 Months Ended  September 30, 2003** | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|
| ** **                         | ** ** | **Banking**                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)**        | ** ** | **Community**                                  | ** ** | **MSD&T** | ** ** | **Total (1)** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income                |       | $                                              | 240,278    |   | $ | 106,701 |   | $ | 346,979 |   | $ | — |   | $ | (898 | ) | $ | 346,081 |   |
| Provision for loan losses          |       | (3,819                                         | )          | (5,253 | ) | (9,072 | ) | — |   | — |   | (9,072 | ) |
| Noninterest income                 |       | 50,151                                         |       | 32,070 |   | 71,498 |   | 57,560 |   | 135 |   | 129,193 |   |
| Noninterest expenses               |       | (127,627                                       | )          | (69,145 | ) | (186,049 | ) | (50,014 | ) | (1,956 | ) | (238,019 | ) |
| Adjustments                        |       | (7,796                                         | )          | 13,589 |   | 5,793 |   | (2,457 | ) | (3,336 | ) | — |   |
| Income (loss) before income  taxes |       | 151,187                                        |       | 77,962 |   | 229,149 |   | 5,089 |   | (6,055 | ) | 228,183 |   |
| Income tax (expense) benefit       |       | (52,125                                        | )          | (28,075 | ) | (80,200 | ) | (2,035 | ) | 221 |   | (82,014 | ) |
| Net income (loss)                  |       | $                                              | 99,062     |   | $ | 49,887 |   | $ | 148,949 |   | $ | 3,054 |   | $ | (5,834 | ) | $ | 146,169 |   |
| Average loans                      |       | $                                              | 4,828,958  |   | $ | 2,909,190 |   | $ | 7,738,148 | ** ** | **—** |   | $ | 240 |   | $ | 7,738,388 |   |
| Average earning assets             |       | 6,793,767                                      |       | 4,087,620 |   | 10,658,211 | ** ** | **—** |   | 84,781 |   | 10,742,992 |   |
| Average assets                     |       | 7,156,379                                      |       | 4,390,264 |   | 11,220,870 | ** ** | **—** |   | 180,161 |   | 11,401,031 |   |
| Average deposits                   |       | 5,757,564                                      |       | 3,129,902 |   | 8,771,045 | ** ** | **—** |   | (175,624 | ) | 8,595,421 |   |
| Average equity                     |       | 846,404                                        |       | 454,583 |   | 1,300,987 | ** ** | **—** |   | 90,134 |   | 1,391,121 |   |

 

11

----

 
| ** **                         | ** ** | **For the 3 Months Ended  September 30, 2004** | ** **    |
|------------------------------------|------------|------------------------------------------------|---------------|
| ** **                         | ** ** | **Banking**                                    | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)**        | ** ** | **Community**                                  | ** **    | **MSD&T** | ** ** | **Total (1)** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income                | ** ** | **$**                                          | **99,483**    | ** ** | **$** | **38,786** | ** ** | **$** | **138,269** | ** ** | **$** | **—** | ** ** | **$** | **480** | ** ** | **$** | **138,749** | ** ** |
| Provision for loan losses          | ** ** | **(175**                                       | **)**         | **(2,267** | **)** | **(2,442** | **)** | **—** | ** ** | **—** | ** ** | **(2,442** | **)** |
| Noninterest income                 | ** ** | **22,121**                                     | ** **    | **11,577** | ** ** | **29,268** | ** ** | **22,319** | ** ** | **1,767** | ** ** | **53,354** | ** ** |
| Noninterest expenses               | ** ** | **(57,121**                                    | **)**         | **(28,128** | **)** | **(80,819** | **)** | **(16,939** | **)** | **(1,459** | **)** | **(99,217** | **)** |
| Adjustments                        | ** ** | **(2,175**                                     | **)**         | **8,040** | ** ** | **5,865** | ** ** | **(1,144** | **)** | **(4,721** | **)** | **—** | ** ** |
| Income (loss) before income  taxes | ** ** | **62,133**                                     | ** **    | **28,008** | ** ** | **90,141** | ** ** | **4,236** | ** ** | **(3,933** | **)** | **90,444** | ** ** |
| Income tax (expense) benefit       | ** ** | **(20,950**                                    | **)**         | **(10,047** | **)** | **(30,997** | **)** | **(1,695** | **)** | **(967** | **)** | **(33,659** | **)** |
| Net income (loss)                  | ** ** | **$**                                          | **41,183**    | ** ** | **$** | **17,961** | ** ** | **$** | **59,144** | ** ** | **$** | **2,541** | ** ** | **$** | **(4,900** | **)** | **$** | **56,785** | ** ** |
| Average loans                      | ** ** | **$**                                          | **6,731,985** | ** ** | **$** | **3,093,622** | ** ** | **$** | **9,825,607** | ** ** | **—** | ** ** | **$** | **186** | ** ** | **$** | **9,825,793** | ** ** |
| Average earning assets             | ** ** | **8,992,959**                                  | ** **    | **4,089,231** | ** ** | **12,827,949** | ** ** | **—** | ** ** | **107,663** | ** ** | **12,935,612** | ** ** |
| Average assets                     | ** ** | **9,494,036**                                  | ** **    | **4,447,860** | ** ** | **13,551,016** | ** ** | **—** | ** ** | **548,472** | ** ** | **14,099,488** | ** ** |
| Average deposits                   | ** ** | **7,565,588**                                  | ** **    | **3,183,183** | ** ** | **10,599,179** | ** ** | **—** | ** ** | **(91,463** | **)** | **10,507,716** | ** ** |
| Average equity                     | ** ** | **930,007**                                    | ** **    | **447,276** | ** ** | **1,377,283** | ** ** | **—** | ** ** | **500,561** | ** ** | **1,877,844** | ** ** |

 
| ** **                         | ** ** | **For the 3 Months Ended  September 30, 2003** | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|
| ** **                         | ** ** | **Banking**                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)**        | ** ** | **Community**                                  | ** ** | **MSD&T** | ** ** | **Total (1)** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income                |       | $                                              | 86,775     |   | $ | 35,212 |   | $ | 121,987 |   | $ | — |   | $ | 245 |   | $ | 122,232 |   |
| Provision for loan losses          |       | (710                                           | )          | (2,295 | ) | (3,005 | ) | — |   | — |   | (3,005 | ) |
| Noninterest income                 |       | 18,609                                         |       | 10,478 |   | 25,530 |   | 20,396 |   | (23 | ) | 45,903 |   |
| Noninterest expenses               |       | (49,275                                        | )          | (25,216 | ) | (70,934 | ) | (19,588 | ) | (667 | ) | (91,189 | ) |
| Adjustments                        |       | (4,576                                         | )          | 5,826 |   | 1,250 |   | (898 | ) | (352 | ) | — |   |
| Income (loss) before income  taxes |       | 50,823                                         |       | 24,005 |   | 74,828 |   | (90 | ) | (797 | ) | 73,941 |   |
| Income tax (expense) benefit       |       | (17,488                                        | )          | (8,632 | ) | (26,120 | ) | 37 |   | (685 | ) | (26,768 | ) |
| Net income (loss)                  |       | $                                              | 33,335     |   | $ | 15,373 |   | $ | 48,708 |   | $ | (53 | ) | $ | (1,482 | ) | $ | 47,173 |   |
| Average loans                      |       | $                                              | 5,422,443  |   | $ | 2,908,605 |   | $ | 8,331,048 | ** ** | **—** |   | $ | 217 |   | $ | 8,331,265 |   |
| Average earning assets             |       | 7,756,209                                      |       | 4,196,854 |   | 11,664,463 | ** ** | **—** |   | 86,503 |   | 11,750,966 |   |
| Average assets                     |       | 8,202,204                                      |       | 4,516,120 |   | 12,320,367 | ** ** | **—** |   | 301,733 |   | 12,622,100 |   |
| Average deposits                   |       | 6,539,970                                      |       | 3,151,528 |   | 9,573,723 | ** ** | **—** |   | (185,009 | ) | 9,388,714 |   |
| Average equity                     |       | 852,712                                        |       | 455,372 |   | 1,308,084 | ** ** | **—** |   | 242,853 |   | 1,550,937 |   |

 

----

(1)  Amounts do not necessarily crossfoot due toeliminations.

 

11. DerivativeInstruments and Hedging Activities

 

FASB Statement No. 133 (SFASNo. 133), *Accounting for Derivative Instruments and HedgingActivities,*FASB Statement No. 138 (SFAS No. 138), *Accounting for Certain Derivative Instruments and Certain HedgingActivities – an amendment to FASB Statement No. 133*and**FASB Statement No. 149 (SFAS No. 149), *Amendment ofStatement No. 133 on Derivative Instruments and Hedging Activities *(collectively referred to as “derivatives”),establishes accounting and reporting standards for derivative instruments andfor hedging activities. Bankshares maintains an overall interest rate riskmanagement strategy that incorporates the use of derivative instruments tominimize significant unplanned fluctuations in earnings that are caused byinterest rate volatility.  Derivativeinstruments that are used as part of the interest rate risk management strategyhave been restricted to interest rate swaps. Interest rate swaps generally involve the exchange of fixed-rate andvariable-rate interest payments between two parties, based on a common notionalprincipal amount and maturity date. As of September 30, 2004, Bankshares hasinterest rate swaps to convert its nonprepayable fixed-rate debt tofloating-rate debt.  Bankshares alsoarranges interest rate swaps, caps and swaptions for commercial loan customersthrough its capital markets group. Derivative transactions done with loan customers are hedged by means ofan off-setting derivative trade with a third party.  In this way, Bankshares manages the marketrisk arising from capital markets related derivative activity.  The increase in the number of contracts sinceDecember 31, 2003 is related to the capital markets group activities.

 

The fair value of derivativeinstruments relating to hedging activities recorded in other assets was $9.0million (notional $280.5 million) and $6.6 million (notional $203.1 million) atSeptember 30, 2004 and December 31, 2003, respectively.  The fair value of derivative instrumentsrelating to hedging activities recorded in other liabilities was $6.6 million(notional $130.5 million) and $8.0 million (notional $150.0 million) atSeptember 30, 2004 and December 31, 2003, respectively. The fair-value hedgesof nonprepayable fixed-rate debt were effective for the reported periods.  The impact of the hedges decreased interestexpense $8.2 million in the first nine months of 2004 and $8.5 million in 2003.

 

12

----

 

The following tablessummarize the gross position of derivatives relating to hedging activities atSeptember 30, 2004 and December 31, 2003:

 
| ** **                                      | ** ** | ** **               | ** ** | ** **           | ** **  | **Weighted Average**   | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|----------------------|-------------|------------------------|------------|
| **September  30, 2004 (Dollars in thousands)**  | ** ** | **Number  of Contracts** | ** ** | **Notional  Amount** | ** **  | **Years to  Maturity** | ** ** | **Fixed Rate** | ** ** | **Variable Rate** | ** ** | **Fair  Value** | ** ** |
| Gross Position Summary:                         | ** ** | ** **               | ** ** | ** **           | ** **  | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Pay Fixed/Receive Variable  Interest Rate Swaps | ** ** | **5**                    | ** ** | **$**                | **24,513**  | ** **             | **6.72**   | ** ** | **4.23** | **%** | **1.68** | **%** | **$** | **(478** | **)** |
| Receive Fixed/Pay Variable  Interest Rate Swaps | ** ** | **8**                    | ** ** | **374,513**          | ** **  | **7.66**               | ** ** | **5.17** | **%** | **2.42** | **%** | **2,832** | ** ** |
| Swaptions/Caps Purchased                        | ** ** | **2**                    | ** ** | **6,000**            | ** **  | **7.11**               | ** ** | ** ** | ** ** | ** ** | ** ** | **—** | ** ** |
| Swaptions/Caps Sold                             | ** ** | **2**                    | ** ** | **6,000**            | ** **  | **7.11**               | ** ** | ** ** | ** ** | ** ** | ** ** | **—** | ** ** |
| Total                                           | ** ** | **17**                   | ** ** | **$**                | **411,026** | ** **             | **7.59**   | ** ** | ** ** | ** ** | ** ** | ** ** | **$** | **2,354** | ** ** |

 
| ** **                                      | ** ** | ** **               | ** ** | ** **           | ** ** | **Weighted Average**   | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|----------------------|------------|------------------------|------------|
| **December  31, 2003 (Dollars in thousands)**   | ** ** | **Number  of Contracts** | ** ** | **Notional  Amount** | ** ** | **Years to  Maturity** | ** ** | **Fixed Rate** | ** ** | **Variable Rate** | ** ** | **Fair  Value** | ** ** |
| Gross Position Summary:                         |       |                     |       |                 |       |                   |       |   |   |   |   |   |   |
| Pay Fixed/Receive Variable  Interest Rate Swaps |       | 1                        |       | $                    | 3,108      |                   | 0.33       |   | 9.38 | % | 4.00 | % | $ | (64 | ) |
| Receive Fixed/Pay Variable  Interest Rate Swaps |       | 3                        |       | 350,000              |       | 8.44                   |       | 5.21 | % | 1.98 | % | (1,366 | ) |
| Total                                           |       | 4                        |       | $                    | 353,108    |                   | 8.37       |   |   |   |   |   | $ | (1,430 | ) |

 

Mortgage loans held-for-salehave inherent forward contract (agreements to sell or purchase loans at aspecific rate or yield) characteristics. Risk may arise from the correspondingparties’ inability to meet the terms of their contracts and from movement ininterest rates. Bankshares has forward commitments to sell and fund individualfixed-rate and variable-rate mortgage loans that are reported at fair value.The fair value adjustment was $0.4 million at September 30, 2004.

 

12.Stock-based Compensation Expense

 

Bankshares has severalstock-based compensation programs for its directors, management and employees.Compensation costs for stock options and restricted stock awards are measuredunder the fair value method and are included in salary expense.  Another form of stock-based compensation isphantom stock, which is used for a portion of the Bankshares’ Directors’Deferred Compensation Plan.  A change inthis plan was approved at the annual shareholders’ meeting, and was effectiveApril 1, 2004.  This plan requires alldeferred fees to be settled in Bankshares’ stock.  This reduces the expense fluctuations thatoccurred with phantom stock, which resulted in variances corresponding to thechanges in Bankshares’ stock price.  Thecompensation cost for the phantom stock is included in other expenses.  Stock-based compensation amounts for the ninemonths and quarters ended September 30, 2004 and 2003, respectively, aresummarized in the following table:

 
| ** **                              | ** ** | **For the 9 Months Ended  September 30,** | ** ** | **For the 3 Months Ended  September 30,** | ** ** |
|-----------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| **(Dollars  in thousands)**             | ** ** | **2004**                                  | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Stock options expense                   | ** ** | **$**                                     | **1,996**  |                                      | $          | 1,218 | ** ** | **$** | **796** |   | $ | 353 |   |
| Restricted stock awards expense         | ** ** | **1,516**                                 |       | 2,576                                     | ** ** | **509** |   | 1,654 |   |
| Subtotal included in salaries  expense  | ** ** | **3,512**                                 |       | 3,794                                     | ** ** | **1,305** |   | 2,007 |   |
| Phantom stock expense                   | ** ** | **(129**                                  | )          | 512                                       | ** ** | **69** |   | 198 |   |
| Total stock-based compensation  expense | ** ** | **$**                                     | **3,383**  |                                      | $          | 4,306 | ** ** | **$** | **1,374** |   | $ | 2,205 |   |

 

13

----

 

13. Pension& Other Postretirement Benefit Plans

 

Bankshares sponsors qualifiedand nonqualified pension plans and other postretirement benefit plans for itsemployees.  The following tablesummarizes the components of the net periodic benefit cost for the pensionplans for the nine months and the three months ended September 30, 2004 and2003, respectively.

 
| ** **                          | ** ** | **For the 9 Months Ended  September 30, 2004** | ** ** | **For the 9 Months Ended  September 30, 2003** | ** ** |
|-------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| **(Dollars  in thousands)**         | ** ** | **Qualified**                                  | ** ** | **Nonqualified**                               | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                        | ** ** | **$**                                          | **4,716**  | ** **                                     | **$**      | **423** | ** ** | **$** | **5,139** |   | $ | 3,840 |   | $ | 345 |   | $ | 4,185 |   |
| Interest cost                       | ** ** | **7,647**                                      | ** ** | **303**                                        | ** ** | **7,950** |   | 7,494 |   | 234 |   | 7,728 |   |
| Expected return on plan assets      | ** ** | **(11,535**                                    | **)**      | **—**                                     | ** ** | **(11,535** | ) | (9,297 | ) | — |   | (9,297 | ) |
| Amortization of prior service  cost | ** ** | **585**                                        | ** ** | **18**                                         | ** ** | **603** |   | 585 |   | 18 |   | 603 |   |
| Recognized net actuarial loss       | ** ** | **661**                                        | ** ** | **87**                                         | ** ** | **748** |   | 1,966 |   | 24 |   | 1,990 |   |
| Amortization of transition  asset   | ** ** | **—**                                     | ** ** | **72**                                         | ** ** | **72** |   | — |   | 75 |   | 75 |   |
| Net periodic benefit cost           | ** ** | **$**                                          | **2,074**  | ** **                                     | **$**      | **903** | ** ** | **$** | **2,977** |   | $ | 4,588 |   | $ | 696 |   | $ | 5,284 |   |

 
| ** **                          | ** ** | **For the 3 Months Ended  September 30, 2004** | ** ** | **For the 3 Months Ended  September 30, 2003** | ** ** |
|-------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| **(Dollars  in thousands)**         | ** ** | **Qualified**                                  | ** ** | **Nonqualified**                               | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                        | ** ** | **$**                                          | **1,572**  | ** **                                     | **$**      | **141** | ** ** | **$** | **1,713** |   | $ | 1,280 |   | $ | 115 |   | $ | 1,395 |   |
| Interest cost                       | ** ** | **2,549**                                      | ** ** | **101**                                        | ** ** | **2,650** |   | 2,498 |   | 78 |   | 2,576 |   |
| Expected return on plan assets      | ** ** | **(3,845**                                     | **)**      | **—**                                     | ** ** | **(3,845** | ) | (3,099 | ) | — |   | (3,099 | ) |
| Amortization of prior service  cost | ** ** | **195**                                        | ** ** | **6**                                          | ** ** | **201** |   | 195 |   | 6 |   | 201 |   |
| Recognized net actuarial loss       | ** ** | **307**                                        | ** ** | **29**                                         | ** ** | **336** |   | 844 |   | 8 |   | 852 |   |
| Amortization of transition  asset   | ** ** | **—**                                     | ** ** | **24**                                         | ** ** | **24** |   | — |   | 25 |   | 25 |   |
| Net periodic benefit cost           | ** ** | **$**                                          | **778**    | ** **                                     | **$**      | **301** | ** ** | **$** | **1,079** |   | $ | 1,718 |   | $ | 232 |   | $ | 1,950 |   |

 

The following table summarizesthe components of the net periodic benefit cost for the other postretirementbenefit plans for the nine months and the three months ended September 30, 2004and 2003, respectively.

 
| ** **                          | ** ** | **For the 9 Months Ended  September 30,** | ** ** | **For the 3 Months Ended  September 30,** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| **(Dollars  in thousands)**         | ** ** | **2004**                                  | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Service cost                        | ** ** | **$**                                     | **195**    |                                      | $          | 147 | ** ** | **$** | **65** |   | $ | 59 |   |
| Interest cost                       | ** ** | **642**                                   |       | 615                                       | ** ** | **214** |   | 248 |   |
| Expected return on plan assets      | ** ** | **—**                                |       | —                                    | ** ** | **—** |   | — |   |
| Amortization of prior service  cost | ** ** | **—**                                |       | —                                    | ** ** | **—** |   | — |   |
| Recognized net actuarial loss       | ** ** | **125**                                   |       | 106                                       | ** ** | **44** |   | 42 |   |
| Amortization of transition  asset   | ** ** | **—**                                |       | —                                    | ** ** | **—** |   | — |   |
| Net periodic benefit cost           | ** ** | **$**                                     | **962**    |                                      | $          | 868 | ** ** | **$** | **323** |   | $ | 349 |   |
|                                     |            |                                           |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

As previously disclosed in its financial statements for the year endedDecember 31, 2003, Bankshares generally makes cash contributions to the pensionplan in amounts up to that permitted by guidelines established under employeebenefit and tax laws after taking into consideration the funded status. Cashcontributions are normally made after valuations have been finalized for theplan year and prior to the tax return filing date.  As of September 30, 2004, no contributionshad been made.

 

14

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14. Recent AccountingStandards

 

In December 2003, theAmerican Institute of Certified Public Accountants issued Statement of Position(“SOP”) 03-3, “Accounting for Certain Loans or Debt Securities Acquired in aTransfer,” which addresses the accounting for differences between contractualcash flows and expected cash flows for loans acquired in a transfer when thosedifferences are attributable at least in part to credit quality.  It includes such loans acquired in purchasebusiness combinations where there is evidence of deterioration in creditquality since origination. This SOP requires the difference between expectedcash flows and the purchase price to be accreted as an adjustment to yield overthe life of the acquired loans; the difference between contractual cash flowsand expected cash flows is not subject to accretion. This SOP would represent achange from current practice where the allowance for loan losses is carriedover in purchase accounting. The SOP is effective for loans acquired beginningafter December 15, 2004. Bankshares is currently evaluating the impact it willhave on operations and financial statements.

 

In November 2003, theEmerging Issues Task Force (“EITF”) Issue 03-1, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments.”The Task Force discussed the meaning of other-than-temporary impairment and itsapplication to certain investments carried at cost. The Task Force requestedthat the FASB staff consider other impairment models within U.S. GAAP whendeveloping 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 CertainInvestments in Debt and Equity Securities,* and that that issue beaddressed by the Task Force as a separate EITF issue. At the EITF meeting, theTask Force reached a consensus on one issue that certain quantitative andqualitative disclosures should be required for securities accounted for under Statement115*,* that are impaired at the balance sheetdate but for which an other-than-temporary impairment has not been recognized.The Board ratified the consensus on that one issue at its November 25, 2003meeting. In September 2004, the FinancialAccounting Standards Board (“FASB”) directed the FASB staff to issue twoproposed FASB Staff Positions (“FSP”): Proposed FSP EITF Issue 03-1-a, whichprovides guidance for the application of paragraph 16 of EITF Issue 03-1 todebt securities that are impaired because of interest rate and/or sector spreadincreases, and Proposed FSP EITF Issue 03-1-b, which delays the effective dateof Issue 03-1 for debt securities that are impaired because of interest rateand/or sector spread increases. The outcome of the proposed guidance undercertain interpretations could have an adverse impact on Bankshares’ capital andearnings as it relates to securities deemed impaired within theavailable-for-sale investment portfolio. Bankshares can not determine thepotential impact until the FASB finalizes the proposed statement.

 

In May 2004, the FASBissued FSP FAS 106-2, “Accounting and Disclosure Requirements Related to theMedicare Prescription Drug, Improvement and Modernization Act of 2003,” whichrequires (a) that the effects of the federal subsidy be considered an actuarialgain and treated like similar gains and losses, and (b) certain disclosures foremployers that sponsor postretirement heath care plans that provideprescription drug benefits. The FASB’s related existing guidance, FSP FAS106-1, “Accounting and Disclosure Requirements Related to the MedicarePrescription Drug, Improvement and Modernization Act of 2003,” is supersededupon the effective date of FSP FAS 106-2. The effective date of the new FSP isthe first interim or annual period beginning after June 15, 2004. Bankshares iscurrently reviewing the potential effect of the benefit that is at leastactuarially equivalent to Medicare part D.

 

15. Subsequent Events /Contingencies

 

1)            MercantileBankshares Corporation (the “Company”) has entered into a Membership InterestsPurchase Agreement (the “Agreement”) with Harbor Group International, L.L.C.(the “Purchaser”), effective as of October 20, 2004. Pursuant to the terms ofthe Agreement, the Company is to convey to the Purchaser all of the membershipinterests in its wholly owned affiliate, MBC Realty, LLC (“Realty”) on the dateof closing, which is anticipated to be on or about December 13, 2004, for atotal consideration of Fifty-One Million Two Hundred Fifty Thousand Dollars($51,250,000.00).

 

Realty is theowner of the real property known as the Mercantile Bank and Trust Building,Baltimore, Maryland, which is the headquarters for the Company and itsaffiliate, Mercantile-Safe Deposit and Trust Company (“MSDTC”).

 

The Purchaser hasa thirty (30) day due diligence period to perform certain inspections andanalysis, and has the right to terminate the Agreement during such period.

 

In connection withthis anticipated transaction MSDTC, the company’s affiliate, has agreed toenter into a lease for approximately all of the space it currently occupies inthe Building effective upon the date of closing, as well as certain other spacecurrently occupied by existing tenants. The lease will be for an initial termof ten (10) years, with two (2) renewal terms of five (5) years each, at aninitial annual rental of Twenty Dollars ($20.00) per square foot for the officespace, escalating by 3.0% per year.

 

2)            OnJuly 12, 2004, former employee John Pileggi filed suit against MercantileBankshares Corporation, Mercantile-Safe Deposit and Trust Company and Edward J.Kelly, III. For additional detail, see Part II Other Information Item 1 “LegalProceedings” below.

 

3).           At September 30,2004, Bankshares had two loans in the “monitored” category which were made in1998 and 1999 and were secured by commercial aircraft.  On November 6, 2004, Bankshares accepted a$6.0 million payment which terminated its interest in one of the loans. See“Nonperforming Assets” discussion beginning on page 26.  The loan had an outstanding principal balanceof $14.1 million at that date.  The $8.1million difference has been charged against the allowance for loan losses inthe fourth quarter of 2004.  Thepossibility that an offer could be forthcoming and the resulting potential losswere reflected in the allowance for loan losses at September 30, 2004.  Accordingly, there will be no significantimpact on Bankshares’ net income in the fourth quarter of 2004.  

 

Had this transaction been recorded at September 30, 2004, Bankshares’Allowance for Loan Losses would have been $153.3 million or 1.53% of totalloans outstanding.  Coverage ofnonperforming loans would have been 394.17%. Nonperforming loans to total loans outstanding would have remainedunchanged at .39%.

 

Although both loans continued to be performing in accordance with theirterms, management’s decision to accept this payment was attributable to anumber of factors including the non-core nature of the loan, the residual riskand the risk of declining collateral value, and continuing concerns about thecommercial airline industry.  The otherloan to the same borrower represents a $2.6 million exposure and remains in themonitored category.  This loan matures inFebruary 2009, will be fully paid at maturity, and carries a significantguarantee.   

 

15

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# **Item2.   Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

#### **MERCANTILEBANKSHARES CORPORATION**

#### ** **

HIGHLIGHTS

 

**Consolidated Financial Results**

 

In March, April andAugust of 2003, Bankshares acquired in separate transactions, Boyd WattersonAsset Management, LLC (“BW”), Peremel & Company (“Peremel”), and F&MBancorp (“F&M”), respectively, which are collectively referred to herein as“the Acquisitions”.  The Acquisitionswere accounted for under the purchase method of accounting and have beenincluded in Bankshares’ financial results since their respective closings. OnOctober 24, 2003, certain assets and liabilities of F&M were transferred toother Bankshares’ affiliates in order to align customers’ accounts with theBankshares’ affiliate serving the geographic area where those customers reside.(See Footnote No. 2 “Business Combinations” to the Consolidated FinancialStatements included in this report.)

 

Net income for thequarter ended September 30, 2004 was $56.8 million, a 20% increase from netincome of $47.2 million for the same period in 2003 and a slight increase overthe $56.3 million reported for the second quarter of 2004.  For the quarter ended September 30, 2004,diluted net income per share was $.71, an increase of 13% from the $.63reported for the same period of last year and unchanged from the $.71 reportedfor the second quarter of this year. Adjusted weighted average shares outstanding increased from 74.8 millionfor the quarter ended September 30, 2003, to 79.6 million for the quarter endedSeptember 30, 2004.  The results ofoperations for the Acquisitions are included from their respective merger datesforward.

 

Factors positivelyaffecting earnings for the third quarter included an improved net interestmargin, growth in average loans and noninterest-bearing deposits and stablecredit quality as measured by total nonperforming assets. Noninterest expensesincreased by $8.0 million or 9% over the prior year. This increase wassignificantly impacted by F&M being included in the entire third quarter of2004 compared to only one-half of the third quarter of 2003. Noninterestexpenses also increased as a result of a $2.7 million charge related to theconsolidation of eleven banks into four; management expects to begin realizingsome cost savings from this in the fourth quarter of 2004 and expects salariesand benefits savings in 2005 to exceed $3 million.  Additionally, other noninterest expenseincreased due to $.9 million of costs incurred in connection with theinvestigation of a potential acquisition, legal costs of $.9 million related toinvestigatory and litigation matters that, in management’s view, are not normalrecurring expenses and Sarbanes-Oxley compliance costs of $.7 million relatedprincipally to Section 404. Noninterest expenses for the third quarter of 2003included F&M merger related costs of $2.4 million and a $3.6 millionseverance charge for the Investment and Wealth Management Division.

 

Bankshares also reportscash operating earnings, defined as “GAAP” (Generally Accepted AccountingPrinciples) earnings excluding the amortization of intangible assets associatedwith purchase accounting for business combinations; securities gains andlosses; and other significant gains, losses or expenses (such as thoseassociated with integrating acquired entities’ operations into Bankshares)unrelated to Bankshares’ core operations. Cash operating earnings totaled $59.2 million for the third quarter of2004, an increase of 19% over the $49.9 million for the same period for 2003and a 3% increase over the $57.3 million for the second quarter of 2004.  Diluted cash operating earnings per share forthe third quarter of 2004 and 2003 were $.74, and $.67, respectively, and $.72per share for the second quarter of 2004. A reconciliation of net income (GAAP basis) to cash operating earningscan be found on page 36 of this filing.

 

Management believes thatreporting several key measures based on cash operating earnings and tangibleequity (equity less intangible assets and their related amortization expense)is important, as this is the basis for measuring the adequacy of capital forregulatory purposes.  For the threemonths ended September 30, 2004, return on average assets was 1.60%, return onaverage tangible equity was 17.63% and average tangible equity to averagetangible assets was 9.67%.  Comparableratios for the three months ended September 30, 2003 were 1.48%, 15.70% and9.91%, respectively.  A reconciliation ofthese ratios from their respective GAAP basis ratios can be found on page 36 ofthis filing.

 

For the first nine monthsof 2004, net income was $168.8 million, an increase of 16% over the $146.2million reported for the comparable period in 2003. Diluted net income pershare was $2.11, an increase of 3% from the $2.05 reported for the same periodof last year. For the nine months ended September 30, 2004, compared to thesame period of 2003, cash operating earnings were $173.3 million and $145.7million, respectively.  Diluted cashoperating earnings per share for these periods were $2.17 and $2.05,respectively.  The ratios of return onaverage assets, return on average tangible equity and average tangible equityto average tangible assets for the year-to-date 2004 were 1.62%, 17.94% and9.65%, respectively.  These ratios forthe year-to-date 2003 were 1.71%, 16.57% and 10.66%, respectively.

 

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SEGMENT REPORTING

 

As noted in Footnote No.10 “Segment Reporting”, Bankshares has historically reported three distinctbusiness segments for which financial information is segregated for use inassessing performance and allocating resources when reporting to the Board ofDirectors. Segment financial information is subjective and, unlike financialaccounting, is not necessarily based on GAAP. As a result, the financialinformation of the reporting segments is not necessarily comparable withsimilar information reported by others and may not be comparable withBankshares’ consolidated results.

 

**Banking**

 

On a combined basis,Community Banking and MSD&T continue to be the primary contributors toBankshares’ earnings. Historically, Bankshares has distinguished between twooperating units, Community and MSD&T, with the former focused on smallbusiness and retail banking and the latter on commercial and specialty lending.With the F&M acquisition and the consolidation of affiliate banks duringthe quarter, this distinction is becoming less apparent. Increased houselending authority at the Community Banks has resulted in additional loan growthwithin their footprint and less referral and overline business to MSD&T.

 

In July 2004, CommunityBanking consolidated 11 affiliate banks into 4 banks. These banks share commonmarkets and the consolidation of these markets allows the surviving banks tolocally serve their customers with greater size, scale and expertise. Thisinitiative was not undertaken to reduce operating costs, although some savingswill arise out of the consolidation. It was to enable these banks to streamlineoperating processes, controls and compliance efforts, recruit seasonedprofessionals to these markets, and provide a greater breadth of services atthe local level. Bankshares is highly committed to the community bank model,whereby local boards of directors provide strong oversight and bank presidentsmaintain strong relationships within the community. As with any strategicinitiative there are costs involved. Year-to-date, Community Banking hasincurred approximately $3.1 million in restructuring charges related to theconsolidations. The majority of these costs were in severance charges and otherpersonnel costs of approximately $2.2 million, and $0.7 million in legal andconsulting fees. Additional restructuring charges in the fourth quarter of 2004are estimated to be approximately $1.0 million and should be partially offsetby lower operating costs at the surviving banks.

 

*Community Banking*

 

Net income for the ninemonths ended September 30, 2004, was $120.2 million. This represented a $21.1million, or 21% increase over the same period last year. Community Banking wasthe primary beneficiary of the F&M acquisition. For the first nine monthsof 2004 compared to the same period last year, taxable-equivalent net interestincome increased by $52.7 million, or 22%, to $296.0 million. Growth in averageearning assets of $2.1 billion, largely attributable to the F&Macquisition, more than offset the effect of a 34 basis points reduction in thenet interest margin. Average loans in Community Banking grew 36% and averagecore deposits grew 29% from the prior year. The decline in the net interestmargin resulted from lower yields on loans and investments as maturities andprepayments were reinvested at lower rates than the portfolio average.  Contributing to the net interest margincompression was the capital restructuring of the Community Banks during thethird quarter of last year. $300 million of subordinated debt issued byBankshares in April 2003, used in part to fund the cash portion of the F&Macquisition, was invested in a like amount of subordinated debt issued by theCommunity Banks. Excess equity capital was paid to Bankshares in the form of aspecial cash dividend. The $7.4 million increase in interest expense incurredduring the first nine months of 2004, related to this subordinated debt andreduced the Community Banks’ net interest margin by 14 basis points. TheCommunity Banks had a reduction in the provision for loan losses compared tothe same period of 2003 as credit quality continued to improve.

 

The year-over-yearincreases in noninterest income and noninterest expenses for the first ninemonths of 2004 compared to the same period of 2003, are attributable to theF&M acquisition and branch expansion programs at several Community Banks.Noninterest income increased year-over-year by $14.4 million, with depositservice charges increasing $5.0 million, insurance fees increasing $8.3million, and electronic banking fees increasing $3.4 million, accounting forthe largest gains. These gains were partially offset by a decrease of $5.3million in net gains on investment securities. Noninterest expenses increasedby $40.8 million in the first nine months of 2004 compared to the same periodof 2003. Over 29% of this increase is related to salaries and benefits, whichgrew by $20.8 million. Severance costs related to the affiliate bankconsolidations was approximately $2.2 million. Occupancy expense increased by $4.0 million, furniture and equipmentexpenses increased by $1.8 million and amortization of intangible assetsincreased $2.8 million.

 

*MSD&T Banking*

 

The net incomecontribution from MSD&T Banking decreased slightly for the nine monthsended September 30, 2004 to $49.7 million compared to the same period lastyear. The primary reason for the decrease was a $2.0 million increase in theloan loss provision, offset somewhat by higher net interest and noninterestincome.

 

Taxable-equivalent netinterest income for the first nine months of 2004 increased $3.1 million or 3%to $111.6 million when compared to the nine months ended September 30, 2003.This increase was attributable to $136.3 million in average loan growth and animprovement in the

 

17

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net interest margin of 11basis points. Lower yields on securities and loans were more than offset byreduced rates paid on deposit products. The provision for loan losses was $7.3million in the first nine months of 2004 compared to $5.3 million in the sameperiod of 2003. Nonperforming loans declined during the current quarter due tocollections and the return of several loans to performing status. Foradditional information, see discussion of nonperforming assets under “NonperformingAssets” on page 26.

 

The increase innoninterest income was spread across numerous categories. Noninterest incomeincreased $1.6 million in the first nine months of 2004 compared to the firstnine months of 2003. The year-over-year increase was mitigated by a decrease ingains on investment securities of $1.3 million. Noninterest expense increasedby $9.4 million from the first nine months of 2003 to $78.5 million. Thisrepresents a 14% increase over the prior year. Personnel costs increased by$6.9 million primarily due to additional branches, incentive compensationaccruals and increased staffing in corporate support functions accounted formost of the increase. MSD&T costs for shared services are charged toInvestment and Wealth Management (“IWM”) and Community Banking and arereflected in the noninterest expense line. Certain other costs not directlycharged are allocated to IWM, Community Banking and Other as reflected in the “adjustments”line.

 

**Investment & WealthManagement**

 

Net income increased $5.2million to $8.2 million for the nine months ended September 30, 2004 ascompared to the $3.1 million reported in the same period last year

 

Revenues for the firstnine months of 2004 increased $9.9 million, or 17%, over the same period last year,primarily due to stronger equity markets, new sales and the Boyd Watterson (“BW”)and Peremel acquisitions. The income categories with significant year-over-yearincreases were asset management and mutual funds of $3.9 million, personaltrust fees of $2.9 million, endowment fees of $1.0 million and hedge fund feesof $0.9 million. Total assets under administration increased to $46.5 billionat September 30, 2004 from $42.7 billion at September 30, 2003. At September30, 2004 and September 30, 2003 assets under management were $21.4 billion and$19.6 billion, respectively.

 

Noninterest expensesincreased by $0.7 million or 1% to $50.7 million for the first nine months of2004 from $50.0 million for the same period last year. The increase innoninterest expense is mostly due to the acquisition of BW, Peremel and theassumption of F&M’s brokerage operations which was partially offset by a$3.6 million severance charge in the third quarter of 2003. During the firstquarter of 2004, Bankshares entered into a 7-year service contract with SunGardWealth Management Services to provide a new core accounting system andback-office operations. Post conversion, which is expected late in 2004,Bankshares expects to achieve net savings in excess of $1.0 million in 2005.Management expects to incur conversion costs of approximately $2.0million.  $1.8 million of the conversioncosts will be amortized over the life of the contract.  Bankshares also expects to incur restructuringcosts of approximately $1.2 million in the fourth quarter of 2004.

 

**Other**

 

The components in the “Other”column consist of amounts for the nonbanking affiliates, unallocated corporateexpenses and intercompany eliminations.

 

The “adjustments” line,which represents corporate allocations from the lead Bank (MSD&T),increased $7.8 million for the nine months ended September 30, 2004 over thesame period in 2003. This increase is mostly due to allocations related toSarbanes-Oxley compliance and increased staffing in corporate supportfunctions.

 

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EARNINGS PERFORMANCE

 

**Analysis of Interest Rates andInterest Differentials**

The following tablepresents the distribution of the average consolidated balance sheet, interestincome/expense and annualized yields earned and rates paid through the ninemonths ended September 30, 2004 and 2003.

 
| ** **                                         | ** ** | **For the 9 Months Ended   September 30, 2004** | ** **     | **For the 9 Months Ended   September 30, 2003** | ** **  |
|----------------------------------------------------|------------|-------------------------------------------------|----------------|-------------------------------------------------|-------------|
| **(Dollars  in thousands)**                        | ** ** | **Average  Balance**                            | ** **     | **Income*/  Expense**                           | ** **  | **Yield*/  Rate** | ** ** | **Average  Balance** | ** ** | **Income*/  Expense** | ** ** | **Yield*/  Rate** | ** ** |
| Earning assets                                     |       |                                            |           |                                            |        |   | ** ** |   |   |   |   |   |   |
| Loans:**                                           |       |                                            |           |                                            |        |   | ** ** |   |   |   |   |   |   |
| Commercial                                         |       | **$**                                           | **2,704,142**  | ** **                                      | **$**       | **105,193** | ** ** | **5.20** | **%** | $ | 2,437,548 |   | $ | 100,610 |   | 5.52 | % |
| Commercial real estate                             |       | **2,867,631**                                   | ** **     | **126,409**                                     | ** **  | **5.89** | ** ** | 2,190,016 |   | 101,890 |   | 6.22 |   |
| Construction                                       |       | **1,120,125**                                   | ** **     | **44,398**                                      | ** **  | **5.29** | ** ** | 888,451 |   | 36,388 |   | 5.48 |   |
| Residential real estate                            |       | **1,429,248**                                   | ** **     | **63,341**                                      | ** **  | **5.92** | ** ** | 1,124,637 |   | 55,426 |   | 6.59 |   |
| Consumer                                           |       | **1,475,729**                                   | ** **     | **63,316**                                      | ** **  | **5.73** | ** ** | 1,097,736 |   | 52,452 |   | 6.39 |   |
| Total loans                                        |       | **9,596,875**                                   | ** **     | **402,657**                                     | ** **  | **5.60** | ** ** | 7,738,388 |   | 346,766 |   | 5.99 |   |
| Federal funds sold, et al                          |       | **64,391**                                      | ** **     | **1,282**                                       | ** **  | **2.66** | ** ** | 262,648 |   | 3,279 |   | 1.67 |   |
| Securities:***                                     |       | ** **                                      | ** **     | ** **                                      | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Taxable securities                                 |       | ** **                                      | ** **     | ** **                                      | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| U.S. Treasury and government  agencies             |       | **1,557,396**                                   | ** **     | **43,653**                                      | ** **  | **3.74** | ** ** | 1,765,230 |   | 57,150 |   | 4.33 |   |
| Mortgage-backed                                    |       | **1,253,440**                                   | ** **     | **35,961**                                      | ** **  | **3.83** | ** ** | 809,744 |   | 23,957 |   | 3.96 |   |
| Other investments                                  |       | **158,361**                                     | ** **     | **4,584**                                       | ** **  | **3.87** | ** ** | 105,663 |   | 5,091 |   | 6.44 |   |
| Tax-exempt securities                              |       | ** **                                      | ** **     | ** **                                      | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| States and political  subdivisions                 |       | **97,662**                                      | ** **     | **4,135**                                       | ** **  | **5.66** | ** ** | 53,886 |   | 2,890 |   | 7.17 |   |
| Total securities                                   |       | **3,066,859**                                   | ** **     | **88,333**                                      | ** **  | **3.85** | ** ** | 2,734,523 |   | 89,088 |   | 4.36 |   |
| Interest-bearing deposits in  other banks          |       | **158**                                         | ** **     | **1**                                           | ** **  | **1.08** | ** ** | 7,433 |   | 52 |   | 0.94 |   |
| Total earning assets                               |       | **12,728,283**                                  | ** **     | **492,273**                                     | ** **  | **5.17** | ** ** | 10,742,992 |   | 439,185 |   | 5.47 |   |
| Cash and due from banks                            |       | **293,399**                                     | ** **     | ** **                                      | ** **  | ** ** | ** ** | 255,251 |   |   |   |   |   |
| Bank premises and equipment,  net                  |       | **141,641**                                     | ** **     | ** **                                      | ** **  | ** ** | ** ** | 111,010 |   |   |   |   |   |
| Other assets                                       |       | **880,524**                                     | ** **     | ** **                                      | ** **  | ** ** | ** ** | 436,326 |   |   |   |   |   |
| Less: allowance for loan losses                    |       | **(158,289**                                    | **)**          | ** **                                      | ** **  | ** ** | ** ** | (144,548 | ) |   |   |   |   |
| Total assets                                       |       | **$**                                           | **13,885,558** |                                            |        | ** ** | ** ** | ** ** | $ | 11,401,031 | ** ** | ** ** | ** ** |   |   |
| Interest-bearing liabilities                       | ** ** | ** **                                      | ** **     | ** **                                      |        |   | ** ** |   |   |   |   |   |   |
| Deposits:                                          |       | ** **                                      | ** **     | ** **                                      | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Savings                                            |       | **$**                                           | **1,418,775**  | ** **                                      | **3,107**   | ** ** | **0.29** | ** ** | $ | 1,109,563 |   | 3,679 |   | 0.44 |   |
| Checking plus interest                             |       | **1,276,945**                                   | ** **     | **1,407**                                       | ** **  | **0.15** | ** ** | 1,022,778 |   | 1,556 |   | 0.20 |   |
| Money market                                       |       | **1,570,271**                                   | ** **     | **6,625**                                       | ** **  | **0.56** | ** ** | 1,273,361 |   | 7,262 |   | 0.76 |   |
| Time deposits $100,000 and over                    |       | **1,300,907**                                   | ** **     | **18,534**                                      | ** **  | **1.90** | ** ** | 1,257,288 |   | 22,549 |   | 2.40 |   |
| Other time deposits                                |       | **1,950,974**                                   | ** **     | **31,109**                                      | ** **  | **2.13** | ** ** | 1,789,902 |   | 35,846 |   | 2.68 |   |
| Total interest-bearing deposits                    |       | **7,517,872**                                   | ** **     | **60,782**                                      | ** **  | **1.08** | ** ** | 6,452,892 |   | 70,892 |   | 1.47 |   |
| Short-term borrowings                              |       | **924,411**                                     | ** **     | **4,889**                                       | ** **  | **0.71** | ** ** | 832,631 |   | 4,317 |   | 0.69 |   |
| Long-term debt                                     |       | **646,281**                                     | ** **     | **16,035**                                      | ** **  | **3.31** | ** ** | 472,859 |   | 13,016 |   | 3.68 |   |
| Total interest-bearing funds                       |       | **9,088,564**                                   | ** **     | **81,706**                                      | ** **  | **1.20** | ** ** | 7,758,382 |   | 88,225 |   | 1.52 |   |
| Noninterest-bearing deposits                       |       | **2,807,004**                                   | ** **     | ** **                                      | ** **  | ** ** | ** ** | 2,142,529 |   |   |   |   |   |
| Other liabilities and accrued  expenses            |       | **131,413**                                     | ** **     | ** **                                      | ** **  | ** ** | ** ** | 108,999 |   |   |   |   |   |
| Total liabilities                                  |       | **12,026,981**                                  |           |                                            | ** **  | ** ** | ** ** | 10,009,910 | ** ** | ** ** | ** ** |   |   |
| Shareholders’ equity                          |       | **1,858,577**                                   | ** **     | ** **                                      | ** **  | ** ** | ** ** | 1,391,121 |   |   |   |   |   |
| Total liabilities &  shareholders’ equity |       | **$**                                           | **13,885,558** |                                            |        | ** ** | ** ** | ** ** | $ | 11,401,031 | ** ** | ** ** | ** ** |   |   |
| Net interest rate spread                           |       | ** **                                      | ** **     | **$**                                           | **410,567** | ** ** | **3.97** | **%** |   |   | $ | 350,960 |   | 3.95 | % |
| Effect of noninterest-bearing  funds               |       |                                            | ** **     | ** **                                      | ** **  | **0.34** | ** ** |   |   |   |   | 0.42 |   |
| Net interest margin on earning  assets             |       |                                            | ** **     | ** **                                      |        | **4.31** | **%** |   |   |   |   | 4.37 | % |
| Taxable-equivalent adjustment  included in:        |       | ** **                                      | ** **     | ** **                                      |        |   | ** ** |   |   |   |   |   |   |
| Loan income                                        |       | ** **                                      | ** **     | **$**                                           | **3,434**   | ** ** | ** ** | ** ** |   |   | $ | 3,675 |   |   |   |
| Investment securities income                       |       | ** **                                      | ** **     | **1,650**                                       | ** **  | ** ** | ** ** |   |   | 1,204 |   |   |   |
| Total                                              |       |                                            |           | **$**                                           | **5,084**   |   |   | ** ** | ** ** |   | $ | 4,879 | ** ** |   |   |

 

----

* Presented on atax-equivalent basis using the statutory federal corporate income tax rate of35% (see non-GAAP reconciliation on page 36)

** Nonaccrual loans areincluded in average loans

*** Balances reported atamortized cost; excludes unrealized gains (losses) on securitiesavailable-for-sale

 

19

----

 

**Analysis of Interest Rates andInterest Differentials**

The following tablepresents the distribution of the average consolidated balance sheet, interestincome/expense and annualized yields earned and rates paid for the thirdquarter of 2004 and 2003.

 
| ** **                                         | ** ** | **For the 3 Months Ended   September 30, 2004** | ** **     | **For the 3 Months Ended   September 30, 2003** | ** **  |
|----------------------------------------------------|------------|-------------------------------------------------|----------------|-------------------------------------------------|-------------|
| **(Dollars  in thousands)**                        | ** ** | **Average  Balance**                            | ** **     | **Income*/  Expense**                           | ** **  | **Yield*/  Rate** | ** ** | **Average  Balance** | ** ** | **Income*/  Expense** | ** ** | **Yield*/  Rate** | ** ** |
| Earning assets                                     |       |                                            |           |                                            |        |   | ** ** |   |   |   |   |   |   |
| Loans:**                                           |       |                                            |           |                                            |        |   | ** ** |   |   |   |   |   |   |
| Commercial                                         | ** ** | **$**                                           | **2,752,242**  | ** **                                      | **$**       | **36,794** | ** ** | **5.32** | **%** | $ | 2,508,721 |   | $ | 33,387 |   | 5.28 | % |
| Commercial real estate                             | ** ** | **2,961,468**                                   | ** **     | **44,105**                                      | ** **  | **5.92** | ** ** | 2,391,892 |   | 36,273 |   | 6.02 |   |
| Construction                                       | ** ** | **1,142,921**                                   | ** **     | **15,775**                                      | ** **  | **5.49** | ** ** | 969,251 |   | 13,047 |   | 5.34 |   |
| Residential real estate                            | ** ** | **1,490,763**                                   | ** **     | **21,733**                                      | ** **  | **5.80** | ** ** | 1,205,020 |   | 19,087 |   | 6.28 |   |
| Consumer                                           | ** ** | **1,478,399**                                   | ** **     | **20,795**                                      | ** **  | **5.60** | ** ** | 1,256,381 |   | 19,582 |   | 6.18 |   |
| Total loans                                        | ** ** | **9,825,793**                                   | ** **     | **139,202**                                     | ** **  | **5.64** | ** ** | 8,331,265 |   | 121,376 |   | 5.78 |   |
| Federal funds sold, et al                          | ** ** | **50,035**                                      | ** **     | **519**                                         | ** **  | **4.13** | ** ** | 413,675 |   | 1,245 |   | 1.19 |   |
| Securities:***                                     | ** ** | ** **                                      | ** **     | ** **                                      | ** **  | ** ** | ** ** | ** ** |   |   |   |   |   |
| Taxable securities                                 | ** ** | ** **                                      | ** **     | ** **                                      | ** **  | ** ** | ** ** | ** ** |   |   |   |   |   |
| U.S. Treasury and government  agencies             | ** ** | **1,571,102**                                   | ** **     | **14,190**                                      | ** **  | **3.59** | ** ** | 1,629,544 |   | 17,192 |   | 4.19 |   |
| Mortgage-backed                                    | ** ** | **1,228,539**                                   | ** **     | **11,858**                                      | ** **  | **3.84** | ** ** | 1,150,073 |   | 10,093 |   | 3.48 |   |
| Other investments                                  | ** ** | **169,264**                                     | ** **     | **1,043**                                       | ** **  | **2.45** | ** ** | 120,093 |   | 1,726 |   | 5.70 |   |
| Tax-exempt securities                              |       |                                            | ** **     | ** **                                      | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |   |   |   |
| States and political  subdivisions                 | ** ** | **90,721**                                      | ** **     | **1,328**                                       | ** **  | **5.82** | ** ** | 84,944 |   | 1,295 |   | 6.05 |   |
| Total securities                                   | ** ** | **3,059,626**                                   | ** **     | **28,419**                                      | ** **  | **3.70** | ** ** | 2,984,654 |   | 30,306 |   | 4.03 |   |
| Interest-bearing deposits in  other banks          | ** ** | **158**                                         | ** **     | **—**                                      | ** **  | **1.08** | ** ** | 21,372 |   | 46 |   | 0.85 |   |
| Total earning assets                               | ** ** | **12,935,612**                                  | ** **     | **168,140**                                     | ** **  | **5.17** | ** ** | 11,750,966 |   | 152,973 |   | 5.16 |   |
| Cash and due from banks                            | ** ** | **296,203**                                     | ** **     | ** **                                      | ** **  | ** ** | ** ** | 295,289 |   |   |   |   |   |
| Bank premises and equipment,  net                  | ** ** | **141,536**                                     | ** **     | ** **                                      | ** **  | ** ** | ** ** | 124,275 |   |   |   |   |   |
| Other assets                                       | ** ** | **886,468**                                     | ** **     | ** **                                      | ** **  | ** ** | ** ** | 602,614 |   |   |   |   |   |
| Less: allowance for loan losses                    | ** ** | **(160,331**                                    | **)**          | ** **                                      | ** **  | ** ** | ** ** | (151,044 | ) |   |   |   |   |
| Total assets                                       | ** ** | **$**                                           | **14,099,488** | ** **                                      | ** **  | ** ** | ** ** | ** ** | $ | 12,622,100 | ** ** |   | ** ** | ** ** | ** ** |
| Interest-bearing liabilities                       | ** ** | ** **                                      | ** **     | ** **                                      | ** **  | ** ** | ** ** | ** ** |   |   |   |   |   |
| Deposits:                                          |       |                                            | ** **     | ** **                                      | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |   |   |   |
| Savings                                            | ** ** | **$**                                           | **1,457,432**  | ** **                                      | **1,080**   | ** ** | **0.29** | ** ** | $ | 1,218,813 |   | 936 |   | 0.30 |   |
| Checking plus interest                             | ** ** | **1,291,808**                                   | ** **     | **472**                                         | ** **  | **0.15** | ** ** | 1,119,989 |   | 451 |   | 0.16 |   |
| Money market                                       | ** ** | **1,556,212**                                   | ** **     | **2,168**                                       | ** **  | **0.55** | ** ** | 1,431,262 |   | 2,203 |   | 0.61 |   |
| Time deposits $100,000 and over                    | ** ** | **1,299,918**                                   | ** **     | **6,214**                                       | ** **  | **1.90** | ** ** | 1,270,016 |   | 7,046 |   | 2.20 |   |
| Other time deposits                                | ** ** | **1,918,216**                                   | ** **     | **10,208**                                      | ** **  | **2.12** | ** ** | 1,942,113 |   | 11,677 |   | 2.39 |   |
| Total interest-bearing deposits                    | ** ** | **7,523,586**                                   | ** **     | **20,142**                                      | ** **  | **1.07** | ** ** | 6,982,193 |   | 22,313 |   | 1.27 | ** ** |
| Short-term borrowings                              | ** ** | **942,789**                                     | ** **     | **1,990**                                       | ** **  | **0.84** | ** ** | 944,979 |   | 1,303 |   | 0.55 |   |
| Long-term debt                                     | ** ** | **641,264**                                     | ** **     | **5,575**                                       | ** **  | **3.46** | ** ** | 611,801 |   | 5,368 |   | 3.48 |   |
| Total interest-bearing funds                       | ** ** | **9,107,639**                                   | ** **     | **27,707**                                      | ** **  | **1.21** | ** ** | 8,538,973 |   | 28,984 |   | 1.35 | ** ** |
| Noninterest-bearing deposits                       | ** ** | **2,984,130**                                   | ** **     | ** **                                      | ** **  | ** ** | ** ** | 2,406,521 |   |   |   |   |   |
| Other liabilities and accrued  expenses            | ** ** | **129,875**                                     | ** **     | ** **                                      | ** **  | ** ** | ** ** | 125,669 |   |   |   |   |   |
| Total liabilities                                  | ** ** | **12,221,644**                                  | ** **     | ** **                                      | ** **  | ** ** | ** ** | 11,071,163 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Shareholders’ equity                          | ** ** | **1,877,844**                                   | ** **     | ** **                                      | ** **  | ** ** | ** ** | 1,550,937 |   |   |   |   |   |
| Total liabilities &  shareholders’ equity | ** ** | **$**                                           | **14,099,488** | ** **                                      | ** **  | ** ** | ** ** | ** ** | $ | 12,622,100 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net interest rate spread                           | ** ** | ** **                                      | ** **     | **$**                                           | **140,433** | ** ** | **3.96** | **%** |   |   | $ | 123,989 |   | 3.81 | % |
| Effect of noninterest-bearing  funds               | ** ** | ** **                                      | ** **     | ** **                                      | ** **  | **0.36** | ** ** | ** ** |   |   |   | 0.38 |   |
| Net interest margin on earning  assets             | ** ** | ** **                                      | ** **     | ** **                                      | ** **  | **4.32** | **%** |   |   |   |   | 4.19 | % |
| Taxable-equivalent adjustment  included in:        | ** ** | ** **                                      | ** **     | ** **                                      | ** **  | ** ** | ** ** | ** ** |   |   |   |   |   |
| Loan income                                        | ** ** | ** **                                      | ** **     | **$**                                           | **1,155**   | ** ** | ** ** | ** ** |   |   | $ | 1,239 |   |   |   |
| Investment securities income                       | ** ** | ** **                                      | ** **     | **529**                                         |        |   | ** ** |   |   | 518 |   |   |   |
| Total                                              | ** ** | ** **                                      | ** **     | **$**                                           | **1,684**   |   |   | ** ** |   |   | $ | 1,757 |   |   |   |

 

----

* Presented on atax-equivalent basis using the statutory federal corporate income tax rate of35% (see non-GAAP reconciliation on page 36)

** Nonaccrual loans areincluded in average loans

*** Balances reported atamortized cost; excludes unrealized gains (losses) on securitiesavailable-for-sale

 

20

----

 

**Rate / Volume Analysis**

A rate/volume analysis,which demonstrates changes in interest income and expense for significantassets and liabilities, appears below:

 
| ** **                                 | ** ** | **For the 9 Months  Ended September 30,  2004 vs. 2003  Due to variances in** | ** ** | **For the 3 Months  Ended September 30,  2004 vs. 2003  Due to variances in** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| **(Dollars  in thousands)**                | ** ** | **Rates**                                                                     | ** ** | **Volumes (5)**                                                               | ** ** | **Total** | ** ** | **Rates** | ** ** | **Volumes (5)** | ** ** | **Total** | ** ** |
| Interest earned on:                        |       |                                                                          |       |                                                                          |       |   |   |   |   |   |   |   |   |
| Loans:                                     |       |                                                                          |       |                                                                          |       |   |   |   |   |   |   |   |   |
| Commercial (1)                             |       | $                                                                             | (6,421     | )                                                                             | $          | 11,004 |   | $ | 4,583 |   | $ | 166 |   | $ | 3,241 |   | $ | 3,407 |   |
| Commercial real estate (2)                 |       | (7,007                                                                        | )          | 31,526                                                                        |       | 24,519 |   | (806 | ) | 8,638 |   | 7,832 |   |
| Construction (3)                           |       | (1,479                                                                        | )          | 9,489                                                                         |       | 8,010 |   | 390 |   | 2,338 |   | 2,728 |   |
| Residential real estate                    |       | (7,097                                                                        | )          | 15,012                                                                        |       | 7,915 |   | (1,880 | ) | 4,526 |   | 2,646 |   |
| Consumer                                   |       | (7,197                                                                        | )          | 18,061                                                                        |       | 10,864 |   | (2,247 | ) | 3,460 |   | 1,213 |   |
| Total loans                                |       | (29,201                                                                       | )          | 85,092                                                                        |       | 55,891 |   | (4,377 | ) | 22,203 |   | 17,826 |   |
| Taxable securities (4)                     |       | (11,279                                                                       | )          | 9,279                                                                         |       | (2,000 | ) | (2,612 | ) | 692 |   | (1,920 | ) |
| Tax-exempt securities (4)                  |       | (1,103                                                                        | )          | 2,348                                                                         |       | 1,245 |   | (55 | ) | 88 |   | 33 |   |
| Federal funds sold, et al                  |       | 478                                                                           |       | (2,475                                                                        | )          | (1,997 | ) | 368 |   | (1,094 | ) | (726 | ) |
| Interest-bearing deposits in  other banks  |       | —                                                                        |       | (51                                                                           | )          | (51 | ) | — |   | (46 | ) | (46 | ) |
| Total interest income                      |       | (41,105                                                                       | )          | 94,193                                                                        |       | 53,088 |   | (6,676 | ) | 21,843 |   | 15,167 |   |
|                                       |       |                                                                          |       |                                                                          |       |   |   |   |   |   |   |   |   |
| Interest paid on:                          |       |                                                                          |       |                                                                          |       |   |   |   |   |   |   |   |   |
| Savings deposits                           |       | (1,597                                                                        | )          | 1,025                                                                         |       | (572 | ) | (39 | ) | 183 |   | 144 |   |
| Checking plus interest deposits            |       | (536                                                                          | )          | 387                                                                           |       | (149 | ) | (48 | ) | 69 |   | 21 |   |
| Money market accounts                      |       | (2,330                                                                        | )          | 1,693                                                                         |       | (637 | ) | (227 | ) | 192 |   | (35 | ) |
| Certificates of deposit  $100,000 and over |       | (4,797                                                                        | )          | 782                                                                           |       | (4,015 | ) | (998 | ) | 166 |   | (832 | ) |
| Other time deposits                        |       | (7,963                                                                        | )          | 3,226                                                                         |       | (4,737 | ) | (1,325 | ) | (144 | ) | (1,469 | ) |
| Short-term borrowings                      |       | 96                                                                            |       | 476                                                                           |       | 572 |   | 690 |   | (3 | ) | 687 |   |
| Long-term debt                             |       | (1,755                                                                        | )          | 4,774                                                                         |       | 3,019 |   | (52 | ) | 259 |   | 207 |   |
| Total interest expense                     |       | (18,882                                                                       | )          | 12,363                                                                        |       | (6,519 | ) | (1,999 | ) | 722 |   | (1,277 | ) |
| Net interest earned                        |       | $                                                                             | (22,223    | )                                                                             | $          | 81,830 |   | $ | 59,607 |   | $ | (4,677 | ) | $ | 21,121 |   | $ | 16,444 |   |

 

----

(1)          Interestyear-to-date tax-equivalent adjustment of $2.3 million and $2.4 million for2004 and 2003, respectively, and quarter-to-date tax-equivalent adjustment of$777 thousand and $791 thousand for 2004 and 2003, respectively, are includedin the commercial loan rate variances.

(2)          Interestyear-to-date tax-equivalent adjustment of $417 thousand and $321 thousand for2004 and 2003, respectively, and quarter-to-date tax-equivalent adjustment of$149 thousand and $136 thousand for 2004 and 2003, respectively, are includedin the commercial real estate loan rate variances.

(3)          Interestyear-to-date tax-equivalent adjustment of $0.7 million and $1.0 million for2004 and 2003, respectively, and quarter-to-date tax-equivalent adjustment of$229 thousand and $313 thousand for 2004 and 2003, respectively, are includedin the construction loan rate variances.

(4)          Interestyear-to-date tax-equivalent adjustment of $1.7 million and $1.2 million for2004 and 2003, respectively, and quarter-to-date tax-equivalent adjustment of$529 thousand and $518 thousand for 2004 and 2003, respectively, are includedin the investment securities rate variances.

(5)          Changesattributable to mix (rate and volume) are included in volume variance.

 

**Net Interest Income and NetInterest Margin**

 

Strong economic growth inthe first half of 2004 resulted in the Federal Reserve Bank (Fed) adjusting itsposition on the level of interest rates. Where the Fed was pursuing anaccommodative monetary policy in 2003, concern over the rising level ofinflation caused the Fed to begin tightening its monetary policy on June 30,2004. The Fed raised interest rates by 25 basis points in June, August andSeptember of 2004. The U.S. banking system generally benefits when rates arehigher than the 40-year historic lows seen in 2003. Bankshares’ ConsolidatedBalance Sheet had been positioned for a rate rise and the third quarter of 2004net interest income reflects some of the benefit of the Fed rate increases.

 

Individual components ofnet interest income and the net interest margin are presented in the rate/yieldtable on page 20.

 

Net interest income isthe interest earned on debt securities, loans (including yield-related loanfees) and other interest-earning assets minus the interest paid for depositsand long-term and short-term debt. The net interest margin is the average yieldon earning assets minus the average interest rate paid for deposits and othersources of funding, such as debt. Net interest income is affected by bothchanges in the amount and composition of interest-earning assets andinterest-bearing liabilities and by changes in the level of interest rates. Netinterest

 

21

----

 

income and the netinterest margin are presented on a taxable-equivalent basis to consistentlyreflect income from taxable and tax-exempt loans and securities based on a 35%marginal tax rate.

 

Net interest income on ataxable-equivalent basis increased to $140.4 million in third quarter of 2004from $124.0 million in third quarter 2003, an increase of 13%.  The increase was primarily due to strong loangrowth and lower core deposit costs.

 

The net interest marginincreased to 4.32% in the third quarter 2004 from 4.19% in the third quarter of2003.  The increase was primarilyattributable to higher outstanding loan balances and lower core deposit fundingcosts. These factors were partially offset by reduced investment portfolioyields from third quarter of 2003 as new investments were added below theportfolio average and the performance of Bankshares’ hedge funds was not asstrong as the prior year. Hedge fund performance during third quarter of 2004reduced the net interest margin by 3 basis points when compared to 2003. Thenet interest margin increased 8 basis points from second quarter of 2004 tothird quarter of 2004, primarily due to higher yields on loans resulting fromprime rate increases, continued loan growth and improved performance inBankshares’ hedge funds.

 

Average earning assetsincreased $1.2 billion in third quarter of 2004 from the same period in 2003due to an increase in average loans and securities outstanding, which includedassets acquired in the F&M acquisition in August of 2003. Loans averaged$9.8 billion in third quarter of 2004, compared with $8.3 billion in thirdquarter of 2003, an increase of 18%. Loans grew across every major lendingsector with the exception of lease financing. Investment securities averaged$3.1 billion in third quarter of 2004 and $3.0 billion in third quarter of2003. On a linked-quarter basis, average earning assets increased $160.4million or 1% over the previous quarter. Average loans outstanding grew by$201.9 million in third quarter of 2004 or 2% fueled by strong growth incommercial real estate loans. Mortgage and consumer financing activities slowedduring the quarter due to higher interest rates and market saturation. As aresult, growth in residential mortgage loans resulted from the purchase ofapproximately $101.4 million in residential mortgage loans from MercantileMortgage Corporation’s joint venture.

 

Average core deposits arean important contributor to growth in net interest income and the net interest margin.This low-cost funding source rose 13% from a year ago. Average core depositswere $9.2 billion and $8.1 billion and funded 65% and 64% of average totalassets in the third quarter of 2004 and 2003, respectively.  Average noninterest-bearing checking accountsincreased from $2.4 billion in third quarter of 2003 to $3.0 billion in thirdquarter of 2004. Total average interest-bearing deposits increased to $7.5billion in the third quarter of 2004 from $7.0 billion in the third quarter2003. On a linked-quarter basis, average core deposits increased $124.7 millionor 1% over the previous quarter. Total average interest-bearing depositsdeclined by $48.1 million or 1% primarily in certificates of deposit accounts.Average money market and checking plus interest accounts declined $18.6 millionas historically low interest rates reduced the attractiveness of these productsto consumers. Average noninterest-bearing checking accounts grew by $157.5million or 6% reflecting growth in both commercial and consumer accounts.

 

Based on current marketconditions, which includes a recent slowing of mortgage refinancing activityand an increase in the prime rate in September 2004, management expects the netinterest margin to continue to expand absent changes in current mix or growthtargets.

 

Taxable-equivalent netinterest income for the first nine months of 2004 increased to $410.6 millionor 17% over the $351.0 million for the first nine months of last yearprincipally due to F&M.  The growthin taxable-equivalent net interest income was attributable to 24% growth inaverage loans and 12% growth in average securities.

 

The net interest margindeclined from 4.37% to 4.31% for the nine months ended September 30, 2003 and2004, respectively. The decline in the net interest margin was attributable tothe reduced benefit derived from the investment of noninterest-bearingfunds.  This benefit fell from 42 basispoints in 2003 to 34 basis points in 2004. Lower yields on loans and securitieswere more than offset by corresponding reductions in the rates paid fordeposits and other funding.

 

Average earning assetsincreased $2.0 billion in first nine months of 2004 from the same period in2003 due to an increase in average loans and investments outstanding, whichincluded assets acquired in the F&M acquisition. Loans averaged $9.6billion in the first nine months of 2004, compared with $7.7 billion in theprevious year, an increase of 24%.

 

Average core depositswere $9.0 billion and $7.3 billion and funded 65% and 64% of average totalassets for year-to-date 2004 and 2003, respectively.  Average noninterest-bearing checking accountsincreased from $2.1 billion in the first nine months of 2003 to $2.8 billion inthe same period of 2004 primarily due to the F&M acquisition.

 

22

----

 

# **NoninterestIncome**

 
| ** **                                | ** ** | **For the 9 Months Ended  September 30,** | ** **  | **% Change** |       | **For the 3 Months Ended  September 30,** | ** ** | **% Change** | ** ** |
|-------------------------------------------|------------|-------------------------------------------|-------------|--------------|------------|-------------------------------------------|------------|--------------|------------|
| **(Dollars  in thousands)**               | ** ** | **2004**                                  | ** **  | **2003**     | ** ** | **2004/2003**                             | ** ** | **2004**     | ** ** | **2003** | ** ** | **2004/2003** | ** ** |
| Investment and wealth  management         | ** ** | **$**                                     | **67,315**  |         | $          | 57,450                                    |       | 17.2         | %          | **$** | **22,396** | ** ** | $ | 20,577 |   | 8.8 | % |
| Service charges on deposit  accounts      | ** ** | **31,107**                                |        | 26,072       |       | 19.3                                      |       | **10,637**   | ** ** | 9,701 |   | 9.6 |   |
| Mortgage banking related fees:            |       |                                      |        |         |       |                                      |       |         | ** ** |   |   |   |   |
| Commercial                                | ** ** | **5,878**                                 |        | 5,092        |       | 15.4                                      |       | **2,395**    | ** ** | 1,773 |   | 35.1 |   |
| Residential                               | ** ** | **2,418**                                 |        | 3,206        |       | (24.6                                     | )          | **668**      | ** ** | 1,630 |   | (59.0 | ) |
| Total mortgage banking related  fees      | ** ** | **8,296**                                 |        | 8,298        |       | —                                    |       | **3,063**    | ** ** | 3,403 |   | (10.0 | ) |
| Investment securities gains and  (losses) | ** ** | **534**                                   |        | 7,015        |       | (92.4                                     | )          | **(1**       | **)**      | (336 | ) | 99.7 |   |
| Other income:                             |       |                                      |        |         |       |                                      |       |         | ** ** |   |   |   |   |
| Electronic banking fees                   | ** ** | **16,310**                                |        | 12,731       |       | 28.1                                      |       | **5,959**    | ** ** | 5,133 |   | 16.1 |   |
| Charges and fees on loans                 | ** ** | **7,941**                                 |        | 6,948        |       | 14.3                                      |       | **2,647**    | ** ** | 2,430 |   | 8.9 |   |
| Insurance                                 | ** ** | **10,312**                                |        | 1,985        |       | 419.5                                     |       | **3,218**    | ** ** | 1,653 |   | 94.7 |   |
| Bank-owned life insurance                 | ** ** | **2,377**                                 |        | 1,427        |       | 66.6                                      |       | **798**      | ** ** | 559 |   | 42.8 |   |
| All other income                          | ** ** | **10,597**                                |        | 7,267        |       | 45.8                                      |       | **4,637**    | ** ** | 2,783 |   | 66.6 |   |
| Total other income                        | ** ** | **47,537**                                |        | 30,358       |       | 56.6                                      |       | **17,259**   | ** ** | 12,558 |   | 37.4 |   |
| Total                                     | ** ** | **$**                                     | **154,789** |         | $          | 129,193                                   |       | 19.8         | %          | **$** | **53,354** | ** ** | $ | 45,903 |   | 16.2 | % |

 

Noninterest income forthe quarter ended September 30, 2004 increased by $7.5 million, or 16%, to$53.4 million compared to $45.9 million for the same period in 2003.Noninterest income increased 3% from the second quarter of 2004. The tableabove shows the major components of noninterest income.  Investment and wealth management revenuerepresents the largest source of noninterest income and increased 9% over theprior year and decreased 2% over the second quarter of 2004. Factors having apositive year-over-year impact on IWM revenues were strong equity markets andincreased new sales across both mutual funds and separately managed accounts.

 

Service charges ondeposit accounts increased year-over-year due to the growth in deposit balancesand the F&M acquisition. For the third quarter of 2004 compared to thethird quarter of 2003, service charges increased by $0.9 million, or 10%.Service charges on deposits increased 3% compared to the second quarter of2004. This increase is largely attributable to an increase in non-sufficientfunds fee revenue.

 

Mortgagebanking-related fees decreased 10% in the third quarter of 2004 compared to thethird quarter of 2003 but increased 34% from the second quarter of 2004. Theprior year decrease is the result of a general slowdown in refinancingactivities, and the integration of F&M’s mortgage banking business intoMercantile Mortgage, LLC. The linked quarter increase is due to an increase incommercial banking origination fees. Bankshares’ mortgage banking revenue is comprised of loan activities ofMercantile Mortgage Corporation’s commercial mortgage subsidiary, ColumbiaNational Real Estate Finance LLC, and its residential mortgage joint venture,Mercantile Mortgage, LLC.

 

The increases in otherincome for the three months ended September 30, 2004 compared to the threemonths ended September 30, 2003 is significantly due to the F&Macquisition. These increases are included in several categories above.Electronic banking fees, which consist of merchant card processing fees, foreignATM fees and check card fees, increased $0.8 million or 16%. Charges and feeson loans consisting of letters of credit fees, late fees and other assessedloan fees increased slightly.  Insurancerevenues, which are principally derived from fee income related to the sale ofinsurance products by F&M’s insurance subsidiaries, increased $1.6 millionor 95%. All other income increased $1.9million or 67%, which consisted of revenues from various sources, such as safedeposit box rent, travelers’ checks, money orders and bill collection fees. Inaddition to the increased income from the F&M acquisition in the all otherincome category, is $0.7 million in gains from the sale of bank premises and$0.9 million increase in revenues derived from private equity investments.

 

Forthe nine months ended September 30, 2004, noninterest income increased by $25.6million or 20%, to $154.8 million compared to $129.2 million for the sameperiod in 2003.  This increase is largelydue to a $9.9 million or 17% increase in investment and wealth managementrevenues, related to increases in the equity markets and to new sales and $8.3million of additional insurance fee income as a result of the F&Macquisition.

 

23

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# **NoninterestExpenses**

 
| ** **                              | ** ** | **For the 9 Months Ended  September 30,** | ** **  | **% Change** |       | **For the 3 Months Ended  September 30,** | ** ** | **% Change** | ** ** |
|-----------------------------------------|------------|-------------------------------------------|-------------|--------------|------------|-------------------------------------------|------------|--------------|------------|
| **(Dollars  in thousands)**             | ** ** | **2004**                                  | ** **  | **2003**     | ** ** | **2004/2003**                             | ** ** | **2004**     | ** ** | **2003** | ** ** | **2004/2003** | ** ** |
| Salaries                                | ** ** | **$**                                     | **138,173** |         | $          | 114,602                                   |       | 20.6         | %          | **$** | **48,696** |   | $ | 43,870 |   | 11.0 | % |
| Employee benefits                       | ** ** | **33,998**                                |        | 28,891       |       | 17.7                                      |       | **10,557**   |       | 10,144 |   | 4.1 |   |
| Net occupancy expense of bank  premises | ** ** | **18,007**                                |        | 13,451       |       | 33.9                                      |       | **6,128**    |       | 5,136 |   | 19.3 |   |
| Furniture and equipment  expenses       | ** ** | **22,873**                                |        | 21,974       |       | 4.1                                       |       | **7,936**    |       | 8,432 |   | (5.9 | ) |
| Communications and supplies             | ** ** | **12,610**                                |        | 10,506       |       | 20.0                                      |       | **4,111**    |       | 3,889 |   | 5.7 |   |
| Other expenses:                         |       |                                      |        |         |       |                                      |       |         |       |   |   |   |   |
| Professional services                   | ** ** | **15,987**                                |        | 12,421       |       | 28.7                                      |       | **7,157**    |       | 5,380 |   | 33.0 |   |
| Advertising and promotional  expenses   | ** ** | **5,585**                                 |        | 5,879        |       | (5.0                                      | )          | **1,747**    |       | 2,168 |   | (19.4 | ) |
| Electronic banking expense              | ** ** | **7,415**                                 |        | 5,866        |       | 26.4                                      |       | **3,001**    |       | 2,432 |   | 23.4 |   |
| Amortization of intangible  assets      | ** ** | **6,132**                                 |        | 3,097        |       | 98.0                                      |       | **2,044**    |       | 1,688 |   | 21.1 |   |
| Outsourcing expense                     | ** ** | **4,037**                                 |        | 3,008        |       | 34.2                                      |       | **1,351**    |       | 1,049 |   | 28.8 |   |
| All other expenses                      | ** ** | **21,153**                                |        | 18,324       |       | 15.4                                      |       | **6,489**    |       | 7,001 |   | (7.3 | ) |
| Total other expenses                    | ** ** | **60,309**                                |        | 48,595       |       | 24.1                                      |       | **21,789**   |       | 19,718 |   | 10.5 |   |
| Total                                   | ** ** | **$**                                     | **285,970** |         | $          | 238,019                                   |       | 20.1         | %          | **$** | **99,217** |   | $ | 91,189 |   | 8.8 | % |

 

Noninterest expenses forthe three months ended September 30, 2004 increased by $8.0 million, or 9% to$99.2 million compared to $91.2 million for the three months ended September30, 2003.  The table above shows themajor components of noninterest expenses. The principal reason for the year-over-year increases were increasedexpenses associated with the consolidation of eleven bank affiliates into four(“the Affiliate Bank Rationalization”), increased professional service costsand costs related to new branches.

 

The efficiency ratio, akey measure of expense management, decreased in the third quarter of 2004compared to the same quarter of 2003. The efficiency ratio is computed bydividing noninterest expenses by the sum of net interest income on atax-equivalent basis and noninterest income. Bankshares’ efficiency ratio was51.20% for the three months ended September 30, 2004 compared to 53.67% for thethree months ended September 30, 2003. On a non-GAAP basis, the cash operatingefficiency ratio excludes amortization expense for intangibles and nonoperatingincome and expenses, such as securities gains and losses and other significantgains, losses or expenses (such as those associated with integrating acquiredentities’ operations into Bankshares) unrelated to Bankshares’ coreoperations.  Bankshares’ cash operatingefficiency ratio was 48.96% and 51.14% for the three months ended September 30,2004 and 2003, respectively. For the reconciliation of GAAP to non-GAAPmeasures, see page 36 in this filing.

 

Employee-relatedexpenses, which include salaries, benefits and incentive compensation, were thelargest component, at 60% of noninterest expenses. The principal reason for theyear-over-year and linked quarter increase were severance costs amounting to$2.2 million relating to the Affiliate Bank Rationalization and $1.3 million inhigher accruals for incentive and commission compensation related to sales andperformance management programs. Salaries and benefit expenses for the thirdquarter of 2004 compared to the second quarter of 2004 increased $3.6 millionor 6.5%.

 

Net occupancy expense, whichincludes premises depreciation, rents, maintenance and utilities, increased dueto the additional branch and corporate office locations related to the F&Macquisition and other strategic locations. On a linked-quarter basis net occupancy expense increased due to usualincreases in rental costs and improvements to branch facilities.

 

Furniture and equipmentexpenses include depreciation, rental and maintenance expense associated withthe upkeep and improvement of hardware and computer software. Furniture andequipment expenses decreased due to the timing of integrating F&M’soperating systems in the fourth quarter of 2003.

 

Communications andsupplies expenses increased due to supplies needed for additional branch officelocations, including brochures and operational supplies, as well as increasedcustomer information mailings and disclosures related to the Affiliate BankRationalization.

 

Other expenses consist ofprofessional services, marketing, electronic banking and several othercategories such as travel and membership, amortization, licensing, insuranceand sundry losses. For the three months ended September 30, 2004 compared tothe three months ended September 30, 2003, other expenses increased $2.1million or 11%. Other than the F&M acquisition, this category increasedprimarily due to a $1.8 million increase in professional fees. Decreases incertain professional fees partially offset costs incurred in connection withthe investigation of potential acquisitions of $0.9 million, legal costs relatedto investigatory and litigation matters that, in management’s view, are notnormal recurring expenses of $0.9 million, and Sarbanes-Oxley compliance costsof $0.7 million related to Section 404. Comparable professional

 

24

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fees expensed in thesecond quarter of 2004 related to the last two items were $0.3 million.Management remains focused on expense control and expects the level of legalexpenses to decline in the fourth quarter of 2004 as a substantial portion offuture legal fees related to the litigation matters are expected to bereimbursable by our insurance carrier. Management expects to begin realizingsome cost savings from the Affiliate Bank Rationalization in the fourth quarterof 2004 and expects salaries and benefits savings in 2005 to exceed $3 million.

 

Noninterest expense forthe nine months ended September 30, 2004 increased to $286.0 million or 20%over the $238.0 million for the nine months ended September 30, 2003. Theincrease in each category was largely due to the acquisition of F&M, BoydWatterson and Peremel. In addition, professional fees increased $3.6 million or29% year-over-year. This increase is due to costs incurred in connection with apotential acquisition of $0.9 million, legal cost related to investigatory andlitigation matters of $1.3 million, and Sarbanes-Oxley compliance costs of $1.1million.

 

ANALYSIS OF FINANCIALCONDITION

 

At September 30, 2004compared to December 31, 2003, total assets increased 4% or $607.5 million. AtSeptember 30, 2004 compared to September 30, 2003, total assets increased 3% or$426.9 million.

 

A comparative schedule ofaverage balances is included in the table on page 19 and page 20.

 

**Securities Available for Sale**

 

The securities availablefor sale portfolio includes both debt and marketable equity securities.Bankshares’ holds debt securities available for sale primarily for liquidity,interest rate risk management and yield enhancement purposes. Accordingly, thisportfolio primarily includes very liquid, high quality federal agency-backeddebt securities. At September 30, 2004, the portfolio totaled $3.0 billion ofdebt securities available for sale, compared with $3.1 billion at December 31,2003. There was a net unrealized gain on debt securities available for sale of$9.9 million and $36.3 million at September 30, 2004 and December 31, 2003,respectively.

 

The weighted-averageexpected maturity of debt securities available for sale was 2.5 years atSeptember 30, 2004. Since 40% of this portfolio is mortgage-backed securities,the expected remaining maturity may differ from contractual maturity becauseborrowers may have the right to prepay obligations before the underlyingmortgages mature. See Note 4 “Investment Securities” to the Financial Statementsfor securities available for sale by security type.

 

Total investmentsecurities available for sale at September 30, 2004 decreased $98.0 million or3% from September 30, 2003.

 

**Loan Portfolio**

 

Total loans at September30, 2004 were $10.0 billion, compared with $9.3 billion at December 31, 2003,an increase of 8%. Commercial and commercial real estate loans increased $489.6million from the beginning of the year with loan growth broad based acrossvirtually all segments, including small business, middle market, commercialreal estate and asset-based lending. Residential real estate loans increased$160.8 million from December 31, 2003 of which approximately $101.4 millionwere purchased in the wholesale market. Consumer loans reflected modest growththis time period as growth in home equity lines of credit was offset bypaydowns in the indirect dealer portfolio. Lease financings continue to paydowndue to the planned exit of this business line.

 

Total loans at September30, 2004 increased $999.2 million or 11% over September 30, 2003.

 

**Deposits**

 

Total deposits atSeptember 30, 2004, were $10.7 billion, an increase of 4% or $459.5 millionover December 31, 2003.  Interest-bearingdeposits, which represent 70% of total deposits increased less than 1%, whilenoninterest-bearing deposits increased 15% from the end of last year. A declinein money market and other time deposits was more than offset by the increase innoninterest-bearing deposits.

 

At September 30, 2004,total deposits increased 4% or $426.2 million compared to one year earlier.Growth in deposits was in core deposits from customers in the local markets.The affiliate banking model positions Bankshares to compete not only with thelarge national and regional banking companies in the gathering of these funds,but also with local community banks. Management believes Bankshares ispositioned to retain these deposits in a rising interest rate scenario.  However, should there be an outflow ofdeposits, a reversal of recent trends, the investment portfolio should provideadequate liquidity.

 

25

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**Capital**

 

Shareholders’ equity atSeptember 30, 2004 was $1.9 billion. Bankshares has authorization enabling it to repurchase up toapproximately 0.5 million additional shares. Year-to-date, Bankshares repurchased 1.0 million shares at a cost of$44.1 million by entering into a privately negotiated agreement for theaccelerated purchase of these shares. Since the share repurchase program beganin the mid-1990’s, management has generally targeted 40% of net income for cashdividends to shareholders and 30% of net income for potential sharerepurchases.

 

At September 30, 2004 andDecember 31, 2003, the cash dividend payout ratio was 48.61% and 51.56%,respectively. A change to the Directors’ Deferred Compensation Plan wasapproved at the 2004 Annual Shareholders’ meeting. Beginning April 1, 2004, alldeferred directors’ fees are covered by the plan. At April 1, 2004, directorshad the option to leave their deferred balance in the old phantom stock plan,or convert their balance into vested shares under the new plan. All butthirteen directors converted their balances to the new plan. This resulted inadding approximately 149,000 stock equivalents and a $6.4 million addition tocapital surplus. These vested shares will be issued after a directorretires.  For more details, see theStatements of Changes in Consolidated Shareholders’ Equity and Footnote No. 12.

 

RISK MANAGEMENT

 

**Credit Risk Analysis**

 

Bankshares’ loans andcommitments are substantially to borrowers located in the immediate region.Bankshares has set an internal limit for each affiliate bank, that is wellbelow the regulatory limit, on the maximum amount of credit that may beextended to a single borrower. For more information on credit risk see “RiskManagement – Credit Risk Analysis” in the Mercantile Bankshares Corporation’s2003 Annual Report on Form 10-K.

 

**Nonperforming Assets**

 

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 eliminated from the income statement andis recognized only as collected. If a loan is impaired and has a specific lossallocation based on an analysis under SFAS No. 114, “**Accountingby Creditors for Impairment of a Loan—an amendment of FASB Statements No. 5 and15,**” all payments are then applied against the loan’s principal.A loan may be put on nonaccrual status sooner than this standard if, inmanagement’s judgment, such action is warranted.

 

During the nine monthsended September 30, 2004, nonperforming assets decreased $11.2 million to $39.3million from $50.5 million at December 31, 2003.  Nonaccrual loans were $38.9 million atSeptember 30, 2004 and other real estate owned, the other component ofnonperforming assets, was $0.4 million. Nonperforming assets as a percent of period-end loans and other realestate owned was .39% at September 30, 2004 and .55% at December 31, 2003,respectively.  The decrease innonperforming loans was due primarily to improvement in credit quality atMSD&T. Credit quality at the Community Banks also continued to improve.

 

At September 30, 2004 andDecember 31, 2003, monitored loans, or loans with characteristics suggestingthat they could be classified as nonperforming in the near future, were $24.8million and $28.4 million, respectively. Two loans at MSD&T contributed$16.8 million and one loan at The Citizens National Bank affiliate contributed$5.0 million to the current total. The MSD&T loans are secured by twocommercial aircraft, which are leased to a regional commercial airline. Inlight of the prevailing conditions in the commercial airline industry,management has included these loans in the “monitored” status. The amount ofloans past due 30-89 days decreased from $43.6 million at December 31, 2003 to$36.5 million at September 30, 2004. Management has taken into considerationthe increased risk inherent in these loans in assessing the adequacy of theallowance for loan losses.  Management isconsidering taking opportunities to more aggressively manage the monitored andnonperforming credits. Such action may include the sale and/or charge-off ofcertain aging or non-core credits.  Thepotential charge-offs have been considered in the determining adequacy of theallowance for loan losses at September 30, 2004.

 

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The table below presentsa comparison of nonperforming assets at September 30, 2004, December 31,2003 and September 30, 2003.

 
| **(Dollars in thousands)**                                                         | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** | **September 30,  2003** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Nonaccrual loans *(1)*                                                             |       |                         |       |                        |       |                         |       |
| Commercial                                                                         | ** ** | **$**                        | **31,855** |                        | $          | 36,569                       |       | $ | 37,764 |   |
| Commercial real estate                                                             | ** ** | **2,925**                    |       | 7,363                       |       | 6,330                        |       |
| Construction                                                                       | ** ** | **25**                       |       | 651                         |       | 935                          |       |
| Residential real estate                                                            | ** ** | **2,675**                    | ** ** | 3,721                       |       | 3,589                        |       |
| Consumer                                                                           | ** ** | **876**                      | ** ** | 1,224                       |       | 818                          |       |
| Lease financing                                                                    | ** ** | **546**                      | ** ** | 824                         |       | 1,565                        |       |
| Total                                                                              | ** ** | **38,902**                   | ** ** | 50,352                      |       | 51,001                       |       |
| Renegotiated loans*(1)*                                                            | ** ** | **—**                   | ** ** | —                      |       | —                       |       |
| Loans contractually past due 90 days or more and still  accruing interest          | ** ** | **—**                   | ** ** | —                      |       | —                       |       |
| Total nonperforming loans                                                          | ** ** | **38,902**                   | ** ** | 50,352                      |       | 51,001                       |       |
| Other real estate owned                                                            | ** ** | **388**                      | ** ** | 191                         |       | 397                          |       |
| Total nonperforming assets                                                         | ** ** | **$**                        | **39,290** | ** **                  | $          | 50,543                       |       | $ | 51,398 |   |
| Nonperforming loans as a percent of period-end loans                               | ** ** | **0.39**                     | **%**      | 0.54                        | %          | 0.57                         | %          |
| Nonperforming assets as a percent of period-end loans  and other real estate owned | ** ** | **0.39**                     | **%**      | 0.55                        | %          | 0.57                         | %          |

 

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(1)          Aggregate gross interestincome of $2.0 million, $4.1 million and $2.8 million for the first nine monthsof 2004, the year 2003 and the first nine months of 2003, respectively, onnonaccrual and renegotiated loans, would have been recorded if these loans hadbeen accruing on their original terms throughout the period or sinceorigination if held for part of the period. The amount of interest income on the nonaccrual and renegotiated loansthat was recorded totaled $0.6 million, $2.1 million and $1.1 million for thefirst nine months of 2004, the year 2003 and the first nine months of 2003,respectively.

 

**Note:**Bankshareswas monitoring loans estimated to aggregate $24.8 million at September 30,2004, $28.4 million at December 31, 2003 and $30.5 million at September 30,2003, not classified as nonaccrual or renegotiated loans.  These loans had characteristics thatindicated they might result in such classification in the future.

 

**Allowance and Provision for LoanLosses**

 

Each 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 eachaffiliate, along with Bankshares’ management, conducts a regular review toassure that adequacy.  On a periodic, butnot-less-than quarterly, basis significant credit exposures, nonperformingloans, impaired loans, historical losses by loan type and various statisticalmeasurements of asset quality are examined to assure the adequacy of theallowance for loan losses. Management believes that the allowance for loanlosses is at an adequate level to absorb losses inherent in the portfolio.

 

The allowance 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.  The provision for loan losses for the thirdquarter of 2004 was $2.4 million, a 19% decrease from the same period last yearand basically unchanged from the second quarter of 2004. The decline in theprovision reflects a continued improvement in the economy and improving creditquality within Bankshares’ Community Banks. In evaluating the Community Banks,management has considered the qualitative risk factors related to the increasedlending authority and volumes resulting from the Affiliate Bank Rationalizationinitiative and the F&M acquisition. The Community Banks’ loan portfoliosare currently more heavily weighted toward consumer and residential real estateloans. Potential losses in these portfolios are more predictable andquantifiable, generally resulting in a lower required allowance. Netcharge-offs for the nine months ended September 30, 2004 were $1.1million, a 78% decrease from $5.1 million for the same period last year. Theallowance for loan losses as a percent of period-end loans decreased to 1.61%at September 30, 2004 from 1.62% at June 30, 2004 and 1.68% at December 31,2003.

 

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

 
| **(Dollars in thousands)**                                               | ** ** | **For the 9 Months Ended  September 30,** |           | **For the 3 Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------|----------------|------------------------------------------------|------------|
| ** **                                                               | **2004**   | ** **                                     | **2003**       |                                           | **2004**   | ** ** | **2003** | ** ** |
| Allowance balance - beginning                                            | ** ** | **$**                                          | **155,337**    | ** **                                     | $          | 138,601 |   | **$** | **158,431** | ** ** | $ | 142,261 |   |
| Allowance of acquired bank                                               | ** ** | **—**                                     | ** **     | 13,205                                         |       | **—** | ** ** | 13,205 |   |
| Charge-offs:                                                             |       |                                           | ** **     |                                           |       |   | ** ** |   |   |
| Commercial                                                               | ** ** | **(1,087**                                     | **)**          | (2,806                                         | )          | **(142** | **)** | (2,087 | ) |
| Commercial real estate                                                   | ** ** | **(67**                                        | **)**          | (556                                           | )          | **(39** | **)** | (214 | ) |
| Construction                                                             | ** ** | **—**                                     | ** **     | (160                                           | )          | **—** | ** ** | (160 | ) |
| Residential real estate                                                  | ** ** | **(384**                                       | **)**          | (54                                            | )          | **(255** | **)** | (4 | ) |
| Consumer                                                                 | ** ** | **(3,458**                                     | **)**          | (2,860                                         | )          | **(1,081** | **)** | (1,287 | ) |
| Lease financing                                                          | ** ** | **(5**                                         | **)**          | (1,188                                         | )          | **(5** | **)** | — |   |
| Total                                                                    | ** ** | **(5,001**                                     | **)**          | (7,624                                         | )          | **(1,522** | **)** | (3,752 | ) |
| Recoveries:                                                              |       |                                           | ** **     |                                           |       |   | ** ** |   |   |
| Commercial                                                               | ** ** | **1,515**                                      | ** **     | 707                                            |       | **1,178** | ** ** | 298 |   |
| Commercial real estate                                                   | ** ** | **51**                                         | ** **     | 162                                            |       | **25** | ** ** | 45 |   |
| Construction                                                             | ** ** | **4**                                          | ** **     | 136                                            |       | **—** | ** ** | 1 |   |
| Residential real estate                                                  | ** ** | **358**                                        | ** **     | 111                                            |       | **167** | ** ** | 72 |   |
| Consumer                                                                 | ** ** | **1,956**                                      | ** **     | 1,379                                          |       | **720** | ** ** | 614 |   |
| Lease financing                                                          | ** ** | **—**                                     | ** **     | 5                                              |       | **—** | ** ** | 5 |   |
| Total                                                                    | ** ** | **3,884**                                      | ** **     | 2,500                                          |       | **2,090** | ** ** | 1,035 |   |
| Net (charge-offs) / recoveries                                           | ** ** | **(1,117**                                     | **)**          | (5,124                                         | )          | **568** | ** ** | (2,717 | ) |
| Provision for loan losses                                                | ** ** | **7,221**                                      | ** **     | 9,072                                          |       | **2,442** | ** ** | 3,005 |   |
| Allowance balance - ending                                               | ** ** | **$**                                          | **161,441**    | ** **                                     | $          | 155,754 |   | **$** | **161,441** | ** ** | $ | 155,754 |   |
| Average loans                                                            | ** ** | **$**                                          | **9,596,875**  | ** **                                     | $          | 7,738,388 |   | **$** | **9,825,793** | ** ** | $ | 8,331,265 |   |
| Percent of net charge-offs / (recoveries) - annualized  to average loans | ** ** | **0.02**                                       | **%**          | 0.08                                           | %          | **(0.02** | **)%** | 0.12 | % |
| Period-end loans                                                         | ** ** | **$**                                          | **10,014,314** | ** **                                     | $          | 9,015,082 |   |   | ** ** |   |   |
| Percent of allowance for loan losses to period-end  loans                | ** ** | **1.61**                                       | **%**          | 1.73                                           | %          |   | ** ** |   |   |

 

**Interest Rate Risk**

 

The objective of interestrate risk management is to contain the risks associated with interest ratefluctuations. The process involves identification and management of thesensitivity of net interest income to changing interest rates and other marketfactors. Interest rate risk, one of the more prominent risks in terms of potentialearnings impact, is an inevitable part of being a financial intermediary. Formore information see “Risk Management – Interest Rate Risk” in the MercantileBankshares Corporation’s 2003 Annual Report on Form 10-K.

 

EARNINGS SIMULATION MODELPROJECTIONS

 

Bankshares assessesinterest rate risk by comparing projected net interest income in the currentrate environment with various interest rate scenarios that differ in thedirection of interest rate changes, the degree of change over time, the speedof the change and the projected shape of the yield curve.  The following table summarizes the effect apositive 100 and 200 basis points change and a negative 50 basis points changein interest rates would have on Bankshares’ net interest income over the next12 months.

 
| **Change in interest rates  (basis points)** | ** **                   | **Calculated increase /  (decrease) in  projected net interest income** | ** **                  |
|----------------------------------------------|------------------------------|-------------------------------------------------------------------------|-----------------------------|
| ** **                                   | **September 30,  2004** | ** **                                                              | **December 31,  2003** | ** ** |
| + 200                                        |                         | 4.7                                                                     | %                           | 4.6 | % |
| + 100                                        |                         | 2.8                                                                     | %                           | 2.4 | % |
| - 50                                         |                         | (1.8                                                                    | )%                          | (2.1 | )% |

 

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Bankshares’ interestsensitivity has become slightly more asset sensitive since December 31,2003 partially due to updated analysis of changes in core deposit behaviors.Based on its most recent simulation model, Bankshares’ net interest incomewould increase by $15.3 million and $25.5 million if interest rates were tomove up gradually over the next six months by 100 basis points or 200 basispoints, respectively.  A downwardmovement of 50 basis points would reduce net interest income by $9.6million.  In response to action by theFederal Reserve to increase short-term interest rates, Bankshares raised itsprime interest rate by 25 basis points in June, July and September 2004.  Bankshares has approximately $3.7 billion inloans that will reprice daily or monthly as prime rate changes. The effects ofa rising rate environment on interest expense are less predictable due tocustomer behavior that shifts the mix of deposit products. Current trends haveseen very strong growth in noninterest-bearing demand deposit accounts, whilemoney market accounts and certificates of deposit have decreased. Approximately$1.2 billion in short and long-term debt will also be subject to this rateincrease over the near term. As rates begin to rise, management expects, basedon Bankshares’ interest sensitivity position, that the net interest margin andnet interest income will expand.

 

Bankshares also utilizesinterest rate derivatives to hedge interest rate risk exposures. The creditrisk amount and estimated net fair values of these derivatives as of September 30,2004 and December 31, 2003 are presented in Note 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 Risk – Trading Activities**

 

In the second quarter2004, Bankshares began marketing capital market products to its customers. Froma market risk perspective, Bankshares’ net income is exposed to changes ininterest rates, credit spreads, and equity and their implied volatilities. Theprimary purpose of Bankshares’ trading business is to accommodate customers inthe management of their market price risks. Derivative transactions executedwith customers are simultaneously hedged in the capital markets. Allderivatives transacted with customers or used to hedge capital markettransactions with customers are carried at fair value. The Asset/Liability ManagementCommittee establishes and monitors counterparty risk limits. The notionalamount, exposure amount and estimated net fair value of all customeraccommodation derivatives at September 30, 2004 are included in Note 11(Derivative Instruments and Hedging Activities) to the Financial Statements.

 

**Market Risk – Equity Markets**

 

Bankshares is directlyand indirectly affected by changes in the equity markets. Bankshares has madeinvestments in private equities. These investments are made within capital allocationsapproved by management. Management reviews these investments at least quarterlyand assesses them for possible other-than-temporary impairment. Private equityinvestments totaled $14.9 million at September 30, 2004 and $8.2 millionat September 30, 2003.

 

Changes in equity marketprices may also indirectly affect Bankshares’ net income (1) by affecting thevalue of third party assets under management or administration and, hence, feeincome, (2) by affecting particular borrowers, whose ability to repay principaland/or interest may be affected by the stock market, or (3) by affectingbrokerage activity, related commission income and other business activities.

 

Bankshares’ maintenanceof capital ratios well above regulatory requirements (see Footnote No. 9 “CapitalAdequacy”) provides management with the flexibility to utilize theavailable-for-sale portfolio for liquidity and interest rate risk managementneeds, even during a period when valuations are depressed. Maintaining a fairlyshort duration in the portfolio also mitigates market risk.

 

**Liquidity Risk**

 

Liquidity risk is thepossibility that Bankshares will not be able to fund present and futurefinancial obligations. The objective of liquidity management is to maintain theability to meet commitments to fund loans, purchase securities and repaydeposits and other liabilities in accordance with their terms. To achieve thisobjective, the Asset/Liability Management Committee establishes and monitorsliquidity guidelines that require sufficient asset-based liquidity to coverpotential funding requirements and to avoid over-reliance on volatile, lessreliable funding markets. Debt securities in the available-for-sale portfolioprovide asset liquidity, in addition to the immediately liquid resources ofcash and due from banks and federal funds sold and securities purchased underresale agreements. By limiting the maturity of securities and maintaining aconservative investment posture, management can rely on the investmentportfolio to help meet any short-term funding needs. U.S. Treasury and agencysecurities, which provide the greatest liquidity, averaged $1.6 billion in thethird quarter of 2004, a 2% increase from the average of $1.5 billion for thesecond quarter of 2004 and a 4% decrease from the average of $1.6 billion forthe third quarter of 2003.

 

Core customer depositshave historically provided a sizable source of relatively stable and low-costfunds. For the three months ended September 30, 2004, core deposits (totaldeposits less certificates of deposit of $100,000 and over), averaged $9.2billion compared to $9.1 billion for the second quarter of 2004 and $8.1billion for the third quarter of 2003. Although not viewed as core deposits, asubstantial portion of short-term borrowings comprised of securities sold underagreements to repurchase and commercial paper, originate from core

 

29

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deposit relationshipstied to the overnight cash management program offered to customers. Long-termdebt and short-term borrowings funded the remaining assets.

 

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

 

Liquidity is alsoavailable through Bankshares’ ability to raise funds in the capital markets.Bankshares accesses capital markets for long-term funding by issuing registereddebt and private placements. In December 2003, Moody’s Investors Serviceaffirmed Mercantile Bankshares Corporation’s rating of “P-1” and theCorporation’s subordinated debt rating of “A2.” In December 2003, Standard& Poor’s Ratings Service affirmed the Corporation’s rating of “A+/Stable/A-1”,and counterparty rating of “A+/Stable/A-1.” Rating agencies base their ratingson many quantitative and qualitative factors, including capital adequacy,liquidity, asset quality, business mix and level and quality of earnings.

 

For additional informationsee “Risk Management – Liquidity Risk” in the Mercantile Bankshares Corporation’s2003 Annual Report on Form 10-K.

 

In the normal course ofbusiness, Bankshares routinely evaluates alternative sources of funding andliquidity.  With the current strongdemand by real estate investors for stable commercial office properties,management initiated the sale/leaseback of its headquarters facility at TwoHopkins Plaza, Baltimore, MD.  Thistransaction will enhance Bankshares’ liquidity through the cash generated fromthe sale and a reduced investment in bank premises. See Footnote No. 15 “SubsequentEvents / Contingencies” of the financial statements for additional information.

 

**Contractual Obligations andCommitments**

 

Through the normal courseof business, Bankshares enters into certain contractual obligations and othercommitments. Such obligations generally relate to funding operations throughdebt arrangements as well as leases of premises and equipment.  As a financial services provider, Banksharesroutinely enters into commitments to extend credit, including loan commitments,standby letters of credit and financial guarantees. For a discussion of thesecommitments see Footnote No. 6 “Commitments” above. For a discussion ofcontractual commitments see “Off-Balance Sheet Arrangements and ContractualObligations” in the Mercantile Bankshares Corporation’s 2003 Annual Report onForm 10-K.  Items disclosed in the AnnualReport on Form 10-K have not materially changed since the report was filed withthe exception of Bankshares entering into a 7 year service contract withSunGard Wealth Management Services to provide a new core accounting system andassume management of IWM’s back-office operations.  The table below summarizes the future minimumannual service fees associated with the SunGard contract:

 
| **(Dollars in thousands)** | ** ** | **Purchase  Obligations** | ** ** |
|----------------------------|------------|---------------------------|------------|
| 2004                       |       | $                         | —     |   |
| 2005                       |       | 5,000                     |       |
| 2006                       |       | 5,000                     |       |
| 2007                       |       | 5,000                     |       |
| 2008                       |       | 5,000                     |       |
| 2009                       |       | 5,000                     |       |
| Thereafter                 |       | 10,000                    |       |
| Total                      |       | $                         | 35,000     |   |

 

30

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**Cautionary Statement**

 

This report containsfinancial information determined by methods other than in accordance withGenerally Accepted Accounting Principles (“GAAP”). Bankshares’ management usesthese non-GAAP measures in their analysis of the Company’s performance. In,particular, net interest income, net interest margin and the cash operatingefficiency ratio are calculated on a fully tax-equivalent basis (“FTE”).  The FTE basis is determined by adjusting netinterest income to reflect tax-exempt interest income on a before-taxequivalent basis. These measures typically adjust GAAP performance measures toexclude intangible assets and the amortization of intangible assets related tothe consummation of mergers. These operating earnings measures may also excludeother significant gains, losses or expenses that are not considered componentsof core earnings. Since these items and their impact on Bankshares’ performanceare difficult to predict, management believes presentations of financial measuresexcluding the impact of these items provide useful supplemental informationthat is essential to a proper understanding of the operating results andfinancial position of Bankshares’ core businesses. These disclosures should notbe viewed as a substitute for results determined in accordance with GAAP, norare they necessarily comparable to operating earnings performance measures thatmay be presented by other companies.

 

This report containsforward-looking statements within the meaning of and pursuant to the safeharbor provisions of the Private Securities Litigation Reform Act of 1995.  A forward-looking statement encompasses anyestimate, prediction, opinion or statement of belief contained in this report,and the underlying management assumptions. Such statements in this report include: identification of trends; loangrowth; comments on adequacy of the allowance for loan losses; credit quality;changes in leasing activities; effects of asset sensitivity and interest ratechanges; information concerning market risk referenced in Item 3; expected proforma assets, loans and deposits of the banks resulting from the plannedreorganization; and the anticipated effect of the proposed reorganization onoperations, regulatory compliance and service to banking customers.  Forward-looking statements are based oncurrent expectations and assessments of potential developments affecting marketconditions, interest rates and other economic conditions, and results may ultimatelyvary from the statements made in this report. In addition, the following factors, among others, could cause actualresults to differ materially from the anticipated results or expectationsexpressed in the forward-looking statements: administrative and operationalefficiencies may not improve to the degree projected; and competitive pressuresand regulatory complexities that affect our banks may be stronger thanexpected.

 

31

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**Supplemental Information byQuarter**

Select Financial Data

*(in thousands, except per share data)*

 
| ** **                                                                            | ** ** | **3Q 04**      | ** **    | **2Q 04**  | ** ** | **1Q 04**  | ** ** | **4Q 03**  | ** ** | **3Q 03**  | ** ** | **3Q 04  vs  2Q 04** | ** ** | **3Q 04  vs  3Q 03** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|---------------|------------|------------|------------|------------|------------|------------|------------|------------|----------------------|------------|----------------------|------------|
| **OPERATING RESULTS**                                                                 |       |           |          |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Net interest income (1)                                                               | ** ** | **$**          | **138,749**   | ** ** | $          | 133,060    |       | $          | 133,674    |       | $          | 133,249              |       | $                    | 122,232    |   | 4.3 | % | 13.5 | % |
| Net interest income - taxable equivalent (1)                                          | ** ** | **140,433**    | ** **    | 134,735    |       | 135,399    |       | 135,130    |       | 123,989    |       | 4.2                  |       | 13.3                 |       |
| Provision for loan losses                                                             | ** ** | **2,442**      | ** **    | 2,353      |       | 2,426      |       | 3,033      |       | 3,005      |       | 3.8                  |       | (18.7                | )          |
| Net income                                                                            | ** ** | **56,785**     | ** **    | 56,313     |       | 55,697     |       | 50,645     |       | 47,173     |       | 0.8                  |       | 20.4                 |       |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| **PER COMMON SHARE DATA**                                                             |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Basic net income                                                                      | ** ** | **$**          | **.72**       | ** ** | $          | .71        |       | $          | .70        |       | $          | .64                  |       | $                    | .64        |   | 1.4 | % | 12.5 | % |
| Diluted net income                                                                    | ** ** | **.71**        | ** **    | .71        |       | .69        |       | .63        |       | .63        |       | —               |       | 12.7                 |       |
| Dividends paid                                                                        | ** ** | **.35**        | ** **    | .35        |       | .33        |       | .33        |       | .33        |       | —               |       | 6.1                  |       |
| Book value at period end                                                              | ** ** | **23.85**      | ** **    | 23.28      |       | 23.61      |       | 23.08      |       | 22.89      |       | 2.4                  |       | 4.2                  |       |
| Market value at period end                                                            | ** ** | **47.96**      | ** **    | 46.82      |       | 42.93      |       | 45.58      |       | 40.00      |       | 2.4                  |       | 19.9                 |       |
| Market range:                                                                         |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| High                                                                                  | ** ** | **49.34**      | ** **    | 47.93      |       | 46.01      |       | 45.95      |       | 42.49      |       | 2.9                  |       | 16.1                 |       |
| Low                                                                                   | ** ** | **44.18**      | ** **    | 40.31      |       | 41.50      |       | 39.76      |       | 38.91      |       | 9.6                  |       | 13.5                 |       |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| **AVERAGE BALANCE SHEET DATA**                                                        |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Total loans                                                                           | ** ** | **$**          | **9,825,793** | ** ** | $          | 9,623,884  |       | $          | 9,338,433  |       | $          | 9,129,330            |       | $                    | 8,331,265  |   | 2.1 | % | 17.9 | % |
| Total earning assets                                                                  | ** ** | **12,935,612** | ** **    | 12,775,183 |       | 12,475,851 |       | 12,523,854 |       | 11,750,966 |       | 1.3                  |       | 10.1                 |       |
| Total assets                                                                          | ** ** | **14,099,488** | ** **    | 13,939,185 |       | 13,618,193 |       | 13,666,099 |       | 12,622,100 |       | 1.2                  |       | 11.7                 |       |
| Total deposits                                                                        | ** ** | **10,507,716** | ** **    | 10,398,257 |       | 10,066,645 |       | 10,168,699 |       | 9,388,714  |       | 1.1                  |       | 11.9                 |       |
| Shareholders’ equity                                                             | ** ** | **1,877,844**  | ** **    | 1,851,761  |       | 1,848,461  |       | 1,811,742  |       | 1,550,937  |       | 1.4                  |       | 21.1                 |       |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| **STATISTICS AND RATIOS (Net  income annualized)**                                    |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Return on average assets                                                              | ** ** | **1.60**       | **%**         | 1.62       | %          | 1.64       | %          | 1.47       | %          | 1.48       | %          |                 |       |                 |       |
| Return on average equity (2)                                                          | ** ** | **12.03**      | ** **    | 12.23      |       | 12.12      |       | 11.09      |       | 12.07      |       |                 |       |                 |       |
| Return on average tangible equity (2)                                                 | ** ** | **17.63**      | ** **    | 18.14      |       | 18.01      |       | 16.49      |       | 15.70      |       |                 |       |                 |       |
| Average equity to average assets (2)                                                  | ** ** | **13.32**      | ** **    | 13.28      |       | 13.57      |       | 13.26      |       | 12.29      |       |                 |       |                 |       |
| Average tangible equity to average tangible assets (2)                                | ** ** | **9.67**       | ** **    | 9.55       |       | 9.75       |       | 9.51       |       | 9.91       |       |                 |       |                 |       |
| Net interest rate spread - taxable equivalent                                         | ** ** | **3.96**       | ** **    | 3.91       |       | 4.03       |       | 3.93       |       | 3.81       |       |                 |       |                 |       |
| Net interest margin on earning assets - taxable  equivalent                           | ** ** | **4.32**       | ** **    | 4.24       |       | 4.37       |       | 4.28       |       | 4.19       |       |                 |       |                 |       |
| Efficiency ratio (1),(3)                                                              | ** ** | **51.20**      | ** **    | 50.12      |       | 50.40      |       | 54.47      |       | 53.67      |       |                 |       |                 |       |
| Operating efficiency ratio (1),(3)                                                    | ** ** | **48.96**      | ** **    | 49.03      |       | 49.24      |       | 50.92      |       | 51.14      |       |                 |       |                 |       |
| Dividend payout ratio                                                                 | ** ** | **48.61**      | ** **    | 49.30      |       | 47.14      |       | 51.56      |       | 51.56      |       |                 |       |                 |       |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Bank offices                                                                          | ** ** | **229**        | ** **    | 229        |       | 229        |       | 227        |       | 236        |       | —               |       | (7                   | )          |
| Employees                                                                             | ** ** | **3,418**      | ** **    | 3,508      |       | 3,575      |       | 3,565      |       | 3,642      |       | (90                  | )          | (224                 | )          |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| **CREDIT QUALITY DATA AT PERIOD  END**                                                |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Net charge-offs / (recoveries)                                                        | ** ** | **$**          | **(568**      | **)**      | $          | 557        |       | $          | 1,128      |       | $          | 3,450                |       | $                    | 2,717      |   | (202.0 | )% | (120.9 | )% |
| Nonaccrual loans                                                                      | ** ** | **38,902**     | ** **    | 39,888     |       | 48,007     |       | 50,352     |       | 51,001     |       | (2.5                 | )          | (23.7                | )          |
| Restructured loans                                                                    | ** ** | **—**     | ** **    | —     |       | —     |       | —     |       | —     |       | —               |       | —               |       |
| Total nonperforming loans                                                             | ** ** | **38,902**     | ** **    | 39,888     |       | 48,007     |       | 50,352     |       | 51,001     |       | (2.5                 | )          | (23.7                | )          |
| Other real estate owned, net                                                          | ** ** | **388**        | ** **    | 402        |       | 134        |       | 191        |       | 397        |       | (3.5                 | )          | (2.3                 | )          |
| Total nonperforming assets                                                            | ** ** | **39,290**     | ** **    | 40,290     |       | 48,141     |       | 50,543     |       | 51,398     |       | (2.5                 | )          | (23.6                | )          |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| **CREDIT QUALITY RATIOS**                                                             |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Provision for loan losses (annualized) as a percent of  period-end loans              | ** ** | **.10**        | **%**         | .10        | %          | .10        | %          | .13        | %          | .13        | %          |                 |       |                 |       |
| Net charge-offs / (recoveries) annualized as a percent  of period-end loans           | ** ** | **(.02**       | **)**         | .02        |       | .05        |       | .15        |       | .12        |       |                 |       |                 |       |
| Nonperforming loans as a percent of period-end loans                                  | ** ** | **.39**        | ** **    | .41        |       | .51        |       | .54        |       | .57        |       |                 |       |                 |       |
| Allowance for loan losses as a percent of period-end  loans                           | ** ** | **1.61**       | ** **    | 1.62       |       | 1.66       |       | 1.68       |       | 1.73       |       |                 |       |                 |       |
| Allowance for loan losses as a percent of  nonperforming loans                        | ** ** | **414.99**     | ** **    | 397.19     |       | 326.28     |       | 308.50     |       | 305.39     |       |                 |       |                 |       |
| Other real estate owned as a percent of period-end  loans and other real estate owned | ** ** | **—**     | ** **    | —     |       | —     |       | —     |       | —     |       |                 |       |                 |       |
| Nonperforming assets as a percent of period-end loans  and other real estate owned    | ** ** | **.39**        | ** **    | .41        |       | .51        |       | .55        |       | .57        |       |                 |       |                 |       |
| Nonperforming assets as a percent of total assets                                     | ** ** | **.27**        | ** **    | .29        |       | .34        |       | .37        |       | .37        |       |                 |       |                 |       |

 

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(1),(2),(3)  See Reconciliation of Non-GAAP measures onpage 36 for additional information.

 

32

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**Statements of Consolidated Income**

*(in thousands, except per share data)*

 
| ** **                                               | ** ** | **3Q 04**   | ** **  | **2Q 04**  | ** ** | **1Q 04** | ** ** | **4Q 03** | ** ** | **3Q 03** | ** ** | **3Q 04  vs  2Q 04** | ** ** | **3Q 04  vs  3Q 03** | ** ** |
|----------------------------------------------------------|------------|-------------|-------------|------------|------------|-----------|------------|-----------|------------|-----------|------------|----------------------|------------|----------------------|------------|
| **INTEREST INCOME**                                      |       |        |        |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Interest and fees on loans                               | ** ** | **$**       | **138,047** | ** ** | $          | 132,116   |       | $         | 129,060    |      | $          | 129,288              |       | $                    | 120,137    |   | 4.5 | % | 14.9 | % |
| Interest and dividends on investment securities:         |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Taxable interest income                                  | ** ** | **26,048**  | ** **  | 26,165     |       | 27,401    |       | 28,660    |       | 27,285    |       | (0.4                 | )          | (4.5                 | )          |
| Tax-exempt interest income                               | ** ** | **803**     | ** **  | 820        |       | 877       |       | 999       |       | 783       |       | (2.1                 | )          | 2.6                  |       |
| Dividends                                                | ** ** | **236**     | ** **  | 300        |       | 261       |       | 114       |       | 212       |       | (21.3                | )          | 11.3                 |       |
| Other investment income                                  | ** ** | **803**     | ** **  | (372       | )          | 3,341     |       | 2,578     |       | 1,508     |       | 315.9                |       | (46.8                | )          |
| ** **                                               |       | **27,890**  | ** **  | 26,913     |       | 31,880    |       | 32,351    |       | 29,788    |       | 3.6                  |       | (6.4                 | )     |
| Other interest income                                    | ** ** | **519**     | ** **  | 589        |       | 175       |       | 630       |       | 1,291     |       | (11.9                | )          | (59.8                | )          |
| Total interest income                                    | ** ** | **166,456** | ** **  | 159,618    |       | 161,115   |       | 162,269   |       | 151,216   |       | 4.3                  |       | 10.1                 |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **INTEREST EXPENSE**                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Interest on deposits                                     | ** ** | **20,142**  | ** **  | 19,873     |       | 20,767    |       | 22,298    |       | 22,313    |       | 1.4                  |       | (9.7                 | )          |
| Interest on short-term borrowings                        | ** ** | **1,990**   | ** **  | 1,480      |       | 1,419     |       | 1,287     |       | 1,303     |       | 34.5                 |       | 52.7                 |       |
| Interest on long-term debt                               | ** ** | **5,575**   | ** **  | 5,205      |       | 5,255     |       | 5,435     |       | 5,368     |       | 7.1                  |       | 3.9                  |       |
| Total interest expense                                   | ** ** | **27,707**  | ** **  | 26,558     |       | 27,441    |       | 29,020    |       | 28,984    |       | 4.3                  |       | (4.4                 | )          |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NET INTEREST INCOME**                                  | ** ** | **138,749** | ** **  | 133,060    |       | 133,674   |       | 133,249   |       | 122,232   |       | 4.3                  |       | 13.5                 |       |
| Provision for loan losses                                | ** ** | **2,442**   | ** **  | 2,353      |       | 2,426     |       | 3,033     |       | 3,005     |       | 3.8                  |       | (18.7                | )          |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NET INTEREST INCOME AFTER  PROVISION FOR LOAN LOSSES** | ** ** | **136,307** | ** **  | 130,707    |       | 131,248   |       | 130,216   |       | 119,227   |       | 4.3                  |       | 14.3                 |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NONINTEREST INCOME**                                   |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Investment and wealth management                         | ** ** | **22,396**  | ** **  | 22,936     |       | 21,983    |       | 21,483    |       | 20,577    |       | (2.4                 | )          | 8.8                  |       |
| Service charges on deposit accounts                      | ** ** | **10,637**  | ** **  | 10,351     |       | 10,119    |       | 10,840    |       | 9,701     |       | 2.8                  |       | 9.6                  |       |
| Mortgage banking related fees                            | ** ** | **3,063**   | ** **  | 2,293      |       | 2,940     |       | 2,813     |       | 3,403     |       | 33.6                 |       | (10.0                | )          |
| Investment securities gains and (losses)                 | ** ** | **(1**      | **)**       | 590        |       | (55       | )          | 122       |       | (336      | )          | (100.2               | )          | 99.7                 |       |
| Other income                                             | ** ** | **17,259**  | ** **  | 15,380     |       | 14,898    |       | 12,140    |       | 12,558    |       | 12.2                 |       | 37.4                 |       |
| Total noninterest income                                 | ** ** | **53,354**  | ** **  | 51,550     |       | 49,885    |       | 47,398    |       | 45,903    |       | 3.5                  |       | 16.2                 |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NONINTEREST EXPENSES**                                 |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Salaries                                                 | ** ** | **48,696**  | ** **  | 44,689     |       | 44,788    |       | 45,724    |       | 43,870    |       | 9.0                  |       | 11.0                 |       |
| Employee benefits                                        | ** ** | **10,557**  | ** **  | 10,928     |       | 12,513    |       | 8,826     |       | 10,144    |       | (3.4                 | )          | 4.1                  |       |
| Net occupancy expense of bank premises                   | ** ** | **6,128**   | ** **  | 5,819      |       | 6,060     |       | 7,305     |       | 5,136     |       | 5.3                  |       | 19.3                 |       |
| Furniture and equipment expenses                         | ** ** | **7,936**   | ** **  | 7,573      |       | 7,364     |       | 9,636     |       | 8,432     |       | 4.8                  |       | (5.9                 | )          |
| Communications and supplies                              | ** ** | **4,111**   | ** **  | 4,195      |       | 4,304     |       | 4,682     |       | 3,889     |       | (2.0                 | )          | 5.7                  |       |
| Other expenses                                           | ** ** | **21,789**  | ** **  | 20,163     |       | 18,357    |       | 23,255    |       | 19,718    |       | 8.1                  |       | 10.5                 |       |
| Total noninterest expenses                               | ** ** | **99,217**  | ** **  | 93,367     |       | 93,386    |       | 99,428    |       | 91,189    |       | 6.3                  |       | 8.8                  |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Income before income taxes                               | ** ** | **90,444**  | ** **  | 88,890     |       | 87,747    |       | 78,186    |       | 73,941    |       | 1.7                  |       | 22.3                 |       |
| Applicable income taxes                                  | ** ** | **33,659**  | ** **  | 32,577     |       | 32,050    |       | 27,541    |       | 26,768    |       | 3.3                  |       | 25.7                 |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NET INCOME**                                           | ** ** | **$**       | **56,785**  | ** ** | $          | 56,313    |       | $         | 55,697     |      | $          | 50,645               |       | $                    | 47,173     |   | 0.8 |   | 20.4 |   |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Weighted average shares outstanding                      | ** ** | **78,965**  | ** **  | 79,119     |       | 79,725    |       | 79,554    |       | 74,253    |       | (0.2                 | )          | 6.3                  |       |
| Adjusted weighted average shares outstanding             | ** ** | **79,611**  | ** **  | 79,751     |       | 80,258    |       | 80,196    |       | 74,840    |       | (0.2                 | )          | 6.4                  |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NET INCOME PER COMMON SHARE:**                         |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Basic                                                    | ** ** | **$**       | **.72**     | ** ** | $          | .71       |       | $         | .70        |      | $          | .64                  |       | $                    | .64        |   | 1.4 |   | 12.5 |   |
| Diluted                                                  | ** ** | **$**       | **.71**     | ** ** | $          | .71       |       | $         | .69        |      | $          | .63                  |       | $                    | .63        |   | — |   | 12.7 |   |

 

33

----

 

**Statements of ConsolidatedNoninterest Income and Noninterest Expenses**

*(in thousands)*

 
| **Noninterest  Income**                  | ** ** | **3Q 04**  | ** ** | **2Q 04** | ** ** | **1Q 04** | ** ** | **4Q 03** | ** ** | **3Q 03** | ** ** | **3Q 04  vs  2Q 04** | ** ** | **3Q 04  vs  3Q 03** | ** ** |
|------------------------------------------|------------|------------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|----------------------|------------|----------------------|------------|
| Investment and wealth management         | ** ** | **$**      | **22,396** |      | $          | 22,936    |       | $         | 21,983     |      | $          | 21,483               |       | $                    | 20,577     |   | (2.4 | )% | 8.8 | % |
| Service charges on deposit accounts      | ** ** | **10,637** |       | 10,351    |       | 10,119    |       | 10,840    |       | 9,701     |       | 2.8                  |       | 9.6                  |       |
| Mortgage banking related fees:           |       |       |       |      |       |      |       |      |       |      |       |                 |       |                 |       |
| Commercial                               | ** ** | **2,395**  |       | 1,563     |       | 1,920     |       | 1,555     |       | 1,773     |       | 53.2                 |       | 35.1                 |       |
| Residential                              | ** ** | **668**    |       | 730       |       | 1,020     |       | 1,258     |       | 1,630     |       | (8.5                 | )          | (59.0                | )          |
| Total mortgage banking related fees      | ** ** | **3,063**  |       | 2,293     |       | 2,940     |       | 2,813     |       | 3,403     |       | 33.6                 |       | (10.0                | )          |
| Investment securities gains and (losses) | ** ** | **(1**     | **)**      | 590       |       | (55       | )          | 122       |       | (336      | )          | (100.2               | )          | 99.7                 |       |
| Other income:                            |       |       |       |      |       |      |       |      |       |      |       |                 |       |                 |       |
| Electronic banking fees                  | ** ** | **5,959**  |       | 5,951     |       | 4,400     |       | 4,083     |       | 5,133     |       | 0.1                  |       | 16.1                 |       |
| Charges and fees on loans                | ** ** | **2,647**  |       | 2,835     |       | 2,458     |       | 2,602     |       | 2,430     |       | (6.6                 | )          | 8.9                  |       |
| Insurance                                | ** ** | **3,218**  |       | 3,267     |       | 3,828     |       | 2,670     |       | 1,653     |       | (1.5                 | )          | 94.7                 |       |
| Bank-owned life insurance                | ** ** | **798**    |       | 785       |       | 794       |       | 576       |       | 559       |       | 1.7                  |       | 42.8                 |       |
| All other income                         | ** ** | **4,637**  |       | 2,542     |       | 3,418     |       | 2,209     |       | 2,783     |       | 82.4                 |       | 66.6                 |       |
| Total other income                       | ** ** | **17,259** |       | 15,380    |       | 14,898    |       | 12,140    |       | 12,558    |       | 12.2                 |       | 37.4                 |       |
| Total                                    | ** ** | **$**      | **53,354** |      | $          | 51,550    |       | $         | 49,885     |      | $          | 47,398               |       | $                    | 45,903     |   | 3.5 | % | 16.2 | % |

 
| **Noninterest Expenses**               | ** ** | **3Q 04**  | ** ** | **2Q 04** | ** ** | **1Q 04** | ** ** | **4Q 03** | ** ** | **3Q 03** | ** ** | **3Q 04  vs  2Q 04** | ** ** | **3Q 04  vs  3Q 03** | ** ** |
|----------------------------------------|------------|------------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|----------------------|------------|----------------------|------------|
| Salaries                               | ** ** | **$**      | **48,696** |      | $          | 44,689    |       | $         | 44,788     |      | $          | 45,724               |       | $                    | 43,870     |   | 9.0 | % | 11.0 | % |
| Employee benefits                      | ** ** | **10,557** |       | 10,928    |       | 12,513    |       | 8,826     |       | 10,144    |       | (3.4                 | )          | 4.1                  |       |
| Net occupancy expense of bank premises | ** ** | **6,128**  |       | 5,819     |       | 6,060     |       | 7,305     |       | 5,136     |       | 5.3                  |       | 19.3                 |       |
| Furniture and equipment expenses       | ** ** | **7,936**  |       | 7,573     |       | 7,364     |       | 9,636     |       | 8,432     |       | 4.8                  |       | (5.9                 | )          |
| Communications and supplies            | ** ** | **4,111**  |       | 4,195     |       | 4,304     |       | 4,682     |       | 3,889     |       | (2.0                 | )          | 5.7                  |       |
| Other expenses:                        |       |       |       |      |       |      |       |      |       |      |       |                 |       |                 |       |
| Professional services                  | ** ** | **7,157**  |       | 4,996     |       | 3,834     |       | 7,080     |       | 5,380     |       | 43.3                 |       | 33.0                 |       |
| Advertising and promotional expenses   | ** ** | **1,747**  |       | 2,135     |       | 1,703     |       | 3,275     |       | 2,168     |       | (18.2                | )          | (19.4                | )          |
| Electronic banking expenses            | ** ** | **3,001**  |       | 2,485     |       | 1,929     |       | 1,791     |       | 2,432     |       | 20.8                 |       | 23.4                 |       |
| Amortization of intangible assets      | ** ** | **2,044**  |       | 2,057     |       | 2,032     |       | 1,847     |       | 1,688     |       | (0.6                 | )          | 21.1                 |       |
| Outsourcing expenses                   | ** ** | **1,351**  |       | 1,227     |       | 1,459     |       | 1,136     |       | 1,049     |       | 10.1                 |       | 28.8                 |       |
| All other expenses                     | ** ** | **6,489**  |       | 7,263     |       | 7,400     |       | 8,126     |       | 7,001     |       | (10.7                | )          | (7.3                 | )          |
| Total other expenses                   | ** ** | **21,789** |       | 20,163    |       | 18,357    |       | 23,255    |       | 19,718    |       | 8.1                  |       | 10.5                 |       |
| Total                                  | ** ** | **$**      | **99,217** |      | $          | 93,367    |       | $         | 93,386     |      | $          | 99,428               |       | $                    | 91,189     |   | 6.3 | % | 8.8 | % |

 

34

----

 

**Consolidated Average BalanceSheets**

*(in thousands)*

 
| ** **                                      | ** ** | ** **           | ** **     | ** **         | ** ** | ** **           | ** ** | ** **         | ** ** | ** **           | ** ** | ** **         | ** ** | ** **           | ** ** | ** **         | ** ** | ** **           | ** ** | ** **         | ** ** | **Average Balance** | ** ** |
|-------------------------------------------------|------------|----------------------|----------------|--------------------|------------|----------------------|------------|--------------------|------------|----------------------|------------|--------------------|------------|----------------------|------------|--------------------|------------|----------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                      | ** ** | **3Q 04**            | ** **     | **2Q 04**          | ** ** | **1Q 04**            | ** ** | **4Q 03**          | ** ** | **3Q 04**            | ** ** | **3Q 04**          | ** ** | **3Q 04**            | ** ** |
| ** **                                      | ** ** | **Average  Balance** | ** **     | **Yield*  / Rate** | ** ** | **Average  Balance** | ** ** | **Yield*  / Rate** | ** ** | **Average  Balance** | ** ** | **Yield*  / Rate** | ** ** | **Average  Balance** | ** ** | **Yield*  / Rate** | ** ** | **Average  Balance** | ** ** | **Yield*  / Rate** | ** ** | **vs  2Q 04**       | ** ** | **Vs  3Q 03** | ** ** |
| Earning assets  Loans:**                        |       |                 | ** **     |               | ** ** |                 |       |               |       |                 |       |               |       |                 |       |               |       |                 |       |               |       |                |       |   |   |
| Commercial                                      | ** ** | **$**                | **2,752,242**  | ** **         | **5.32**   | **%**                | $          | 2,727,051          |       | 5.13                 | %          | $                  | 2,632,605  |                 | 5.14       | %                  | $          | 2,628,283            |       | 5.13               | %          | $                   | 2,508,721  |   | 5.28 | % | 0.9 | % | 9.7 | % |
| Commercial real estate                          | ** ** | **2,961,468**        | ** **     | **5.92**           | ** ** | 2,871,615            |       | 5.83               |       | 2,768,779            |       | 5.91               |       | 2,664,891            |       | 6.00               |       | 2,391,892            |       | 6.02               |       | 3.1                 |       | 23.8 |   |
| Construction                                    | ** ** | **1,142,921**        | ** **     | **5.49**           | ** ** | 1,113,301            |       | 5.21               |       | 1,103,901            |       | 5.18               |       | 1,053,049            |       | 5.25               |       | 969,251              |       | 5.34               |       | 2.7                 |       | 17.9 |   |
| Residential real estate                         | ** ** | **1,490,763**        | ** **     | **5.80**           | ** ** | 1,437,331            |       | 5.91               |       | 1,358,975            |       | 6.06               |       | 1,309,345            |       | 6.13               |       | 1,205,020            |       | 6.28               |       | 3.7                 |       | 23.7 |   |
| Consumer                                        | ** ** | **1,478,399**        | ** **     | **5.60**           | ** ** | 1,474,586            |       | 5.81               |       | 1,474,173            |       | 5.79               |       | 1,473,762            |       | 5.94               |       | 1,256,381            |       | 6.18               |       | 0.3                 |       | 17.7 |   |
| Total loans                                     | ** ** | **9,825,793**        | ** **     | **5.64**           | ** ** | 9,623,884            |       | 5.57               |       | 9,338,433            |       | 5.61               |       | 9,129,330            |       | 5.67               |       | 8,331,265            |       | 5.78               |       | 2.1                 |       | 17.9 |   |
|                                            |       |                 | ** **     |               | ** ** |                 |       |               |       |                 |       |               |       |                 |       |               |       |                 |       |               |       |                |       |   |   |
| Federal funds sold, et al  Securities: ***      | ** ** | **50,035**           | ** **     | **4.13**           | ** ** | 95,504               |       | 2.48               |       | 47,791               |       | 1.47               |       | 215,329              |       | 1.15               |       | 413,675              |       | 1.19               |       | (47.6               | )          | (87.9 | ) |
| Taxable securities                              |       |                 | ** **     |               | ** ** |                 |       |               |       |                 |       |               |       |                 |       |               |       |                 |       |               |       |                |       |   |   |
|  U.S. Treasury  and gov. agencies          | ** ** | **1,571,102**        | ** **     | **3.59**           | ** ** | 1,543,661            |       | 3.74               |       | 1,560,700            |       | 3.89               |       | 1,629,554            |       | 4.01               |       | 1,629,544            |       | 4.19               |       | 1.8                 |       | (3.6 | ) |
|  Mortgage-backed                           | ** ** | **1,228,539**        | ** **     | **3.84**           | ** ** | 1,254,512            |       | 3.78               |       | 1,277,802            |       | 3.87               |       | 1,275,875            |       | 3.79               |       | 1,150,073            |       | 3.48               |       | (2.1                | )          | 6.8 |   |
|  Other  investments                        | ** ** | **169,264**          | ** **     | **2.45**           | ** ** | 159,282              |       | (.17               | )          | 146,592              |       | 9.90               |       | 142,405              |       | 7.51               |       | 120,093              |       | 5.70               |       | 6.3                 |       | 40.9 |   |
| Tax-exempt securities                           |       |                 | ** **     |               | ** ** |                 |       |               |       |                 |       |               |       |                 |       |               |       |                 |       |               |       |                |       |   |   |
| States and political subdivisions               | ** ** | **90,721**           | ** **     | **5.82**           | ** ** | 98,182               |       | 5.55               |       | 104,375              |       | 5.59               |       | 117,374              |       | 5.59               |       | 84,944               |       | 6.05               |       | (7.6                | )          | 6.8 |   |
| Total securities                                | ** ** | **3,059,626**        | ** **     | **3.70**           | ** ** | 3,055,637            |       | 3.61               |       | 3,089,469            |       | 4.23               |       | 3,165,208            |       | 4.14               |       | 2,984,654            |       | 4.03               |       | 0.1                 |       | 2.5 |   |
| Interest-bearing deposits in other banks        | ** ** | **158**              | ** **     | **1.08**           | ** ** | 158                  |       | 1.06               |       | 158                  |       | 1.09               |       | 13,987               |       | .23                |       | 21,372               |       | .85                |       | —              |       | (99.3 | ) |
| Total earning assets                            | ** ** | **12,935,612**       | ** **     | **5.17**           | ** ** | 12,775,183           |       | 5.08               |       | 12,475,851           |       | 5.25               |       | 12,523,854           |       | 5.20               |       | 11,750,966           |       | 5.16               |       | 1.3                 |       | 10.1 |   |
|                                            |       |                 | ** **     |               | ** ** |                 |       |               |       |                 |       |               |       |                 |       |               |       |                 |       |               |       |                |       |   |   |
| Cash and due from banks                         | ** ** | **296,203**          | ** **     |               | ** ** | 298,440              |       |               |       | 285,524              |       |               |       | 298,581              |       |               |       | 295,289              |       |               |       | (0.7                | )          | 0.3 |   |
| Bank premises & equipment, net              | ** ** | **141,536**          | ** **     |               | ** ** | 141,757              |       |               |       | 141,632              |       |               |       | 139,022              |       |               |       | 124,275              |       |               |       | (0.2                | )          | 13.9 |   |
| Other assets                                    | ** ** | **886,468**          | ** **     |               | ** ** | 881,921              |       |               |       | 871,583              |       |               |       | 861,348              |       |               |       | 602,614              |       |               |       | 0.5                 |       | 47.1 |   |
| Less: allowance for loan losses                 | ** ** | **(160,331**         | **)**          |               | ** ** | (158,116             | )          |               |       | (156,397             | )          |               |       | (156,706             | )          |               |       | (151,044             | )          |               |       | 1.4                 |       | 6.1 |   |
| Total assets                                    | ** ** | **$**                | **14,099,488** | ** **         |       | ** **           | $          | 13,939,185         |       |                 |       | $                  | 13,618,193 |                 |       |               | $          | 13,666,099           |       |               |       | $                   | 12,622,100 |   |   |   | 1.2 |   | 11.7 |   |
|                                            |       |                 | ** **     |               | ** ** |                 |       |               |       |                 |       |               |       |                 |       |               |       |                 |       |               |       |                |       |   |   |
| Interest-bearing liabilities  Deposits:         |       |                 | ** **     |               | ** ** |                 |       |               |       |                 |       |               |       |                 |       |               |       |                 |       |               |       |                |       |   |   |
| Savings                                         | ** ** | **$**                | **1,457,432**  | ** **         | **.29**    | ** **           | $          | 1,434,288          |       | .29                  |       | $                  | 1,364,181  |                 | .29        |               | $          | 1,341,697            |       | .30                |       | $                   | 1,218,813  |   | .30 |   | 1.6 |   | 19.6 |   |
| Checking plus interest                          | ** ** | **1,291,808**        | ** **     | **.15**            | ** ** | 1,302,313            |       | .15                |       | 1,236,552            |       | .15                |       | 1,217,573            |       | .16                |       | 1,119,989            |       | .16                |       | (0.8                | )          | 15.3 |   |
| Money market                                    | ** ** | **1,556,212**        | ** **     | **.55**            | ** ** | 1,564,295            |       | .54                |       | 1,590,460            |       | .60                |       | 1,606,119            |       | .62                |       | 1,431,262            |       | .61                |       | (0.5                | )          | 8.7 |   |
| Time deposits $100,000 & over               | ** ** | **1,299,918**        | ** **     | **1.90**           | ** ** | 1,315,119            |       | 1.82               |       | 1,287,695            |       | 1.99               |       | 1,316,951            |       | 2.08               |       | 1,270,016            |       | 2.20               |       | (1.2                | )          | 2.4 |   |
| Other time deposits                             | ** ** | **1,918,216**        | ** **     | **2.12**           | ** ** | 1,955,632            |       | 2.12               |       | 1,979,433            |       | 2.15               |       | 2,038,739            |       | 2.21               |       | 1,942,113            |       | 2.39               |       | (1.9                | )          | (1.2 | ) |
| Total interest-bearing deposits                 | ** ** | **7,523,586**        | ** **     | **1.07**           | ** ** | 7,571,647            |       | 1.06               |       | 7,458,321            |       | 1.12               |       | 7,521,079            |       | 1.18               |       | 6,982,193            |       | 1.27               |       | (0.6                | )          | 7.8 |   |
| Short-term borrowings                           | ** ** | **942,789**          | ** **     | **.84**            | ** ** | 910,854              |       | .65                |       | 919,388              |       | .62                |       | 907,914              |       | .56                |       | 944,979              |       | .55                |       | 3.5                 |       | (0.2 | ) |
| Long-term debt                                  | ** ** | **641,264**          | ** **     | **3.46**           | ** ** | 648,576              |       | 3.23               |       | 649,058              |       | 3.26               |       | 649,516              |       | 3.32               |       | 611,801              |       | 3.48               |       | (1.1                | )          | 4.8 |   |
| Total interest-bearing funds                    | ** ** | **9,107,639**        | ** **     | **1.21**           | ** ** | 9,131,077            |       | 1.17               |       | 9,026,767            |       | 1.22               |       | 9,078,509            |       | 1.27               |       | 8,538,973            |       | 1.35               |       | (0.3                | )          | 6.7 |   |
|                                            |       |                 | ** **     |               | ** ** |                 |       |               |       |                 |       |               |       |                 |       |               |       |                 |       |               |       |                |       |   |   |
| Noninterest-bearing deposits                    | ** ** | **2,984,130**        | ** **     |               | ** ** | 2,826,610            |       |               |       | 2,608,324            |       |               |       | 2,647,620            |       |               |       | 2,406,521            |       |               |       | 5.6                 |       | 24.0 |   |
| Other liabilities and accrued expenses          | ** ** | **129,875**          | ** **     |               | ** ** | 129,737              |       |               |       | 134,641              |       |               |       | 128,228              |       |               |       | 125,669              |       |               |       | 0.1                 |       | 3.3  |   |
| Total liabilities                               | ** ** | **12,221,644**       | ** **     |               | ** ** | 12,087,424           |       |               |       | 11,769,732           |       |               |       | 11,854,357           |       |               |       | 11,071,163           |       |               |       | 1.1                 |       | 10.4 |   |
| Shareholders’ equity                       | ** ** | **1,877,844**        | ** **     |               | ** ** | 1,851,761            |       |               |       | 1,848,461            |       |               |       | 1,811,742            |       |               |       | 1,550,937            |       |               |       | 1.4                 |       | 21.1 |   |
| Total liabilities and shareholders’ equity | ** ** | **$**                | **14,099,488** | ** **         |       | ** **           | $          | 13,939,185         |       |                 |       | $                  | 13,618,193 |                 |       |               | $          | 13,666,099           |       |               |       | $                   | 12,622,100 |   |   |   | 1.2 |   | 11.7 |   |
|                                            |       |                 | ** **     |               | ** ** |                 |       |               |       |                 |       |               |       |                 |       |               |       |                 |       |               |       |                |       |   |   |
| Net interest rate spread                        | ** ** | ** **           | ** **     | **3.96**           | **%**      |                 |       | 3.91               | %          |                 |       | 4.03               | %          |                 |       | 3.93               | %          |                 |       | 3.81               | %          |                |       |   |   |
| Effect of noninterest-bearing funds             | ** ** | ** **           | ** **     | **.36**            | ** ** |                 |       | .33                |       |                 |       | .34                |       |                 |       | .35                |       |                 |       | .38                |       |                |       |   |   |
| Net interest margin on earning assets           | ** ** | ** **           | ** **     | **4.32**           | **%**      |                 |       | 4.24               | %          |                 |       | 4.37               | %          |                 |       | 4.28               | %          |                 |       | 4.19               | %          |                |       |   |   |

 

----

* Presented on atax-equivalent basis using the statutory federal corporate income tax rate of35% (see reconciliation of non-GAAP measures on page 36)

** Nonaccrual loans areincluded in average loans

*** Balances reported atamortized cost; excludes unrealized gains (losses) on securitiesavailable-for-sale

 

35

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

 
| **(In thousands, except per share data)**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | ** **                                      | **YTD  2004** | ** **  | **YTD  2003** | ** ** | **3Q 04**  | ** ** | **2Q 04**  | ** **  | **1Q 04**  | ** ** | **4Q 03** | ** ** | **3Q 03** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------|---------------|-------------|---------------|------------|------------|------------|------------|-------------|------------|------------|-----------|------------|-----------|------------|
| (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)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** **                                      | **$**         | **405,483** |          | $          | 346,081    | ** ** | **$**      | **138,749** |       | $          | 133,060   |       | $         | 133,674    |   | $ | 133,249 |   | $ | 122,232 |   |
| Taxable-equivalent adjustment                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** **                                      | **5,084**     |        | 4,879         | ** ** | **1,684**  |       | 1,675      |        | 1,725      |       | 1,881     |       | 1,757     |       |
| Net interest income - taxable equivalent                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | ** **                                      | **$**         | **410,567** |          | $          | 350,960    | ** ** | **$**      | **140,433** |       | $          | 134,735   |       | $         | 135,399    |   | $ | 135,130 |   | $ | 123,989 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** **                                      | ** **    |        |          | ** ** | ** ** |       |       |        |       |       |      |       |      |       |
| (2)          Management excludes the balance of intangible assets  and their related amortization expense from its calculation of return on  average tangible assets, 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 the  Company. 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 assets (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** **                                      | **1.62**      | **%**       | 1.71          | %          | **1.60**   | **%**      | 1.62       | %           | 1.64       | %          | 1.47      | %          | 1.48      | %          |
| Impact of excluding average intangible assets and  amortization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** **                                      | **0.11**      | ** **  | 0.06          |       | **0.11**   | ** ** | 0.11       |        | 0.12       |       | 0.10      |       | 0.08      |       |
| Return on average tangible assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** **                                      | **1.73**      | **%**       | 1.77          | %          | **1.71**   | **%**      | 1.73       | %           | 1.76       | %          | 1.57      | %          | 1.56      | %          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |          | ** **  |          |       |       | ** ** |       |        |       |       |      |       |      |       |
| Return on average equity (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** **                                      | **12.13**     | **%**       | 14.05         | %          | **12.03**  | **%**      | 12.23      | %           | 12.12      | %          | 11.09     | %          | 12.07     | %          |
| Impact of excluding average intangible assets and amortization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               | ** **                                      | **5.81**      | ** **  | 2.52          |       | **5.60**   | ** ** | 5.91       |        | 5.89       |       | 5.40      |       | 3.63      |       |
| Return on average tangible equity                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** **                                      | **17.94**     | **%**       | 16.57         | %          | **17.63**  | **%**      | 18.14      | %           | 18.01      | %          | 16.49     | %          | 15.70     | %          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |          | ** **  |          |       |       | ** ** |       |        |       |       |      |       |      |       |
| Average equity to average assets (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** **                                      | **13.38**     | **%**       | 12.20         | %          | **13.32**  | **%**      | 13.28      | %           | 13.57      | %          | 13.26     | %          | 12.29     | %          |
| Impact of excluding average intangible assets and  amortization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** **                                      | **(3.73**     | **)**       | (1.54         | )          | **(3.65**  | **)**      | (3.73      | )           | (3.82      | )          | (3.75     | )          | (2.38     | )          |
| Average tangible equity to average tangible assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | ** **                                      | **9.65**      | **%**       | 10.66         | %          | **9.67**   | **%**      | 9.55       | %           | 9.75       | %          | 9.51      | %          | 9.91      | %          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** **                                      | ** **    | ** **  |          |       | ** ** | ** ** |       |        |       |       |      |       |      |       |
| When computing the cash  operating efficiency ratio and cash operating earnings, management excludes  the amortization of intangible assets, restructuring charges, merger-related  expenses, gains on building sales and gains and losses from sales of investment  securities in order to assess the core operating results of the Company 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)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** **                                      | **50.58**     | **%**       | 49.57         | %          | **51.20**  | **%**      | 50.12      | %           | 50.40      | %          | 54.47     | %          | 53.67     | %          |
| Impact of excluding:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Securities gains and (losses)                   |          | **0.05**    | ** **    | 0.51       |       | **—** | ** ** | 0.16        |       | (0.01      | )         | 0.04       |      | (0.10      | ) |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Gains on building sales                         | ** **    | **0.14**    | ** **    | 0.03       |       | **0.20**   | ** ** | 0.08        |       | 0.17       |      | —     |      | —     |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Amortization of deposit intangibles             | ** **    | **(0.72**   | **)**         | (0.40      | )          | **(0.71**  | **)**      | (0.73       | )          | (0.74      | )         | (0.60      | )         | (0.69      | ) |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Amortization of other intangibles               | ** **    | **(0.36**   | **)**         | (0.25      | )          | **(0.35**  | **)**      | (0.37       | )          | (0.36      | )         | (0.40      | )         | (0.30      | ) |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Restructuring expenses                          | ** **    | **(0.55**   | **)**         | —     |       | **(1.38**  | **)**      | (0.23       | )          | —     |      | —     |      | —     |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Merger-related expenses                         | ** **    | **(0.07**   | **)**         | (0.48      | )          | **—** | ** ** | —      |       | (0.22      | )         | (2.59      | )         | (1.44      | ) |
| Cash operating efficiency ratio                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** **                                      | **49.07**     | **%**       | 48.98         | %          | **48.96**  | **%**      | 49.03      | %           | 49.24      | %          | 50.92     | %          | 51.14     | %          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** **                                      | ** **    | ** **  |          |       | ** ** | ** ** |       |        |       |       |      |       |      |       |
| (4)          Bankshares presents cash operating earnings and  diluted cash operating earnings per share in order to assess the core  operating results of the Company.                                                                                                                                                                                                                                                                                                                                                                                          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** **                                      | ** **    |        |          | ** ** | ** ** |       |       |        |       |       |      |       |      |       |
| Net income (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** **                                      | **$**         | **168,795** | ** **    | $          | 146,169    |       | **$**      | **56,785**  | ** ** | $          | 56,313    |       | $         | 55,697     |   | $ | 50,645 |   | $ | 47,173 |   |
| Less:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | Securities (gains) and losses, net of tax       | ** **    | **(323**    | **)**         | (4,240     | )          | **1**      | ** ** | (357        | )          | 33         |      | (74        | )         | 203        |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Gains on building sales                         | ** **    | **(979**    | **)**         | (138       | )          | **(442**   | **)**      | (144        | )          | (394       | )         | —     |      | —     |   |
| Plus:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | Amortization of deposit intangibles, net of tax | ** **    | **2,478**   | ** **    | 1,151      |       | **826**    | ** ** | 826         |       | 826        |      | 670        |      | 708        |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Amortization of other intangibles, net of tax   | ** **    | **1,228**   | ** **    | 721        |       | **409**    | ** ** | 417         |       | 402        |      | 446        |      | 311        |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Restructuring expenses, net of tax              | ** **    | **1,861**   | ** **    | —     |       | **1,610**  | ** ** | 251         |       | —     |      | —     |      | —     |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Merger-related expenses, net of tax             | ** **    | **248**     | ** **    | 1,998      |       | **—** | ** ** | —      |       | 248        |      | 2,847      |      | 1,481      |   |
| Cash operating earnings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** **                                      | **$**         | **173,308** | ** **    | $          | 145,661    |       | **$**      | **59,189**  | ** ** | $          | 57,306    |       | $         | 56,812     |   | $ | 54,534 |   | $ | 49,876 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                            |          | ** **  |          |       |       | ** ** |       |        |       |       |      |       |      |       |
| Diluted net income per share (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | ** **                                      | **$**         | **2.11**    | ** **    | $          | 2.05       |       | **$**      | **0.71**    | ** ** | $          | 0.71      |       | $         | 0.69       |   | $ | 0.63 |   | $ | 0.63 |   |
| Less:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | Securities (gains) and losses, net of tax       | ** **    | **—**  | ** **    | (0.06      | )          | **—** | ** ** | —      |       | —     |      | —     |      | —     |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Gains on building sales                         | ** **    | **(0.01**   | **)**         | —     |       | **(0.01**  | **)**      | —      |       | —     |      | —     |      | —     |   |
| Plus:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | Amortization of deposit intangibles, net of tax | ** **    | **0.03**    | ** **    | 0.02       |       | **0.01**   | ** ** | 0.01        |       | 0.01       |      | 0.01       |      | 0.01       |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Amortization of other intangibles, net of tax   | ** **    | **0.02**    | ** **    | 0.01       |       | **0.01**   | ** ** | —      |       | 0.01       |      | 0.01       |      | 0.01       |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Restructuring expenses, net of tax              | ** **    | **0.02**    | ** **    | —     |       | **0.02**   | ** ** | —      |       | —     |      | —     |      | —     |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | Merger-related expenses, net of tax             | ** **    | **—**  | ** **    | 0.03       |       | **—** | ** ** | —      |       | —     |      | 0.04       |      | 0.02       |   |
| Diluted cash operating earnings per share                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | ** **                                      | **$**         | **2.17**    | ** **    | $          | 2.05       |       | **$**      | **0.74**    | ** ** | $          | 0.72      |       | $         | 0.71       |   | $ | 0.69 |   | $ | 0.67 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |                                                 |               |             |               |            |            |            |            |             |            |            |           |            |           |            |  |  |  |  |  |  |  |  |  |

 

36

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

 

Information responsive tothis item as of December 31, 2003 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, 2003. Therewas no material change in such information as of September 30, 2004.

 

# **Item4. Controls and Procedures**

 

As of September 30,2004, Bankshares’ management, under the supervision and with the participationof the Company’s principal executive officer and principal financial officer,evaluated the effectiveness of the design and operation of the Company’sdisclosure controls and procedures, as that term is defined in Rule 13a-15(e)under the Securities and Exchange Act of 1934, as amended. Based on the evaluation,the principal executive officer and principal financial officer concluded thatthe Company’s disclosure controls and procedures are effective. There were nosignificant changes in the Company’s internal controls during the last fiscalquarter.

 

# **PARTII – OTHER INFORMATION**

# ** **

# **Item1. Legal Proceedings**

 

On July 12, formeremployee John Pileggi filed suit against Mercantile Bankshares Corp.,Mercantile Safe Deposit and Trust Company and Edward J. Kelly. The complaintalleges that the public statements made by the defendants regarding thecircumstances of Mr. Pileggi’s termination gives rise to claims of libel,invasion of privacy and false light. Mr. Pileggi also alleges breach ofcontract. The complaint seeks actual and punitive damages amounting to $240 million.The Bank terminated Mr. Pileggi’s employment on March 18, 2004 for thereasons set out in a press release of that same date. Bankshares believes thesuit is without merit.

 

On September 27,2004, Mercantile Bankshares Corporation and Mercantile-Safe Deposit and TrustCompany filed a countersuit against Mr. Pileggi.  The countersuit alleges that Mr. Pileggi,during his employment with the Bank, engaged in activities that constitutedfraud, breach of contract, and breach of his fiduciary duty to the Bank,including, but not limited to, the activity described in the Bank’s pressrelease dated March 18, 2004.  Thecountersuit seeks compensatory and punitive damages amounting to $8,200,000,along with other appropriate relief.

 

**Item 6.****                      ****Exhibits and Reports on Form 8-K**

 

(a)                                  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

 

(b)                                 Reports on Form 8-K

 

Form 8-K filed, dated July 20,2004, Item 9. Regulation FD Disclosure, announced second quarter earnings.

Form 8-K filed, dated July 26,2004, Item 9. Regulation FD Disclosure, transcript of second quarter earningsconference call.

Form8-K filed, dated September 15, 2004, Item 8.01. Other Events andRegulation FD Disclosure, announced quarterly cash dividend

 

37

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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)                                                                |   |
|                  |   |   |                                                                              |   |
| November 8, 2004 |   |   |  /s/ Edward J.  Kelly, III                                                   |   |
| Date                  |   |   |  By: Edward J.  Kelly, III                                                   |   |
|                  |   |   |  Chairman of the  Board,   President and   Chief Executive Officer |   |
|                  |   |   |                                                                              |   |
| November 8, 2004 |   |   |  /s/ Terry L.  Troupe                                                        |   |
| Date                  |   |   |  By: Terry L.  Troupe                                                        |   |
|                  |   |   |  Chief Financial  Officer                                                    |   |
|                  |   |   |                                                                              |   |
| November 8, 2004 |   |   |  /s/ William T.  Skinner, Jr.                                                |   |
| Date                  |   |   |  By: William T.  Skinner, Jr.                                                |   |
|                  |   |   |  Controller                                                                  |   |

 

38

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