**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 June 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 its charter)

 

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

#### ** **

#### **2Hopkins PlazaBaltimore, 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 sincelast report)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes ý  No o

 

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

 

As of July 31, 2004,79,092,605 shares of registrant’s Common Stock, $2 par value per share, wereoutstanding.

 

 

----

 

**PART I – FINANCIAL INFORMATION**

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

 

**MERCANTILEBANKSHARES CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

 
| **(Dollars  in thousands, except per share data)**                                                                                                                                                                                                    |   | **June 30,  2004** | ** **     | **December 31,  2003** | ** ** | **June 30,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|----------------|------------------------|------------|--------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                            |   |               | ** **     |                   |       |               |       |
| Cash and due from banks                                                                                                                                                                                                                               |   | **$**              | **296,046**    | ** **             | $          | 321,882            |       | $ | 350,833 |   |
| Interest-bearing deposits in other banks                                                                                                                                                                                                              |   | **158**            | ** **     | 14,583                 |       | 258                |       |
| Federal funds sold                                                                                                                                                                                                                                    |   | **125,000**        | ** **     | 26,236                 |       | 324,274            |       |
| Securities purchased under resale agreements                                                                                                                                                                                                          |   | **—**         | ** **     | —                 |       | 100,000            |       |
| Total cash and cash equivalents                                                                                                                                                                                                                       |   | **421,204**        | ** **     | 362,701                |       | 775,365            |       |
| Investment securities available-for-sale (Note 4)                                                                                                                                                                                                     |   | **3,014,862**      | ** **     | 3,123,514              |       | 2,692,101          |       |
| Investment securities held-to-maturity (Note 4)                                                                                                                                                                                                       |   | **50,699**         | ** **     | 49,417                 |       | 51,189             |       |
| Total investment securities                                                                                                                                                                                                                           |   | **3,065,561**      | ** **     | 3,172,931              |       | 2,743,290          |       |
| Loans held-for-sale                                                                                                                                                                                                                                   |   | **747**            | ** **     | 14,925                 |       | 85,740             |       |
| Loans:                                                                                                                                                                                                                                                |   | ** **         | ** **     |                   |       |               |       |
| Commercial                                                                                                                                                                                                                                            |   | **2,723,066**      | ** **     | 2,577,021              |       | 2,314,680          |       |
| Commercial real estate                                                                                                                                                                                                                                |   | **2,910,749**      | ** **     | 2,738,832              |       | 2,145,959          |       |
| Construction                                                                                                                                                                                                                                          |   | **1,129,208**      | ** **     | 1,064,021              |       | 887,237            |       |
| Residential real estate                                                                                                                                                                                                                               |   | **1,468,804**      | ** **     | 1,335,375              |       | 1,092,785          |       |
| Consumer                                                                                                                                                                                                                                              |   | **1,472,300**      | ** **     | 1,482,860              |       | 1,031,760          |       |
| Lease financing                                                                                                                                                                                                                                       |   | **57,983**         | ** **     | 74,051                 |       | 88,510             |       |
| Total loans                                                                                                                                                                                                                                           |   | **9,762,110**      | ** **     | 9,272,160              |       | 7,560,931          |       |
| Less: allowance for loan losses                                                                                                                                                                                                                       |   | **(158,431**       | **)**          | (155,337               | )          | (142,261           | )          |
| Loans, net                                                                                                                                                                                                                                            |   | **9,603,679**      | ** **     | 9,116,823              |       | 7,418,670          |       |
| Bank premises and equipment, less accumulated depreciation of $156,722  (June 2004), $152,771 (December 2003) and $124,171 (June 2003)                                                                                                                |   | **141,523**        | ** **     | 140,922                |       | 104,099            |       |
| Other real estate owned, net                                                                                                                                                                                                                          |   | **402**            | ** **     | 191                    |       | 376                |       |
| Goodwill, net (Note 7)                                                                                                                                                                                                                                |   | **517,615**        | ** **     | 522,173                |       | 119,730            |       |
| Other intangible assets, net (Note 7)                                                                                                                                                                                                                 |   | **52,478**         | ** **     | 56,223                 |       | 16,107             |       |
| Other assets                                                                                                                                                                                                                                          |   | **326,936**        | ** **     | 308,583                |       | 232,924            |       |
| Total assets                                                                                                                                                                                                                                          |   | **$**              | **14,130,145** | ** **             | $          | 13,695,472         |       | $ | 11,496,301 |   |
|                                                                                                                                                                                                                                                  |   | ** **         | ** **     |                   |       |               |       |
| **LIABILITIES**                                                                                                                                                                                                                                       |   | ** **         | ** **     |                   |       |               |       |
| Deposits:                                                                                                                                                                                                                                             |   | ** **         | ** **     |                   |       |               |       |
| Noninterest-bearing deposits                                                                                                                                                                                                                          |   | **$**              | **3,043,242**  | ** **             | $          | 2,750,721          |       | $ | 2,276,408 |   |
| Interest-bearing deposits                                                                                                                                                                                                                             |   | **7,600,452**      | ** **     | 7,511,832              |       | 6,359,166          |       |
| Total deposits                                                                                                                                                                                                                                        |   | **10,643,694**     | ** **     | 10,262,553             |       | 8,635,574          |       |
| Short-term borrowings                                                                                                                                                                                                                                 |   | **891,879**        | ** **     | 809,021                |       | 816,309            |       |
| Accrued expenses and other liabilities                                                                                                                                                                                                                |   | **115,705**        | ** **     | 134,735                |       | 90,291             |       |
| Long-term debt                                                                                                                                                                                                                                        |   | **637,570**        | ** **     | 647,722                |       | 578,533            |       |
| Total liabilities                                                                                                                                                                                                                                     |   | **12,288,848**     | ** **     | 11,854,031             |       | 10,120,707         |       |
|                                                                                                                                                                                                                                                  |   | ** **         | ** **     |                   |       |               |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                         |   | ** **         | ** **     |                   |       |               |       |
| Preferred stock, no par value; authorized 2,000,000 shares; issued and  outstanding - None                                                                                                                                                            |   | ** **         | ** **     |                   |       |               |       |
| Common stock, $2 par value; authorized 130,000,000 shares; issued  shares - 79,088,986 (June 2004), 79,772,705 (December 2003) and 69,093,254  (June 2003); restricted shares - 137,278 (June 2004), 121,369 (December 2003)  and 171,369 (June 2003) |   | **158,178**        | ** **     | 159,545                |       | 138,187            |       |
| Capital surplus                                                                                                                                                                                                                                       |   | **522,758**        | ** **     | 548,664                |       | 128,714            |       |
| Retained earnings                                                                                                                                                                                                                                     |   | **1,168,462**      | ** **     | 1,110,748              |       | 1,063,381          |       |
| Accumulated other comprehensive income (loss)                                                                                                                                                                                                         |   | **(8,101**         | **)**          | 22,484                 |       | 45,312             |       |
| Total shareholders’ equity                                                                                                                                                                                                                       |   | **1,841,297**      | ** **     | 1,841,441              |       | 1,375,594          |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                                                       |   | **$**              | **14,130,145** | ** **             | $          | 13,695,472         |       | $ | 11,496,301 |   |

 

See notes to consolidatedfinancial statements

 

2

----

 

**MERCANTILEBANKSHARES CORPORATION**

**STATEMENTSOF CONSOLIDATED INCOME**

 
| ** **                                              | ** ** | **For the 6 Months  Ended  June 30,** | ** **  | **For the 3 Months  Ended  June 30,** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------|-------------|--------------------------------------------|------------|
| **(Dollars  in thousands, except per share data)**      | ** ** | **2004**                                   | ** **  | **2003**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **INTEREST INCOME**                                     |       |                                       |        |                                       |       |   |   |   |   |
| Interest and fees on loans                              | ** ** | **$**                                      | **261,176** |                                       | $          | 222,954 | ** ** | **$** | **132,116** |   | $ | 111,962 |   |
| Interest and dividends on investment securities:        |       |                                       |        |                                       |       |   |   |   |   |
| Taxable interest income                                 | ** ** | **53,566**                                 |        | 53,822                                     | ** ** | **26,165** |   | 26,638 |   |
| Tax-exempt interest income                              | ** ** | **1,697**                                  |        | 964                                        | ** ** | **820** |   | 497 |   |
| Dividends                                               | ** ** | **561**                                    |        | 428                                        | ** ** | **300** |   | 199 |   |
| Other investment income (losses)                        | ** ** | **2,969**                                  |        | 2,882                                      | ** ** | **(372** | ) | 2,318 |   |
| Total interest and dividends on investment securities   | ** ** | **58,793**                                 |        | 58,096                                     | ** ** | **26,913** |   | 29,652 |   |
| Other interest income                                   | ** ** | **764**                                    |        | 2,040                                      | ** ** | **589** |   | 1,314 |   |
| Total interest income                                   | ** ** | **320,733**                                |        | 283,090                                    | ** ** | **159,618** |   | 142,928 |   |
| **INTEREST EXPENSE**                                    |       |                                       |        |                                       |       |   |   |   |   |
| Interest on deposits                                    | ** ** | **40,640**                                 |        | 48,579                                     | ** ** | **19,873** |   | 23,450 |   |
| Interest on short-term borrowings                       | ** ** | **2,899**                                  |        | 3,014                                      | ** ** | **1,480** |   | 1,469 |   |
| Interest on long-term debt                              | ** ** | **10,460**                                 |        | 7,648                                      | ** ** | **5,205** |   | 5,286 |   |
| Total interest expense                                  | ** ** | **53,999**                                 |        | 59,241                                     | ** ** | **26,558** |   | 30,205 |   |
| **NET INTEREST INCOME**                                 | ** ** | **266,734**                                |        | 223,849                                    | ** ** | **133,060** |   | 112,723 |   |
| Provision for loan losses                               | ** ** | **4,779**                                  |        | 6,067                                      | ** ** | **2,353** |   | 3,051 |   |
| **NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES** | ** ** | **261,955**                                |        | 217,782                                    | ** ** | **130,707** |   | 109,672 |   |
| **NONINTEREST INCOME**                                  |       |                                       |        |                                       |       |   |   |   |   |
| Investment and wealth management                        | ** ** | **44,919**                                 |        | 36,873                                     | ** ** | **22,936** |   | 19,508 |   |
| Service charges on deposit accounts                     | ** ** | **20,470**                                 |        | 16,371                                     | ** ** | **10,351** |   | 8,311 |   |
| Mortgage banking related fees                           | ** ** | **5,233**                                  |        | 4,895                                      | ** ** | **2,293** |   | 2,507 |   |
| Investment securities gains                             | ** ** | **535**                                    |        | 7,351                                      | ** ** | **590** |   | 6,536 |   |
| Other income                                            | ** ** | **30,278**                                 |        | 17,800                                     | ** ** | **15,380** |   | 8,575 |   |
| Total noninterest income                                | ** ** | **101,435**                                |        | 83,290                                     | ** ** | **51,550** |   | 45,437 |   |
| **NONINTEREST EXPENSES**                                |       |                                       |        |                                       |       |   |   |   |   |
| Salaries                                                | ** ** | **89,477**                                 |        | 70,732                                     | ** ** | **44,689** |   | 36,317 |   |
| Employee benefits                                       | ** ** | **23,441**                                 |        | 18,747                                     | ** ** | **10,928** |   | 9,319 |   |
| Net occupancy expense of bank premises                  | ** ** | **11,879**                                 |        | 8,315                                      | ** ** | **5,819** |   | 4,219 |   |
| Furniture and equipment expenses                        | ** ** | **14,937**                                 |        | 13,542                                     | ** ** | **7,573** |   | 6,743 |   |
| Communications and supplies                             | ** ** | **8,499**                                  |        | 6,617                                      | ** ** | **4,195** |   | 3,181 |   |
| Other expenses                                          | ** ** | **38,520**                                 |        | 28,877                                     | ** ** | **20,163** |   | 17,270 |   |
| Total noninterest expenses                              | ** ** | **186,753**                                |        | 146,830                                    | ** ** | **93,367** |   | 77,049 |   |
| Income before income taxes                              | ** ** | **176,637**                                |        | 154,242                                    | ** ** | **88,890** |   | 78,060 |   |
| Applicable income taxes                                 | ** ** | **64,627**                                 |        | 55,246                                     | ** ** | **32,577** |   | 28,050 |   |
| **NET INCOME**                                          | ** ** | **$**                                      | **112,010** |                                       | $          | 98,996 | ** ** | **$** | **56,313** |   | $ | 50,010 |   |
| **NET INCOME PER SHARE OF COMMON STOCK (Note 3):**      |       |                                       |        |                                       |       |   |   |   |   |
| Basic                                                   | ** ** | **$**                                      | **1.41**    |                                       | $          | 1.44 | ** ** | **$** | **0.71** |   | $ | 0.73 |   |
| Diluted                                                 | ** ** | **$**                                      | **1.40**    |                                       | $          | 1.43 | ** ** | **$** | **0.71** |   | $ | 0.72 |   |
| **DIVIDENDS PAID PER COMMON SHARE**                     | ** ** | **$**                                      | **0.68**    |                                       | $          | 0.63 | ** ** | **$** | **0.35** |   | $ | 0.33 |   |

 

See notes to consolidatedfinancial statements

 

3

----

 

**MERCANTILEBANKSHARES CORPORATION**

**STATEMENTSOF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY**

 

**For The SixMonths Ended June 30, 2004 and 2003**

 
| **(Dollars  in thousands, except per share data)**                                                            | ** ** | **Total** | ** **    | **CommonStock** | ** ** | **CapitalSurplus** | ** ** | **RetainedEarnings** | ** **  | **Accumulated  Other  ComprehensiveIncome (Loss)** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------|---------------|-----------------|------------|--------------------|------------|----------------------|-------------|----------------------------------------------------|------------|
| BALANCE, DECEMBER 31, 2002                                                                                    |       | $         | 1,324,358     |            | $          | 137,672            |       | $                    | 120,577     |                                               | $          | 1,010,248 |   | $ | 55,861 |   |
| Net income                                                                                                    |       | 98,996    |          |            |       |               |       | 98,996               |        |                                               |       |
| Unrealized gains (losses) on securities available-for-sale, net of  reclassification adjustment, net of taxes |       | (10,549   | )             |            |       |               |       |                 |        | (10,549                                            | )          |
| Comprehensive income                                                                                          |       | 88,447    |          |            |       |               |       |                 |        |                                               |       |
| Cash dividends paid:                                                                                          |       |      |          |            |       |               |       |                 |        |                                               |       |
| Common stock ($.63 per share)                                                                                 |       | (43,365   | )             |            |       |               |       | (43,365              | )           |                                               |       |
| Issuance of 60,823 shares for dividend reinvestment and stock purchase  plan                                  |       | 2,119     |          | 122             |       | 1,997              |       |                 |        |                                               |       |
| Issuance of 12,249 shares for employee stock purchase dividend  reinvestment plan                             |       | 455       |          | 25              |       | 430                |       |                 |        |                                               |       |
| Issuance of 89,053 shares for employee stock option plan                                                      |       | 1,540     |          | 177             |       | 1,363              |       |                 |        |                                               |       |
| Issuance of 100,537 shares for restricted stock awards                                                        |       | 3,561     |          | 202             |       | 3,359              |       |                 |        |                                               |       |
| Deferred compensation – restricted stock awards                                                          |       | (2,498    | )             |            |       |               |       | (2,498               | )           |                                               |       |
| Purchase of 5,500 shares under stock repurchase plan                                                          |       | (212      | )             | (11             | )          | (201               | )          |                 |        |                                               |       |
| Vested stock options                                                                                          |       | 1,189     |          | —          |       | 1,189              |       | —               |        | —                                             |       |
| BALANCE, JUNE 30, 2003                                                                                        |       | $         | 1,375,594     |            | $          | 138,187            |       | $                    | 128,714     |                                               | $          | 1,063,381 |   | $ | 45,312 |   |
| BALANCE, DECEMBER 31, 2003                                                                                    |       | $         | 1,841,441     |            | $          | 159,545            |       | $                    | 548,664     |                                               | $          | 1,110,748 |   | $ | 22,484 |   |
| Net income                                                                                                    |       | 112,010   |          |            |       |               |       | 112,010              |        |                                               |       |
| Unrealized gains (losses) on securities available-for-sale, net of  reclassification adjustment, net of taxes |       | (30,585   | )             |            |       |               |       |                 |        | (30,585                                            | )          |
| Comprehensive income                                                                                          |       | 81,425    |          |            |       |               |       |                 |        |                                               |       |
| Cash dividends paid:                                                                                          |       |      |          |            |       |               |       |                 |        |                                               |       |
| Common stock ($.68 per share)                                                                                 |       | (53,957   | )             |            |       |               |       | (53,957              | )           |                                               |       |
| Issuance of 61,696 shares for dividend reinvestment and stock purchase  plan                                  |       | 2,639     |          | 123             |       | 2,516              |       |                 |        |                                               |       |
| Issuance of 12,660 shares for employee stock purchase dividend  reinvestment plan                             |       | 557       |          | 25              |       | 532                |       |                 |        |                                               |       |
| Issuance of 215,631 shares for employee stock option plan                                                     |       | 3,894     |          | 432             |       | 3,462              |       |                 |        |                                               |       |
| Issuance of 26,294 shares for restricted stock awards                                                         |       | 1,199     |          | 53              |       | 1,146              |       |                 |        |                                               |       |
| Deferred compensation, net – restricted stock awards                                                     |       | (285      | )             |            |       |               |       | (285                 | )           |                                               |       |
| Transfer opening balance related to directors’ deferred compensation  plan                               |       | 6,406     |          |            |       | 6,406              |       |                 |        |                                               |       |
| Directors’ deferred compensation plan contribution                                                       |       | 196       |          |            |       | 196                |       |                 |        |                                               |       |
| Directors’ deferred compensation plan – dividend                                                    |       | —    |          |            |       | 54                 |       | (54                  | )           |                                               |       |
| Purchase of 1,000,000 shares under stock repurchase plan                                                      |       | (44,110   | )             | (2,000          | )          | (42,110            | )          |                 |        |                                               |       |
| Vested stock options                                                                                          |       | 1,892     |          | —          |       | 1,892              |       | —               |        | —                                             |       |
| **BALANCE, JUNE 30, 2004**                                                                                    | ** ** | **$**     | **1,841,297** | ** **      | **$**      | **158,178**        | ** ** | **$**                | **522,758** | ** **                                         | **$**      | **1,168,462** | ** ** | **$** | **(8,101** | **)** |

 

See notes to consolidatedfinancial statements

 

4

----

 

**MERCANTILEBANKSHARES CORPORATION**

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

 
| **Increase (decrease) in cash and  cash equivalents**                              | ** ** | **For the 6 Months Ended**

**June 30,** | ** **  |
|------------------------------------------------------------------------------------|------------|------------------------------------------|-------------|
| **(Dollars in thousands)**                                                         | ** ** | **2004**                                 | ** **  | **2003** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                          |       |                                     | ** **  |   |   |
| Net income                                                                         | ** ** | **$**                                    | **112,010** | ** ** | $ | 98,996 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                                     | ** **  |   |   |
| Provision for loan losses                                                          | ** ** | **4,779**                                | ** **  | 6,067 |   |
| Depreciation and amortization                                                      | ** ** | **7,787**                                | ** **  | 6,331 |   |
| Amortization of other intangible assets                                            | ** ** | **4,088**                                | ** **  | 1,409 |   |
| Investment securities gains                                                        | ** ** | **(535**                                 | **)**       | (7,351 | ) |
| Write-downs (income) of investments in private equity funds                        | ** ** | **(229**                                 | **)**       | 188 |   |
| Gains on sales of other real estate owned                                          | ** ** | **(13**                                  | **)**       | (268 | ) |
| Gains on sales of buildings                                                        | ** ** | **(963**                                 | **)**       | (228 | ) |
| Net (increase) decrease in assets:                                                 |       |                                     | ** **  |   |   |
| Interest receivable                                                                | ** ** | **3,954**                                | ** **  | 5,036 |   |
| Other receivables                                                                  | ** ** | **3,751**                                | ** **  | (7,564 | ) |
| Bank-owned life insurance                                                          | ** ** | **(1,579**                               | **)**       | (868 | ) |
| Other assets                                                                       | ** ** | **(4,864**                               | **)**       | 1,104 |   |
| Loans held-for-sale                                                                | ** ** | **14,178**                               | ** **  | (85,740 | ) |
| Net increase (decrease) in liabilities:                                            |       |                                     | ** **  |   |   |
| Interest payable                                                                   | ** ** | **(1,125**                               | **)**       | 921 |   |
| Accrued expenses                                                                   | ** ** | **(9,788**                               | **)**       | (2,182 | ) |
| Taxes payable                                                                      | ** ** | **(5,278**                               | **)**       | (4,094 | ) |
| Net cash provided by operating activities                                          | ** ** | **126,173**                              | ** **  | 11,757 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                          |       |                                     | ** **  |   |   |
| Proceeds from maturities of investment securities held-to-maturity                 | ** ** | **3,913**                                | ** **  | 4,603 |   |
| Proceeds from maturities of investment securities available-for-sale               | ** ** | **532,465**                              | ** **  | 439,129 |   |
| Proceeds from sales of investment securities  available-for-sale              | ** ** | **42,055**                               | ** **  | 399,958 |   |
| Purchases of investment securities held-to-maturity                                | ** ** | **(5,195**                               | **)**       | (2,401 | ) |
| Purchases of investment securities available-for-sale                              | ** ** | **(514,304**                             | **)**       | (954,481 | ) |
| Net increase in customer loans                                                     | ** ** | **(493,705**                             | **)**       | (251,555 | ) |
| Proceeds from sales of other real estate owned                                     | ** ** | **75**                                   | ** **  | 268 |   |
| Capital expenditures                                                               | ** ** | **(5,403**                               | **)**       | (8,376 | ) |
| Proceeds from sales of buildings                                                   | ** ** | **2,594**                                | ** **  | 602 |   |
| Business acquisitions (net of cash received)                                       | ** ** | **—**                               | ** **  | (28,530 | ) |
| Other investing activity                                                           | ** ** | **(2,956**                               | **)**       | (1,085 | ) |
| Net cash used in investing activities                                              | ** ** | **(440,461**                             | **)**       | (401,868 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                          |       |                                     | ** **  |   |   |
| Net increase in noninterest-bearing deposits                                       | ** ** | **292,521**                              | ** **  | 189,663 |   |
| Net increase in checking plus interest and savings accounts                        | ** ** | **178,657**                              | ** **  | 150,951 |   |
| Net (decrease) increase in certificates of deposit                                 | ** ** | **(90,037**                              | **)**       | 34,020 |   |
| Net increase (decrease) in short-term borrowings                                   | ** ** | **82,858**                               | ** **  | (7,076 | ) |
| Proceeds from issuance of long-term debt                                           | ** ** | **—**                               | ** **  | 300,000 |   |
| Repayment of long-term debt                                                        | ** ** | **(231**                                 | **)**       | (8,400 | ) |
| Proceeds from issuance of shares                                                   | ** ** | **7,090**                                | ** **  | 4,114 |   |
| Repurchase of common shares                                                        | ** ** | **(44,110**                              | **)**       | (212 | ) |
| Dividends paid                                                                     | ** ** | **(53,957**                              | **)**       | (43,365 | ) |
| Net cash provided by financing activities                                          | ** ** | **372,791**                              | ** **  | 619,695 |   |
| Net increase in cash and cash equivalents                                          | ** ** | **58,503**                               | ** **  | 229,584 |   |
| Cash and cash equivalents at beginning of period                                   | ** ** | **362,701**                              | ** **  | 545,781 |   |
| Cash and cash equivalents at end of period                                         | ** ** | **$**                                    | **421,204** | ** ** | $ | 775,365 |   |
| **SUPPLEMENTAL INFORMATION**                                                       |       |                                     | ** **  |   |   |
| Cash payments for interest                                                         | ** ** | **$**                                    | **55,125**  | ** ** | $ | 58,321 |   |
| Cash payments for income taxes                                                     | ** ** | **62,571**                               | ** **  | 50,199 |   |

 

See notes to consolidatedfinancial statements

 

5

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**MERCANTILEBANKSHARES CORPORATION**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

1. Basis of Presentation

 

The consolidated financialstatements, which include the accounts of Mercantile Bankshares Corporation(“Bankshares”) (Nasdaq: MRBK) and all of its affiliates, are prepared inconformity with accounting principles generally accepted in the United Statesof America and follow 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 conformwith current period presentation.

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andcontingent assets and liabilities in the financial statements, and thedisclosure of revenue and expenses during the reporting period.  These assumptions are based on informationavailable as of the date of the financial statements and could differ fromactual results.  See Annual Report onForm 10-K for more detail.

 

2. Business Combinations

 

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.  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 June 30, 2004.

 

On August 12, 2003,Bankshares completed its acquisition of F&M Bancorp (“F&M”), a bankholding company headquartered in Frederick, Maryland.  The total consideration paid to F&Mshareholders in connection with the acquisition was $124.1 million in cash and10.4 million shares of Bankshares’ common stock.  F&M transactions have been included inBankshares’ financial results since August 13, 2003.  Acquired assets on August 12, 2003 totaled$2.2 billion, including $1.4 billion of loans and leases; liabilities assumedwere $2.0 billion, including $1.7 billion of deposits. As of June 30, 2004,Bankshares had recorded $395.8 million of goodwill, $36.0 million of coredeposit intangible, $5.8 million of mostly client relationship intangibles(relating to the two insurance subsidiaries) and $1.1 million in a trademarkintangible. The weighted average amortization period for the newly-acquiredcore deposit intangible is nine years, and the client-relationship identifiedintangible ranges from three to fifteen years. On October 24, 2003, certainassets and liabilities of F&M were transferred to other Banksharesaffiliates in order to align customers’ accounts with the Bankshares’ affiliateserving the geographic area where those customers reside.

 

6

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3. Earnings Per Share

 

Basic earnings per share(“EPS”) are computed by dividing income available to common shareholders byweighted average common shares outstanding. Diluted EPS are computed using the same components as basic EPS with thedenominator adjusted for the dilutive effect of stock awards.  The following tables provide reconciliationbetween the computation of basic EPS and diluted EPS for the six months andquarters ended June 30, 2004 and 2003, respectively.

 
| ** **                                                   | ** ** | **For the 6 Months Ended June 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                                                    | ** ** | **$**                               | **112,010** | ** ** | **79,422** | ** ** | **$** | **1.41** |   | $ | 98,996 |   | 68,815 |   | $ | 1.44 |   |
| Dilutive effect of stock options and restricted stock awards | ** ** | ** **                          |        | **510** |   |   |   |   |   | 438 |   |   |   |
| Vested directors deferred compensation plan shares           | ** ** | ** **                          |        | **75** |   |   |   |   |   | — |   |   |   |
| Diluted EPS                                                  | ** ** | **$**                               | **112,010** | ** ** | **80,007** | ** ** | **$** | **1.40** |   | $ | 98,996 |   | 69,253 |   | $ | 1.43 |   |

 
| ** **                                                   | ** ** | **For the 3 Months Ended June 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                                                    | ** ** | **$**                               | **56,313** | ** ** | **79,119** | ** ** | **$** | **0.71** |   | $ | 50,010 |   | 68,860 |   | $ | 0.73 |   |
| Dilutive effect of stock options and restricted stock awards | ** ** | ** **                          |       | **483** |   |   |   |   |   | 458 |   |   |   |
| Vested directors deferred compensation plan shares           | ** ** | ** **                          |       | **149** |   |   |   |   |   | — |   |   |   |
| Diluted EPS                                                  | ** ** | **$**                               | **56,313** | ** ** | **79,751** | ** ** | **$** | **0.71** |   | $ | 50,010 |   | 69,318 |   | $ | 0.72 |   |

 

Antidilutive options andawards excluded from the computation of diluted earnings per share were 445,909and 238,838 for the six months ended June 30, 2004 and 2003, respectively, and593,500 and 249,978 for the second quarter of 2004 and 2003, respectively.

 

# **4. Investment Securities**

 

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

 
| ** **                        | ** ** | **June 30, 2004**   | ** **    | **December 31, 2003** | ** ** | **June 30, 2003**   | ** ** |
|-----------------------------------|------------|---------------------|---------------|-----------------------|------------|---------------------|------------|
| **(Dollars  in thousands)**       | ** ** | **Amortized  Cost** | ** **    | **Fair  Value**       | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
| Securities available-for-sale     |       |                |          |                  |       |                |       |   |   |   |   |   |   |
| U.S. Treasury                     |       | **$**               | **761,492**   | ** **            | **$**      | **770,566**         | ** ** | $ | 823,356 |   | $ | 845,754 |   | $ | 950,507 |   | $ | 988,831 |   |
| U.S. Government agencies          |       | **805,462**         | ** **    | **806,149**           | ** ** | 778,916             |       | 793,611 |   | 657,177 |   | 685,061 |   |
| Mortgage-backed securities        |       | **1,246,021**       | ** **    | **1,221,506**         | ** ** | 1,288,109           |       | 1,283,630 |   | 927,625 |   | 933,508 |   |
| States and political subdivisions |       | **69,019**          | ** **    | **69,284**            | ** ** | 77,897              |       | 79,870 |   | 449 |   | 477 |   |
| Other investments                 |       | **145,375**         | ** **    | **147,357**           | ** ** | 118,948             |       | 120,649 |   | 83,694 |   | 84,224 |   |
| Total                             |       | **$**               | **3,027,369** | ** **            | **$**      | **3,014,862**       | ** ** | $ | 3,087,226 |   | $ | 3,123,514 |   | $ | 2,619,452 |   | $ | 2,692,101 |   |
|                              |       | ** **          | ** **    | ** **            | ** ** |                |       |   |   |   |   |   |   |
| Securities held-to-maturity       |       | ** **          | ** **    | ** **            | ** ** |                |       |   |   |   |   |   |   |
| States and political subdivisions |       | **$**               | **25,663**    | ** **            | **$**      | **26,590**          | ** ** | $ | 28,213 |   | $ | 30,115 |   | $ | 36,224 |   | $ | 39,239 |   |
| Other investments                 |       | **25,036**          | ** **    | **25,036**            | ** ** | 21,204              |       | 21,204 |   | 14,965 |   | 14,965 |   |
| Total                             |       | **$**               | **50,699**    | ** **            | **$**      | **51,626**          | ** ** | $ | 49,417 |   | $ | 51,319 |   | $ | 51,189 |   | $ | 54,204 |   |

 

7

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# **5. Impaired Loans**

 

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.

 

 Under Statements of Financial AccountingStandards (SFAS) Nos. 114 and 118, “Accounting by Creditors for Impairment of aLoan-an amendment of FASB Statements No. 5 and 15,” a loan is consideredimpaired, based on current information and events, if it is probable thatBankshares will not collect all principal and interest payments according tothe contractual terms of the loan agreement. The impairment of a loan ismeasured based on the present value of expected future cash flows discounted atthe loan’s effective interest rate, or the fair value of the collateral if therepayment is expected to be provided predominantly by the underlyingcollateral. A majority of Bankshares’ impaired loans are measured by referenceto the fair value of the collateral. Information with respect toimpaired loans and the related valuation allowance (if the measure of theimpaired loan is less than the recorded investment) at June 30, 2004, December31, 2003 and June 30, 2003 is shown below. See Annual Report on Form 10-K for more detail.

 
| **(Dollars  in thousands)**                                                      | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** | **June 30,  2003** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|--------------------|------------|
| Impaired loans with a specific valuation allowance                               |       | $                  | 24,864     |                   | $          | 26,715             |       | $ | 18,523 |   |
| All other impaired loans                                                         |       | 12,160             |       | 18,692                 |       | 15,066             |       |
| Total impaired loans                                                             |       | $                  | 37,024     |                   | $          | 45,407             |       | $ | 33,589 |   |
|                                                                             |       |               |       |                   |       |               |       |
| Specific allowance for loan losses applicable to impaired loans                  |       | $                  | 14,497     |                   | $          | 14,925             |       | $ | 8,840 |   |
| General allowance for loan losses applicable to other than impaired  loans       |       | 143,934            |       | 140,412                |       | 133,421            |       |
| Total allowance for loan losses                                                  |       | $                  | 158,431    |                   | $          | 155,337            |       | $ | 142,261 |   |
|                                                                             |       |               |       |                   |       |               |       |
| Year-to-date interest income on impaired loans recorded on the cash  basis       |       | $                  | 212        |                   | $          | 443                |       | $ | 155 |   |
| Year-to-date average recorded investment in impaired loans during the  period    |       | $                  | 41,116     |                   | $          | 31,241             |       | $ | 26,438 |   |
| Quarter-to-date interest income on impaired loans recorded on the cash  basis    |       | $                  | 109        |                   | $          | 223                |       | $ | 58 |   |
| Quarter-to-date average recorded investment in impaired loans during  the period |       | $                  | 39,752     |                   | $          | 37,382             |       | $ | 28,822 |   |

 

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

 

6. Commitments

 

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 extendcredit are agreements to lend to a customer as long as there is no violation ofany condition 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 $3.9 billion at June 30,2004, $3.6 billion at December 31, 2003, and $2.8 billion at June 30, 2003.

 

Letters of credit arecommitments issued to guarantee the performance of a customer to a third party.Outstanding letters of credit were $320.9 million at June 30, 2004, $281.4million at December 31, 2003 and $245.2 million at June 30, 2003.  Fees received for issuing letters of creditare deferred and amortized over the life of the commitment.  The fees on letters of credit at June 30,2004, December 31, 2003, and June 30, 2003 had a carrying value of $1.2million, $1.0 million and $0.4 million, respectively, representing unamortizedfees.

 

8

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Bankshares’ mortgagebanking subsidiary is a Fannie Mae Delegated Underwriting and Servicing lender,and has a loss sharing arrangement for loans originated on behalf of and soldto Fannie Mae.  The unamortized principalbalance of the underlying loans totaled $183.9 million, $149.4 million and$123.6 million at June 30, 2004, December 31, 2003 and June 30, 2003,respectively.  No loss reserve has beenestablished for possible 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 June 30, 2004.  The mortgage subsidiary also has originatedand sold loans with recourse in the event of foreclosure on the underlying realestate.  The unamortized amount ofprincipal balance of loans sold with recourse totaled $2.0 million at June 30,2004, $2.3 million at December 31, 2003 and $2.8 million at June 30, 2003.  These mortgages are generally in goodstanding, are well-collateralized and no loss has ensued and no future loss isexpected.

 

Bankshares has committedto invest funds in third-party private equity investments. At June 30, 2004,December 31, 2003 and June 30, 2003, $18.7 million, $16.1 million and $18.0million, respectively, remained unfunded.

 

# **7. Goodwill and Other IntangibleAssets**

 

Goodwill decreased by$4.6 million during the second quarter of 2004. This decrease was related to finalizing F&M’s purchase accountingadjustments.

 

The following tablediscloses the gross carrying amount and accumulated amortization of intangibleassets subject to amortization at June 30, 2004 and December 31, 2003:

 
| ** **                  | ** ** | **June 30, 2004**          | ** ** | **December 31, 2003**         | ** ** |
|-----------------------------|------------|----------------------------|------------|-------------------------------|------------|
| **(Dollars  in thousands)** | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** |
| Deposit intangibles         |       | **$**                      | **49,881** | ** **                    | **$**      | **(12,280** | **)** | **$** | **37,601** |   | $ | 49,881 |   | $ | (9,546 | ) | $ | 40,335 |   |
| Mortgage servicing rights   |       | **2,670**                  | ** ** | **(1,957**                    | **)**      | **713** |   | 2,351 |   | (1,790 | ) | 561 |   |
| Customer lists and other    |       | **17,010**                 | ** ** | **(2,846**                    | **)**      | **14,164** |   | 17,010 |   | (1,683 | ) | 15,327 |   |
| Total                       |       | **$**                      | **69,561** | ** **                    | **$**      | **(17,083** | **)** | **$** | **52,478** |   | $ | 69,242 |   | $ | (13,019 | ) | $ | 56,223 |   |

 

The projections ofamortization expense shown for mortgage servicing rights are based on assetbalances and the interest rate environment as of June 30, 2004. Futureamortization expense may be significantly different depending upon changes inthe mortgage servicing portfolio, mortgage interest rates and marketconditions.

 

The following table showsthe current period and estimated future amortization expense for amortizedintangible assets. Identifiable intangible assets are amortized based on estimatedlives of up to 15 years. Bankshares recorded $36.0 million of core depositintangibles and $6.9 million in customer list and other intangibles inconjunction with the F&M acquisition. Management reviews other intangibleassets for impairment yearly, or whenever events or changes in circumstancesindicate that their carrying amounts may not be recoverable. For thoseintangible assets subject to amortization, impairment is indicated if the sumof undiscounted estimated future net cash flow is less than the carrying amountof the asset. Impairment is recognized by writing down the carrying value ofthe asset. Any impairment recognized in a valuation account is reflected in theincome statement in the corresponding period. Bankshares recorded a $124 thousandimpairment in the second quarter of 2004 for mortgage servicing rights. Themortgage servicing impairment valuation increased to $293 thousand at June 30,2004 compared to $169 thousand at December 31, 2003.

 

The following table showsthe current period and estimated future amortization expense for amortizedintangible assets.

 
| **(Dollars  in thousands)**                       | ** ** | ** ** | ** ** | **Core  deposit  intangibles** | ** ** | **Mortgage  servicing  intangibles** | ** ** | **Customer lists  and other  intangibles** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|------------|------------|--------------------------------|------------|--------------------------------------|------------|--------------------------------------------|------------|-----------|------------|
| Six months ended June 30, 2004 (actual)           | ** ** | ** ** | ** ** | **$**                          | **2,734**  | ** **                           | **$**      | **182**                                    | ** ** | **$**     | **1,172**  | ** ** | **$** | **4,088** | ** ** |
| Six months ended December 31, 2004 (estimated)    |       |       |       | 2,734                          |       | 152                                  |       | 1,163                                      |       | 4,049     |       |
| Twelve months ended December 31, 2004 (estimated) |       |       |       | 5,468                          |       | 334                                  |       | 2,335                                      |       | 8,137     |       |
|                                              |       |       |       |                           |       |                                 |       |                                       |       |      |       |
| Estimate for year ended December 31,              |       | 2005       |       | 5,467                          |       | 342                                  |       | 2,326                                      |       | 8,135     |       |
|                                              |       | 2006       |       | 5,467                          |       | 219                                  |       | 2,083                                      |       | 7,769     |       |
|                                              |       | 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 tablesummarizes the market value change and related tax effect of unrealized gains(losses) on securities available-for-sale for the six months ended June 30,2004 and 2003.  The net amount isincluded in accumulated other comprehensive income (loss) in the Statements ofChanges in Consolidated Shareholders’ Equity.

 
| ** **                                                            | ** ** | **For the 6 Months Ended June 30,** | ** **  |
|-----------------------------------------------------------------------|------------|-------------------------------------|-------------|
| ** **                                                            | ** ** | **2004**                            | ** **  | **2003** | ** ** |
| **(Dollars  in thousands)**                                           | ** ** | **Pretax  Amount**                  | ** **  | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** | **Pretax  Amount** | ** ** | **Tax  (Expense)  Benefit** | ** ** | **Net  Amount** | ** ** |
| Unrealized gains (losses) on securities available-for-sale:           |       |                                |        |   |   |   |   |   |   |   |   |   |   |
| Unrealized holding gains (losses) arising during the period           | ** ** | **$**                               | **(48,260** | **)** | **$** | **17,998** | ** ** | **$** | **(30,262** | **)** | $ | (9,484 | ) | $ | 3,379 |   | $ | (6,105 | ) |
| Reclassification adjustment for (gains) losses included in net income | ** ** | **(535**                            | **)**       | **212** | ** ** | **(323** | **)** | (7,351 | ) | 2,907 |   | (4,444 | ) |
| Total                                                                 | ** ** | **$**                               | **(48,795** | **)** | **$** | **18,210** | ** ** | **$** | **(30,585** | **)** | $ | (16,835 | ) | $ | 6,286 |   | $ | (10,549 | ) |

 

# **9. Capital Adequacy**

 

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 June 30, 2004, Bankshares and all ofits bank affiliates exceeded all capital adequacy requirements to be consideredwell capitalized.

 

Capital ratios and theamounts used to calculate them are presented in the following table forBankshares and Mercantile-Safe Deposit & Trust Company (MSD&T), thelead bank, as of June 30, 2004 and December 31, 2003.

 
| ** **                    | ** ** | **June 30, 2004** | ** **    | **December 31, 2003** | ** ** |
|-------------------------------|------------|-------------------|---------------|-----------------------|------------|
| **(Dollars  in thousands)**   | ** ** | **Bankshares**    | ** **    | **MSD&T**         | ** ** | **Bankshares** | ** ** | **MSD&T** | ** ** |
|                          |       |              |          |                  |       |   |   |   |   |
| Tier I capital                |       | **$**             | **1,286,355** | ** **            | **$**      | **401,076** | ** ** | $ | 1,248,492 |   | $ | 396,186 |   |
| Total risk-based capital      |       | **1,707,056**     | ** **    | **446,391**           | ** ** | 1,666,064 |   | 440,479 |   |
| Net risk-weighted assets      |       | **10,552,378**    | ** **    | **3,607,148**         | ** ** | 10,020,487 |   | 3,529,223 |   |
| Adjusted average total assets |       | **13,290,852**    | ** **    | **4,433,480**         | ** ** | 13,011,399 |   | 4,353,713 |   |
|                          |       | ** **        | ** **    | ** **            | ** ** |   |   |   |   |
| Tier I capital ratio          |       | **12.19**         | **%**         | **11.12**             | **%**      | 12.46 | % | 11.23 | % |
| Total capital ratio           |       | **16.18**         | **%**         | **12.38**             | **%**      | 16.63 | % | 12.48 | % |
| Leverage ratio                |       | **9.68**          | **%**         | **9.05**              | **%**      | 9.60 | % | 9.10 | % |
|                               |            |                   |               |                       |            |  |  |  |  |  |  |  |  |

 

Bankshareshas an ongoing share repurchase program. At June 30, 2004 there were 476,327 shares remaining for repurchase ofthe 2,000,000 shares previously authorized by the Board of Directors onDecember 11, 2001.  For the six monthsended June 30, 2004 and the twelve months ended December 31, 2003, 1,000,000and 5,500 shares, respectively, were repurchased by Bankshares.  In April 2004, Bankshares entered into aprivately negotiated agreement for the accelerated repurchase of the onemillion shares.  Shares repurchased in2003 were acquired in open market transactions.

 

10

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10. Segment Reporting

 

Operating segments asdefined by SFAS No. 131 *Disclosures about Segmentsof an Enterprise and Related Information* are components of anenterprise with separate financial information. The component engages in business activities from which it derivesrevenues and incurs expenses and whose operating results management relies onfor decision-making and performance assessment. Bankshares has three reportablesegments — its 19 Community Banks, MSD&T Banking and Investment and WealthManagement  (IWM).

 

The following tablespresent selected segment information for the six months ended June 30, 2004 and2003.  The components in the “Other”column consist of amounts for the nonbanking affiliates and intercompanyeliminations.   Certain expense amountssuch as operations overhead have been reclassified from internal financialreporting in order to provide for full cost absorption.  These reclassifications are shown in the“Adjustments” line.  F&M is includedin the column “Community Banking” whereas BW and Peremel are included in thecolumn “IWM”.

 
| ** **                        | ** ** | **For the 6 Months Ended June 30,  2004** | ** **    |
|-----------------------------------|------------|-------------------------------------------|---------------|
| ** **                        | ** ** | **Banking**                               | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)**       | ** ** | **Community**                             | ** **    | **MSD&T** | ** ** | **Total (1)** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income               |       | **$**                                     | **193,063**   | ** ** | **$** | **71,218** | ** ** | **$** | **264,281** | ** ** | **$** | **—** | ** ** | **$** | **2,453** | ** ** | **$** | **266,734** | ** ** |
| Provision for loan losses         |       | **256**                                   | ** **    | **(5,035** | **)** | **(4,779** | **)** | **—** | ** ** | **—** | ** ** | **(4,779** | **)** |
| Noninterest income                |       | **42,474**                                | ** **    | **22,087** | ** ** | **55,613** | ** ** | **45,229** | ** ** | **593** | ** ** | **101,435** | ** ** |
| Noninterest expenses              |       | **(111,323**                              | **)**         | **(50,389** | **)** | **(152,764** | **)** | **(33,809** | **)** | **(180** | **)** | **(186,753** | **)** |
| Adjustments                       |       | **(3,486**                                | **)**         | **11,872** | ** ** | **8,386** | ** ** | **(1,926** | **)** | **(6,460** | **)** | **—** | ** ** |
| Income (loss) before income taxes |       | **120,984**                               | ** **    | **49,753** | ** ** | **170,737** | ** ** | **9,494** | ** ** | **(3,594** | **)** | **176,637** | ** ** |
| Income tax (expense) benefit      |       | **(42,009**                               | **)**         | **(17,973** | **)** | **(59,982** | **)** | **(3,797** | **)** | **(848** | **)** | **(64,627** | **)** |
| Net income (loss)                 |       | **$**                                     | **78,975**    | ** ** | **$** | **31,780** | ** ** | **$** | **110,755** | ** ** | **$** | **5,697** | ** ** | **$** | **(4,442** | **)** | **$** | **112,010** | ** ** |
| Average loans                     |       | **$**                                     | **6,459,844** | ** ** | **$** | **3,021,123** | ** ** | **$** | **9,480,967** | ** ** | **—** | ** ** | **$** | **192** | ** ** | **$** | **9,481,159** | ** ** |
| Average earning assets            |       | **8,793,808**                             | ** **    | **4,060,059** | ** ** | **12,518,189** | ** ** | **—** | ** ** | **105,293** | ** ** | **12,623,482** | ** ** |
| Average assets                    |       | **9,269,341**                             | ** **    | **4,412,700** | ** ** | **13,227,398** | ** ** | **—** | ** ** | **550,019** | ** ** | **13,777,417** | ** ** |
| Average deposits                  |       | **7,344,946**                             | ** **    | **3,089,790** | ** ** | **10,299,390** | ** ** | **—** | ** ** | **(66,939** | **)** | **10,232,451** | ** ** |
| Average equity                    |       | **939,744**                               | ** **    | **444,236** | ** ** | **1,383,980** | ** ** | **—** | ** ** | **464,858** | ** ** | **1,848,838** | ** ** |

 
| ** **                        | ** ** | **For the 6 Months Ended June 30,  2003** | ** ** |
|-----------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **Banking**                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)**       | ** ** | **Community**                             | ** ** | **MSD&T** | ** ** | **Total (1)** | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest income               |       | $                                         | 153,503    |   | $ | 71,489 |   | $ | 224,992 |   | $ | — |   | $ | (1,143 | ) | $ | 223,849 |   |
| Provision for loan losses         |       | (3,109                                    | )          | (2,958 | ) | (6,067 | ) | — |   | — |   | (6,067 | ) |
| Noninterest income                |       | 31,542                                    |       | 21,592 |   | 45,968 |   | 37,164 |   | 158 |   | 83,290 |   |
| Noninterest expenses              |       | (78,352                                   | )          | (43,929 | ) | (115,115 | ) | (30,426 | ) | (1,289 | ) | (146,830 | ) |
| Adjustments                       |       | (3,220                                    | )          | 7,763 |   | 4,543 |   | (1,559 | ) | (2,984 | ) | — |   |
| Income (loss) before income taxes |       | 100,364                                   |       | 53,957 |   | 154,321 |   | 5,179 |   | (5,258 | ) | 154,242 |   |
| Income tax (expense) benefit      |       | (34,637                                   | )          | (19,443 | ) | (54,080 | ) | (2,072 | ) | 906 |   | (55,246 | ) |
| Net income (loss)                 |       | $                                         | 65,727     |   | $ | 34,514 |   | $ | 100,241 |   | $ | 3,107 |   | $ | (4,352 | ) | $ | 98,996 |   |
| Average loans                     |       | $                                         | 4,527,296  |   | $ | 2,909,487 |   | $ | 7,436,783 | ** ** | **—** |   | $ | 253 |   | $ | 7,437,036 |   |
| Average earning assets            |       | 6,304,570                                 |       | 4,032,098 |   | 10,146,223 | ** ** | **—** |   | 84,427 |   | 10,230,650 |   |
| Average assets                    |       | 6,624,800                                 |       | 4,326,291 |   | 10,661,253 | ** ** | **—** |   | 119,121 |   | 10,780,374 |   |
| Average deposits                  |       | 5,359,878                                 |       | 3,118,910 |   | 8,362,812 | ** ** | **—** |   | (170,611 | ) | 8,192,201 |   |
| Average equity                    |       | 843,198                                   |       | 454,182 |   | 1,297,380 | ** ** | **—** |   | 12,517 |   | 1,309,897 |   |

 

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(1)  Amounts do not necessarily add due toeliminations.

 

11

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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 asderivatives), establishes accounting and reporting standards for derivativeinstruments and for hedging activities. Bankshares maintains an overallinterest rate risk management strategy that incorporates the use of derivativeinstruments to minimize significant unplanned fluctuations in earnings that arecaused by interest rate volatility. Derivative instruments that are used as part of the interest rate riskmanagement strategy have been restricted to interest rate swaps.  Interest rate swaps generally involve theexchange of fixed-rate and variable-rate interest payments between two parties,based on a common notional principal amount and maturity date. As of June 30,2004, Bankshares has interest rate swaps to convert its nonprepayablefixed-rate debt to floating-rate debt. Bankshares also arranges interest rate swaps for commercial loancustomers through its capital markets group. The increase in the number of contracts since December 31, 2003 isrelated to their activities.

 

The fair value ofderivative instruments recorded in other assets was $2.4 million (notional$210.5 million) and $6.6 million (notional $203.1 million) at June 30, 2004 andDecember 31, 2003, respectively.  Thefair value of derivative instruments recorded in other liabilities was $13.3million (notional $160.5 million) and $8.0 million (notional $150.0 million) atJune 30, 2004 and December 31, 2003, respectively.  For the six months ended June 30, 2004,Bankshares recognized a net gain of $6 thousand, which represented theineffective portion of the fair-value hedge of fixed-rate loans made toborrowers.  For the year ended December31, 2003, Bankshares recognized a net gain of $70 thousand.  The impact of the hedge decreased interestincome $61 thousand in the first six months of 2004 and $167 thousand in2003.  The fair-value hedges ofnonprepayable fixed-rate debt were effective for the reported periods.  The impact of the hedges decreased interestexpense $5.7 million in the first six months of 2004 and $8.5 million in 2003.

 

The following tablessummarize the gross position of derivatives at June 30, 2004 and December 31,2003:

 
| ** **                                     | ** ** | ** **               | ** ** | ** **           | ** **  | **Weighted Average**   | ** ** |
|------------------------------------------------|------------|--------------------------|------------|----------------------|-------------|------------------------|------------|
| **June 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 | ** ** | **4**                    | ** ** | **$**                | **10,512**  | ** **             | **6.64**   | ** ** | **4.68** | **%** | **1.25** | **%** | **$** | **8** | ** ** |
| Receive Fixed/Pay Variable Interest Rate Swaps | ** ** | **7**                    | ** ** | **360,512**          | ** **  | **7.95**               | ** ** | **5.21** | **%** | **1.99** | **%** | **(10,862** | **)** |
| Total                                          | ** ** | **11**                   | ** ** | **$**                | **371,024** | ** **             | **7.91**   | ** ** | ** ** | ** ** | ** ** | ** ** | **$** | **(10,854** | **)** |

 
| ** **                                     | ** ** | ** **               | ** ** | ** **           | ** ** | **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 loansheld-for-sale have inherent forward contract (agreements to sell or purchaseloans at a specific rate or yield) characteristics. Risk may arise from thecorresponding parties’ inability to meet the terms of their contracts and frommovement in interest rates. Bankshares had forward commitments to sell and fundindividual fixed-rate and variable-rate mortgage loans that are reported atfair value. The fair value adjustments were not material at June 30, 2004 andDecember 31, 2003.

 

12

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12. Stock-basedCompensation Expense

 

Bankshares has severalstock-based compensation programs for its directors, management and employees.Compensation costs for stock options and restricted stock awards are includedin salary expense.  Another form ofstock-based compensation is phantom stock, which is used for a portion of theBankshares’ Directors’ Deferred Compensation Plan.  A change in this plan was approved at theannual shareholders’ meeting, and was effective April 1, 2004.  This plan requires all deferred fees to besettled in Bankshares’ stock.  Thisreduces the expense fluctuations that occurred with phantom stock, whichresulted in variances corresponding to the changes in Bankshares’ stockprice.  The compensation cost for thephantom stock is included in other expenses. Stock-based compensation amounts for the six months ended and quarterended June 30, 2004 and 2003, respectively, are summarized in the followingtable:

 
| ** **                             | ** ** | **For the 6 Months Ended  June 30,** | ** ** | **For the 3 Months Ended  June 30,** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|
| **(Dollars  in thousands)**            | ** ** | **2004**                             | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Stock options expense                  | ** ** | **$**                                | **1,200**  | ** **                           | $          | 865 | ** ** | **$** | **794** |   | $ | 406 |   |
| Restricted stock awards expense        | ** ** | **1,007**                            | ** ** | 922                                  | ** ** | **519** |   | 604 |   |
| Subtotal included in salaries expense  | ** ** | **2,207**                            | ** ** | 1,787                                | ** ** | **1,313** |   | 1,010 |   |
| Phantom stock expense                  | ** ** | **(198**                             | **)**      | 314                                  | ** ** | **180** |   | 989 |   |
| Total stock-based compensation expense | ** ** | **$**                                | **2,009**  | ** **                           | $          | 2,101 | ** ** | **$** | **1,493** |   | $ | 1,999 |   |

 

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

 

Bankshares sponsorsqualified and nonqualified pension plans and other postretirement benefit plansfor its employees.  The following tablesummarizes the components of the net periodic benefit cost for the pension plansfor the six months ended and the three months ended June 30, 2004 and 2003,respectively.

 
| ** **                           | ** ** | **For the 6 Months Ended June 30,  2004** | ** ** | **For the 6 Months Ended June 30,  2003** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **Qualified**                             | ** ** | **Nonqualified**                          | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                         |       | **$**                                     | **3,144**  | ** **                                | **$**      | **282** | ** ** | **$** | **3,426** | ** ** | $ | 2,560 |   | $ | 230 |   | $ | 2,790 |   |
| Interest cost                        |       | **5,098**                                 | ** ** | **202**                                   | ** ** | **5,300** | ** ** | 4,996 |   | 156 |   | 5,152 |   |
| Expected return on plan assets       |       | **(7,690**                                | **)**      | **—**                                | ** ** | **(7,690** | **)** | (6,198 | ) | — |   | (6,198 | ) |
| Amortization of prior service cost   |       | **390**                                   | ** ** | **12**                                    | ** ** | **402** | ** ** | 390 |   | 12 |   | 402 |   |
| Recognized net actuarial (gain) loss |       | **354**                                   | ** ** | **58**                                    | ** ** | **412** | ** ** | 1,122 |   | 16 |   | 1,138 |   |
| Amortization of transition asset     |       | **—**                                | ** ** | **48**                                    | ** ** | **48** | ** ** | — |   | 50 |   | 50 |   |
| Net periodic benefit cost            |       | **$**                                     | **1,296**  | ** **                                | **$**      | **602** | ** ** | **$** | **1,898** | ** ** | $ | 2,870 |   | $ | 464 |   | $ | 3,334 |   |

 

 
| ** **                           | ** ** | **For the 3 Months Ended June 30,  2004** | ** ** | **For the 3 Months Ended June 30,  2003** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **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 (gain) loss |       | **201**                                   | ** ** | **29**                                    | ** ** | **230** | ** ** | 517 |   | 8 |   | 525 |   |
| Amortization of transition asset     |       | **—**                                | ** ** | **24**                                    | ** ** | **24** | ** ** | — |   | 25 |   | 25 |   |
| Net periodic benefit cost            |       | **$**                                     | **672**    | ** **                                | **$**      | **301** | ** ** | **$** | **973** | ** ** | $ | 1,391 |   | $ | 232 |   | $ | 1,623 |   |

 

13

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The following tablesummarizes the components of the net periodic benefit cost for the otherpostretirement benefit plans for the six months ended and the three monthsended June 30, 2004 and 2003, respectively.

 
| ** **                           | ** ** | **For the 6 Months Ended June 30,** | ** ** | **For the 3 Months Ended June 30,** | ** ** |
|--------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** **                           | ** ** | **2004**                            | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Service cost                         | ** ** | **$**                               | **130**    |                                | $          | 88 | ** ** | **$** | **65** |   | $ | 59 |   |
| Interest cost                        | ** ** | **428**                             |       | 367                                 | ** ** | **214** |   | 246 |   |
| Expected return on plan assets       | ** ** | **—**                          |       | —                              | ** ** | **—** |   | — |   |
| Amortization of prior service cost   | ** ** | **—**                          |       | —                              | ** ** | **—** |   | — |   |
| Recognized net actuarial (gain) loss | ** ** | **81**                              |       | 64                                  | ** ** | **43** |   | 43 |   |
| Amortization of transition asset     | ** ** | **—**                          |       | —                              | ** ** | **—** |   | — |   |
| Net periodic benefit cost            | ** ** | **$**                               | **639**    |                                | $          | 519 | ** ** | **$** | **322** |   | $ | 348 |   |

 

As previously disclosedin its financial statements for the year ended December 31, 2003, Banksharesgenerally makes cash contributions to the pension plan in amounts permitted byguidelines established under employee benefit and tax laws.  Bankshares currently estimates it will beable to contribute up to approximately $10 million to the pension plan for2004.  Cash contributions are normallymade after valuations have been finalized for the plan year and prior to thetax return filing date.  As of June 30,2004, no contributions had been made.

 

# **14.**         Recent Accounting Standards

 

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.

 

On March 9, 2004, theSecurities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No.105 (“SAB 105”), “Application of Accounting Principles to Loan Commitments,”which summarizes the views of the SEC staff regarding the application ofGenerally Accepted Accounting Principles to loan commitments accounted for asderivative instruments.  SAB 105 statesthat the value of the servicing asset should not be included in the estimate offair value of interest rate lock commitments (“IRLCs”).    IRLCs associated with mortgages to be heldfor sale represent commitments to extend credit at specified interestrates.  SAB 105 is applicable for allIRLCs accounted for as derivatives and entered into on or after April 1, 2004.  This SAB does not have a material impact onBankshares’ financial statements.

 

# **15.**         Subsequent Event/Contingencies

 

On July 12, 2004, formeremployee John Pileggi filed suit against Mercantile Bankshares Corporation,Mercantile-Safe Deposit and Trust Company and Edward J. Kelly, III. Foradditional detail, see Part II Other Information Item 1 “Legal Proceedings”below.

 

During the second quarterof 2004, the Maryland Legislature passed two tax bills relating to certainpayments among related entities.  Thefirst bill requires taxpayers to add back otherwise deductible interest andintangible expenses paid to related entities for tax years beginning afterDecember 31, 2003.  Some exceptionsapply, including certain interest expenses deducted among related banks, solong as the transactions fall within the legislation’s “safe harbor”provision.  In applying the add back andsafe harbor provisions, Maryland’s Comptroller has been granted discretionaryauthority to determine whether the transaction giving rise to the payment hadas a principal purpose the avoidance of tax and whether it was at arm’slength.  Additionally, the Comptroller’sOffice now has the power to reallocate or reapportion income among relatedentities if it determines that the entities’ income is not accurately reflectedon their tax returns.  The second billgives taxpayers the right to take advantage of an amnesty period.  Bankshares is currently in the process ofdetermining what impact, if any, this legislation will have on its operationsand financial results.

 

14

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**Item 2.  Management’s Discussion and Analysis of Financial Condition and Resultsof 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 the Bankshares’affiliate serving the geographic area where those customers reside. (SeeFootnote No. 2 to the Consolidated Financial Statements included in thisreport.)

 

Net income for thequarter ended June 30, 2004 was $56.3 million, a 13% increase from net incomeof $50.0 million for the same period in 2003 and a 1% increase over the $55.7million reported for the first quarter of 2004. For the quarter ended June 30, 2004, diluted net income per share was$.71, a decrease of 1% from the $.72 reported for the same period of last yearand an increase of 3% over the $.69 reported for the first quarter of thisyear.  Adjusted weighted average sharesoutstanding increased from 69.3 million for the quarter ended June 30, 2003, to79.8 million for the quarter ended June 30, 2004 as a result of the F&Macquisition.  The results of operationsfor the Acquisitions are included from their respective merger dates forward.

 

Factors positivelyaffecting earnings for the second quarter included strong growth in average loansand deposits, up 3.1% and 3.3%, respectively, from the first quarter of 2004,improved noninterest income and expense control.  Partially offsetting these factors was a 13basis point (“bp”) decline in the net interest margin to 4.24% from 4.37% inthe first quarter of 2004.  A loss of$0.7 million from Bankshares’ investment in three hedge funds, as compared to again of $3.0 million in the first quarter of 2004, accounted for 12 bp of themargin contraction.  These investmentsare carried in the “other investments” category within investment securitiesavailable-for-sale.

 

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 $57.3 million for the second quarter of2004, an increase of 22% over the $47.0 million for the same period for 2003and a slight increase over the $56.8 million for the first quarter of2004.  Diluted cash operating earningsper share for the second quarter of 2004 and 2003 were $.72, and $.68,respectively, and $.71 per share for the first quarter of 2004.  A reconciliation of net income (GAAP basis)to cash operating earnings can be found on page 33 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 for regulatorypurposes.  For the three months endedJune 30, 2004, return on average tangible assets was 1.73%, return on averagetangible equity was 18.14% and average tangible equity to average tangibleassets was 9.55%.  Comparable ratios forthe three months ended June 30, 2003 were 1.86%, 17.05% and 10.91%,respectively.  A reconciliation of theseratios from their respective GAAP basis ratios can be found on page 33 of thisfiling.

 

For the first six monthsof 2004, net income was $112.0 million, an increase of 13% over the $99.0million reported for the comparable period in 2003. Diluted net income pershare was $1.40, a decrease of 2% from the $1.43 reported for the same periodof last year. For the six months ended June 30, 2004, compared to the same periodof 2003, cash operating earnings were $114.1 million and $95.8 million,respectively.  Diluted cash operatingearnings per share for these periods were $1.43 and $1.38, respectively.  The ratios of return on average tangibleassets, return on average tangible equity and average tangible equity toaverage tangible assets for the year-to-date 2004 were 1.74%, 18.10% and 9.64%,respectively.  These ratios for theyear-to-date 2003 were 1.89%, 17.02% and 11.10%, respectively.

 

15

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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 Banks 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 announced plan to consolidate 11 affiliatebanks into 4 banks, 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.

 

*Community Banking*

 

Net income for the sixmonths ended June 30, 2004, was $79.0 million. This represented a $13.2million, or 20% increase over the same period last year. Community Banking wasthe primary beneficiary of the F&M acquisition. For the first half of 2004compared to the same period last year, net interest income increased by $39.6million, or 26%, to $193.1 million. Growth in average earning assets of $2.5billion, largely attributable to the F&M acquisition, more than offset theeffect of a 51 bp reduction in the net interest margin. Contributing to the netinterest margin compression was the capital restructuring of the CommunityBanks during the third quarter of last year. $300 million of subordinated debtissued by Bankshares in April 2003, used in part to fund the cash portion ofthe F&M acquisition, was invested in a like amount of subordinated debtissued by the Community Banks. Excess equity capital was paid to Bankshares inthe form of a special cash dividend. The $6.2 million in interest expense incurredduring the first half of 2004 related to this subordinated debt reduced theCommunity Banks’ net interest margin by 15 bp. The Community Banks had areduction in the provision for loan losses compared to the same period of 2003as credit quality remained stable.

 

The year-over-yearincreases in noninterest income and noninterest expenses for the first half of2004 compared to the same period of 2003, are attributable to the F&Macquisition and branch / market expansion programs at several Community Banks.Noninterest income increased year-over-year by $10.9 million, with depositservice charges increasing $4.1 million, insurance fees increasing $6.8million, and electronic banking fees increasing $2.7 million accounting for thelargest gains. These gains were partially offset by a decrease of $5.7 millionin net gains on investment securities. Noninterest expenses increased by $33.0million in the first half of 2004 compared to the same period of 2003. Over 50%of this increase is related to salaries and benefits, which grew by $16.4million. Staffing levels increased from 1,868 full time equivalent to 2,267full time equivalent year-over-year mostly due to the acquisition ofF&M.  Occupancy expense increased by$3.1 million, furniture and equipment expenses increased by $1.6 million andamortization of intangible assets increased $2.4 million.

 

*MSD&T*

 

The net incomecontribution from MSD&T Banking declined by $2.7 million for the six monthsended June 30, 2004 to $31.8 million compared to the same period last year.Contributing to the decline were reduced net interest income, a higherprovision for loan losses and increased noninterest expenses. Partiallyoffsetting these items was an increase in noninterest income.

 

The decline in netinterest income in the first half of 2004 compared to the same period in 2003was attributable to a 6 bp decline in the net interest margin from 3.64% to3.58%. This decline is consistent with the overall decline experienced byBankshares. The provision for loan losses was $5.0 million in the first half of2004 compared to $3.0 million in the first half of 2003. Nonperforming loansdeclined during the current quarter due to collections and the return ofseveral loans to performing status. For additional information, see discussionof nonperforming assets under “Nonperforming Assets” below.

 

The increase innoninterest income was spread across numerous categories. Noninterest incomeincreased $0.5 million in the first half of 2004 compared to the first half of2003. The year-over-year increase was mitigated by decreases in gains oninvestment securities of $1.3 million in 2003 and -0- in 2004, and a 5%decrease in mortgage banking related fees as a result of a slow down inrefinancing activities. Noninterest expense increased by $6.5 million from thefirst half of 2003 to $50.4 million. This represents a 15% increase over theprior year. Increased personnel costs of $7.0 million accounted for theincrease. Staffing levels increased from 1,143 full time equivalents to 1,216full time equivalents year-over-year principally due to compliance and otherstaff functions. Costs for shared services are charged to Investment and WealthManagement (“IWM”) and Community Banking and are reflected in the noninterest 

 

16

----

 

expense line. Certainother costs not directly charged are allocated to IWM and Community Banking asreflected in the “adjustments” line.

 

**Investment & WealthManagement**

 

Net income increased $2.6million or 83% to $5.7 million for the six months ended June 30, 2004 ascompared to the $3.1 million reported in the same period last year

 

Revenues for the firsthalf of 2004 increased $8.1 million, or 22%, over the same period last year,with $5.4 million of the increase related to the BW and Peremel acquisitions.The remaining increase was primarily due to strong equity markets and newsales. Total assets under administration increased to $46.2 billion at June 30,2004 from $42.0 billion at June 30, 2003. At June 30, 2004 and June 30, 2003 assetsunder management were $21.4 billion and $19.4 billion, respectively.

 

Noninterest expensesincreased by $3.4 million or 11% to $33.8 million for the first half of 2004from $30.4 million for the same period last year. The increase in noninterestexpense is mostly due to the acquisition of BW and Peremel. Full timeequivalent staff levels have increased from 293 at June 30, 2003 to 310 at June30, 2004. The Peremel acquisition and the assumption of F&M’s brokerageoperation accounted for the full time equivalent increase. During the firstquarter of 2004, Bankshares entered into a 7-year service contract with SunGardWealth Management Services to provide a new core accounting system and assumemanagement of IWM’s back-office operations. Post conversion, which is expectedlate in 2004, Bankshares expects to achieve net savings in excess of $1.0million in 2005. Management expects to incur conversion costs of $2.5million.  $1.7 million of the conversioncosts will be amortized over the life of the contract.  Bankshares also expects to incur exit costsof approximately $1.2 million in the second half of 2004.

 

17

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CONSOLIDATED RESULTS

**Net Interest Income and NetInterest Margin**

 

**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 sixmonths ended June 30, 2004 and 2003. 

 
| ** **                                        | ** ** | **For the 6 Months Ended  June 30, 2004** | ** **     | **For the 6 Months Ended  June 30, 2003** | ** **  |
|---------------------------------------------------|------------|-------------------------------------------|----------------|-------------------------------------------|-------------|
| **(Dollars in thousands)**                        | ** ** | **Average  Balance**                      | ** **     | **Income*/  Expense**                     | ** **  | **Yield*/  Rate** | ** ** | **Average  Balance** | ** ** | **Income*/  Expense** | ** ** | **Yield*/  Rate** | ** ** |
| Earning assets                                    |       |                                      |           |                                      |        |   |   |   |   |   |   |   |   |
| Loans:**                                          |       |                                      |           |                                      |        |   |   |   |   |   |   |   |   |
| Commercial                                        |       | **$**                                     | **2,679,828**  | ** **                                | **$**       | **68,399** | ** ** | **5.13** | **%** | $ | 2,401,370 |   | $ | 67,224 |   | 5.65 | % |
| Commercial real estate                            |       | **2,820,197**                             | ** **     | **82,304**                                | ** **  | **5.87** | ** ** | 2,087,406 |   | 65,616 |   | 6.34 |   |
| Construction                                      |       | **1,108,601**                             | ** **     | **28,623**                                | ** **  | **5.19** | ** ** | 847,382 |   | 23,341 |   | 5.55 |   |
| Residential real estate                           |       | **1,398,153**                             | ** **     | **41,608**                                | ** **  | **5.98** | ** ** | 1,083,780 |   | 36,339 |   | 6.76 |   |
| Consumer                                          |       | **1,474,380**                             | ** **     | **42,521**                                | ** **  | **5.80** | ** ** | 1,017,098 |   | 32,870 |   | 6.52 |   |
| Total loans                                       |       | **9,481,159**                             | ** **     | **263,455**                               | ** **  | **5.59** | ** ** | 7,437,036 |   | 225,390 |   | 6.11 |   |
| Federal funds sold, et al                         |       | **71,648**                                | ** **     | **763**                                   | ** **  | **2.14** | ** ** | 185,883 |   | 2,034 |   | 2.21 |   |
| Securities:***                                    |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Taxable securities                                |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| U.S. Treasury and government agencies             |       | **1,550,468**                             | ** **     | **29,463**                                | ** **  | **3.82** | ** ** | 1,834,196 |   | 39,958 |   | 4.39 |   |
| Mortgage-backed                                   |       | **1,266,028**                             | ** **     | **24,103**                                | ** **  | **3.83** | ** ** | 636,760 |   | 13,864 |   | 4.39 |   |
| Other investments                                 |       | **152,850**                               | ** **     | **3,541**                                 | ** **  | **4.66** | ** ** | 98,328 |   | 3,365 |   | 6.90 |   |
| Tax-exempt securities                             |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| States and political subdivisions                 |       | **101,171**                               | ** **     | **2,807**                                 | ** **  | **5.58** | ** ** | 38,099 |   | 1,595 |   | 8.44 |   |
| Total securities                                  |       | **3,070,517**                             | ** **     | **59,914**                                | ** **  | **3.92** | ** ** | 2,607,383 |   | 58,782 |   | 4.55 |   |
| Interest-bearing deposits in other banks          |       | **158**                                   | ** **     | **1**                                     | ** **  | **1.07** | ** ** | 348 |   | 6 |   | 3.70 |   |
| Total earning assets                              |       | **12,623,482**                            | ** **     | **324,133**                               | ** **  | **5.16** | ** ** | 10,230,650 |   | 286,212 |   | 5.64 |   |
| Cash and due from banks                           |       | **291,982**                               | ** **     |                                      |        | ** ** | ** ** | 234,901 |   |   |   |   |   |
| Bank premises and equipment, net                  |       | **141,694**                               | ** **     |                                      |        | ** ** | ** ** | 104,268 |   |   |   |   |   |
| Other assets                                      |       | **877,515**                               | ** **     |                                      |        | ** ** | ** ** | 351,801 |   |   |   |   |   |
| Less: allowance for loan losses                   |       | **(157,256**                              | **)**          |                                      |        | ** ** | ** ** | (141,246 | ) |   |   |   |   |
| Total assets                                      |       | **$**                                     | **13,777,417** | ** **                                |        |   | ** ** | ** ** | $ | 10,780,374 |   |   |   |   |   |
| Interest-bearing liabilities                      |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Deposits:                                         |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Savings                                           |       | **$**                                     | **1,399,234**  | ** **                                | **2,027**   | ** ** | **0.29** | ** ** | $ | 1,054,033 |   | 2,743 |   | 0.52 |   |
| Checking plus interest                            |       | **1,269,432**                             | ** **     | **935**                                   | ** **  | **0.15** | ** ** | 973,366 |   | 1,105 |   | 0.23 |   |
| Money market                                      |       | **1,577,378**                             | ** **     | **4,457**                                 | ** **  | **0.57** | ** ** | 1,193,102 |   | 5,059 |   | 0.86 |   |
| Time deposits $100,000 and over                   |       | **1,301,407**                             | ** **     | **12,320**                                | ** **  | **1.90** | ** ** | 1,250,819 |   | 15,503 |   | 2.50 |   |
| Other time deposits                               |       | **1,967,533**                             | ** **     | **20,901**                                | ** **  | **2.14** | ** ** | 1,712,535 |   | 24,169 |   | 2.85 |   |
| Total interest-bearing deposits                   |       | **7,514,984**                             | ** **     | **40,640**                                | ** **  | **1.09** | ** ** | 6,183,855 |   | 48,579 |   | 1.58 |   |
| Short-term borrowings                             |       | **915,121**                               | ** **     | **2,899**                                 | ** **  | **0.64** | ** ** | 775,526 |   | 3,014 |   | 0.78 |   |
| Long-term debt                                    |       | **648,817**                               | ** **     | **10,460**                                | ** **  | **3.24** | ** ** | 402,225 |   | 7,648 |   | 3.83 |   |
| Total interest-bearing funds                      |       | **9,078,922**                             | ** **     | **53,999**                                | ** **  | **1.20** | ** ** | 7,361,606 |   | 59,241 |   | 1.62 |   |
| Noninterest-bearing deposits                      |       | **2,717,467**                             | ** **     |                                      |        | ** ** | ** ** | 2,008,346 |   |   |   |   |   |
| Other liabilities and accrued expenses            |       | **132,190**                               | ** **     |                                      |        | ** ** | ** ** | 100,525 |   |   |   |   |   |
| Total liabilities                                 |       | **11,928,579**                            | ** **     |                                      |        | ** ** | ** ** | 9,470,477 |   |   |   |   |   |
| Shareholders’ equity                         |       | **1,848,838**                             | ** **     |                                      |        | ** ** | ** ** | 1,309,897 |   |   |   |   |   |
| Total liabilities & shareholders’ equity |       | **$**                                     | **13,777,417** | ** **                                |        |   | ** ** | ** ** | $ | 10,780,374 |   |   |   |   |   |
| Net interest rate spread                          |       | ** **                                | ** **     | **$**                                     | **270,134** | ** ** | **3.96** | **%** |   |   | $ | 226,971 |   | 4.02 | % |
| Effect of noninterest-bearing funds               |       | ** **                                | ** **     | ** **                                | ** **  | **0.34** | ** ** |   |   |   |   | 0.45 |   |
| Net interest margin on earning assets             |       | ** **                                | ** **     | ** **                                | ** **  | **4.30** | **%** |   |   |   |   | 4.47 | % |
| Taxable-equivalent adjustment included in:        |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Loan income                                       |       | ** **                                | ** **     | **$**                                     | **2,279**   | ** ** | ** ** | ** ** |   |   | $ | 2,436 |   |   |   |
| Investment securities income                      |       | ** **                                | ** **     | **1,121**                                 | ** **  | ** ** | ** ** |   |   | 686 |   |   |   |
| Total                                             |       | ** **                                | ** **     | **$**                                     | **3,400**   | ** ** | ** ** | ** ** |   |   | $ | 3,122 |   |   |   |

 

----

* Presented on atax-equivalent basis using the statutory federal corporate income tax rate of35% (see non-GAAP reconciliation on page 33)

** Nonaccrual loans areincluded in average loans

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

 

18

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**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 second quarterof 2004 and 2003.

 
| ** **                                        | ** ** | **For the 3 Months Ended  June 30, 2004** | ** **     | **For the 3 Months Ended  June 30, 2003** | ** **  |
|---------------------------------------------------|------------|-------------------------------------------|----------------|-------------------------------------------|-------------|
| **(Dollars in thousands)**                        | ** ** | **Average  Balance**                      | ** **     | **Income*/  Expense**                     | ** **  | **Yield*/  Rate** | ** ** | **Average  Balance** | ** ** | **Income*/  Expense** | ** ** | **Yield*/  Rate** | ** ** |
| Earning assets                                    |       |                                      |           |                                      |        |   |   |   |   |   |   |   |   |
| Loans:**                                          |       |                                      |           |                                      |        |   |   |   |   |   |   |   |   |
| Commercial                                        |       | **$**                                     | **2,727,051**  | ** **                                | **$**       | **34,775** | ** ** | **5.13** | **%** | $ | 2,411,227 |   | $ | 33,464 |   | 5.57 | % |
| Commercial real estate                            |       | **2,871,615**                             | ** **     | **41,648**                                | ** **  | **5.83** | ** ** | 2,116,259 |   | 33,317 |   | 6.31 |   |
| Construction                                      |       | **1,113,301**                             | ** **     | **14,414**                                | ** **  | **5.21** | ** ** | 870,955 |   | 11,955 |   | 5.51 |   |
| Residential real estate                           |       | **1,437,331**                             | ** **     | **21,120**                                | ** **  | **5.91** | ** ** | 1,089,772 |   | 18,026 |   | 6.63 |   |
| Consumer                                          |       | **1,474,586**                             | ** **     | **21,292**                                | ** **  | **5.81** | ** ** | 1,025,363 |   | 16,421 |   | 6.42 |   |
| Total loans                                       |       | **9,623,884**                             | ** **     | **133,249**                               | ** **  | **5.57** | ** ** | 7,513,576 |   | 113,183 |   | 6.04 |   |
| Federal funds sold, et al                         |       | **95,504**                                | ** **     | **588**                                   | ** **  | **2.48** | ** ** | 313,844 |   | 1,311 |   | 1.68 |   |
| Securities:***                                    |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Taxable securities                                |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| U.S. Treasury and government agencies             |       | **1,543,661**                             | ** **     | **14,369**                                | ** **  | **3.74** | ** ** | 1,741,380 |   | 18,763 |   | 4.32 |   |
| Mortgage-backed                                   |       | **1,254,512**                             | ** **     | **11,796**                                | ** **  | **3.78** | ** ** | 760,630 |   | 7,875 |   | 4.15 |   |
| Other investments                                 |       | **159,282**                               | ** **     | **(66**                                   | **)**       | **(0.17** | **)** | 98,277 |   | 2,544 |   | 10.38 |   |
| Tax-exempt securities                             |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| States and political subdivisions                 |       | **98,182**                                | ** **     | **1,356**                                 | ** **  | **5.55** | ** ** | 37,412 |   | 823 |   | 8.82 |   |
| Total securities                                  |       | **3,055,637**                             | ** **     | **27,455**                                | ** **  | **3.61** | ** ** | 2,637,699 |   | 30,005 |   | 4.56 |   |
| Interest-bearing deposits in other banks          |       | **158**                                   | ** **     | **1**                                     | ** **  | **1.06** | ** ** | 338 |   | 3 |   | 3.50 |   |
| Total earning assets                              |       | **12,775,183**                            | ** **     | **161,293**                               | ** **  | **5.08** | ** ** | 10,465,457 |   | 144,502 |   | 5.54 |   |
| Cash and due from banks                           |       | **298,440**                               | ** **     |                                      |        | ** ** | ** ** | 243,728 |   |   |   |   |   |
| Bank premises and equipment, net                  |       | **141,757**                               | ** **     |                                      |        | ** ** | ** ** | 104,825 |   |   |   |   |   |
| Other assets                                      |       | **881,921**                               | ** **     |                                      |        | ** ** | ** ** | 361,951 |   |   |   |   |   |
| Less: allowance for loan losses                   |       | **(158,116**                              | **)**          |                                      |        | ** ** | ** ** | (142,237 | ) |   |   |   |   |
| Total assets                                      |       | **$**                                     | **13,939,185** | ** **                                |        |   | ** ** | ** ** | $ | 11,033,724 |   |   |   |   |   |
| Interest-bearing liabilities                      |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Deposits:                                         |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Savings                                           |       | **$**                                     | **1,434,288**  | ** **                                | **1,043**   | ** ** | **0.29** | ** ** | $ | 1,078,760 |   | 1,373 |   | 0.51 |   |
| Checking plus interest                            |       | **1,302,313**                             | ** **     | **474**                                   | ** **  | **0.15** | ** ** | 993,268 |   | 547 |   | 0.22 |   |
| Money market                                      |       | **1,564,295**                             | ** **     | **2,095**                                 | ** **  | **0.54** | ** ** | 1,201,044 |   | 2,422 |   | 0.81 |   |
| Time deposits $100,000 and over                   |       | **1,315,119**                             | ** **     | **5,941**                                 | ** **  | **1.82** | ** ** | 1,277,652 |   | 7,535 |   | 2.37 |   |
| Other time deposits                               |       | **1,955,632**                             | ** **     | **10,320**                                | ** **  | **2.12** | ** ** | 1,708,177 |   | 11,573 |   | 2.72 |   |
| Total interest-bearing deposits                   |       | **7,571,647**                             | ** **     | **19,873**                                | ** **  | **1.06** | ** ** | 6,258,901 |   | 23,450 |   | 1.50 |   |
| Short-term borrowings                             |       | **910,854**                               | ** **     | **1,480**                                 | ** **  | **0.65** | ** ** | 771,892 |   | 1,469 |   | 0.76 |   |
| Long-term debt                                    |       | **648,576**                               | ** **     | **5,205**                                 | ** **  | **3.23** | ** ** | 527,223 |   | 5,286 |   | 4.02 |   |
| Total interest-bearing funds                      |       | **9,131,077**                             | ** **     | **26,558**                                | ** **  | **1.17** | ** ** | 7,558,016 |   | 30,205 |   | 1.60 |   |
| Noninterest-bearing deposits                      |       | **2,826,610**                             | ** **     |                                      |        | ** ** | ** ** | 2,054,813 |   |   |   |   |   |
| Other liabilities and accrued expenses            |       | **129,737**                               | ** **     |                                      |        | ** ** | ** ** | 96,602 |   |   |   |   |   |
| Total liabilities                                 |       | **12,087,424**                            | ** **     |                                      |        | ** ** | ** ** | 9,709,431 |   |   |   |   |   |
| Shareholders’ equity                         |       | **1,851,761**                             | ** **     |                                      |        | ** ** | ** ** | 1,324,293 |   |   |   |   |   |
| Total liabilities & shareholders’ equity |       | **$**                                     | **13,939,185** | ** **                                |        |   | ** ** | ** ** | $ | 11,033,724 |   |   |   |   |   |
| Net interest rate spread                          |       | ** **                                | ** **     | **$**                                     | **134,735** | ** ** | **3.91** | **%** |   |   | $ | 114,297 | ** ** | 3.94 | % |
| Effect of noninterest-bearing funds               |       | ** **                                | ** **     | ** **                                | ** **  | **0.33** | ** ** |   |   |   |   | 0.44 |   |
| Net interest margin on earning assets             |       | ** **                                | ** **     | ** **                                | ** **  | **4.24** | **%** |   |   |   |   | 4.38 | % |
| Taxable-equivalent adjustment included in:        |       | ** **                                | ** **     | ** **                                | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Loan income                                       |       | ** **                                | ** **     | **$**                                     | **1,133**   | ** ** | ** ** | ** ** |   |   | $ | 1,221 |   |   |   |
| Investment securities income                      |       | ** **                                | ** **     | **542**                                   | ** **  | ** ** | ** ** |   |   | 353 |   |   |   |
| Total                                             |       | ** **                                | ** **     | **$**                                     | **1,675**   | ** ** | ** ** | ** ** |   |   | $ | 1,574 |   |   |   |

 

----

* Presented on atax-equivalent basis using the statutory federal corporate income tax rate of35% (see non-GAAP reconciliation on page 33)

** Nonaccrual loans areincluded in average loans

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

 

19

----

 

**Rate / Volume Analysis**

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

 
| ** **                                | ** ** | **For the 6 Months  Ended June 30,  2004 vs. 2003  Due to variances in** | ** ** | **For the 3 Months  Ended June 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)                            |       | $                                                                        | (6,620     | )                                                                        | $          | 7,795 |   | $ | 1,175 |   | $ | (3,072 | ) | $ | 4,383 |   | $ | 1,311 |   |
| Commercial real estate (2)                |       | (6,347                                                                   | )          | 23,035                                                                   |       | 16,688 |   | (3,561 | ) | 11,892 |   | 8,331 |   |
| Construction (3)                          |       | (1,913                                                                   | )          | 7,195                                                                    |       | 5,282 |   | (868 | ) | 3,327 |   | 2,459 |   |
| Residential real estate                   |       | (5,272                                                                   | )          | 10,541                                                                   |       | 5,269 |   | (2,655 | ) | 5,749 |   | 3,094 |   |
| Consumer                                  |       | (5,127                                                                   | )          | 14,778                                                                   |       | 9,651 |   | (2,323 | ) | 7,194 |   | 4,871 |   |
| Total loans                               |       | (25,279                                                                  | )          | 63,344                                                                   |       | 38,065 |   | (12,479 | ) | 32,545 |   | 20,066 |   |
| Taxable securities (4)                    |       | (8,985                                                                   | )          | 8,905                                                                    |       | (80 | ) | (7,091 | ) | 4,008 |   | (3,083 | ) |
| Tax-exempt securities (4)                 |       | (1,428                                                                   | )          | 2,640                                                                    |       | 1,212 |   | (804 | ) | 1,337 |   | 533 |   |
| Federal funds sold, et al                 |       | (21                                                                      | )          | (1,250                                                                   | )          | (1,271 | ) | 189 |   | (912 | ) | (723 | ) |
| Interest-bearing deposits in other banks  |       | (2                                                                       | )          | (3                                                                       | )          | (5 | ) | — |   | (2 | ) | (2 | ) |
| Total interest income                     |       | (35,715                                                                  | )          | 73,636                                                                   |       | 37,921 |   | (20,185 | ) | 36,976 |   | 16,791 |   |
|                                      |       |                                                                     |       |                                                                     |       |   |   |   |   |   |   |   |   |
| Interest paid on:                         |       |                                                                     |       |                                                                     |       |   |   |   |   |   |   |   |   |
| Savings deposits                          |       | (1,614                                                                   | )          | 898                                                                      |       | (716 | ) | (783 | ) | 453 |   | (330 | ) |
| Checking plus interest deposits           |       | (506                                                                     | )          | 336                                                                      |       | (170 | ) | (243 | ) | 170 |   | (73 | ) |
| Money market accounts                     |       | (2,231                                                                   | )          | 1,629                                                                    |       | (602 | ) | (1,060 | ) | 733 |   | (327 | ) |
| Certificates of deposit $100,000 and over |       | (3,810                                                                   | )          | 627                                                                      |       | (3,183 | ) | (1,815 | ) | 221 |   | (1,594 | ) |
| Other time deposits                       |       | (6,867                                                                   | )          | 3,599                                                                    |       | (3,268 | ) | (2,930 | ) | 1,677 |   | (1,253 | ) |
| Short-term borrowings                     |       | (658                                                                     | )          | 543                                                                      |       | (115 | ) | (253 | ) | 264 |   | 11 |   |
| Long-term debt                            |       | (1,877                                                                   | )          | 4,689                                                                    |       | 2,812 |   | (1,298 | ) | 1,217 |   | (81 | ) |
| Total interest expense                    |       | (17,563                                                                  | )          | 12,321                                                                   |       | (5,242 | ) | (8,382 | ) | 4,735 |   | (3,647 | ) |
| Net interest earned                       |       | $                                                                        | (18,152    | )                                                                        | $          | 61,315 |   | $ | 43,163 |   | $ | (11,803 | ) | $ | 32,241 |   | $ | 20,438 |   |

 

----

(1)          Interest year-to-date tax-equivalent adjustment of $1.6 million for 2004and 2003, respectively, and quarter-to-date tax-equivalent adjustment of $759thousand and $781 thousand for 2004 and 2003, respectively, are included in thecommercial loan rate variances.

(2)          Interest year-to-date tax-equivalent adjustment of $268 thousand and $185thousand for 2004 and 2003, respectively, and quarter-to-date tax-equivalentadjustment of $154 thousand and $99 thousand for 2004 and 2003, respectively,are included in the commercial real estate loan rate variances.

(3)          Interest year-to-date tax-equivalent adjustment of $458 thousand and $680thousand for 2004 and 2003, respectively, and quarter-to-date tax-equivalentadjustment of $221 thousand and $341 thousand for 2004 and 2003, respectively,are included in the construction loan rate variances.

(4)          Interest year-to-date tax-equivalent adjustment of $1.1 million and $0.7million for 2004 and 2003, respectively, and quarter-to-date tax-equivalentadjustment of $542 thousand and $353 thousand for 2004 and 2003, respectively,are included in the investment securities rate variances.

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

 

**Net Interest Income and NetInterest Margin**(continued)

 

Net interest income forthe quarter ended June 30, 2004 increased 18% to $133.1 million from the secondquarter last year primarily as a result of the F&M acquisition.  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. Thegrowth in net interest income was attributable to the growth of 22% in averageearning assets that more than offset a decline in the net interest margin.  Average loan growth from March 31, 2004 toJune 30, 2004 was $285.5 million or 3% (12% annualized).

 

The positive effect oninterest income of year-over-year growth in average earning assets waspartially offset by a 14 bp decline in the net interest margin from 4.38% forthe second quarter of 2003 to 4.24% for the current quarter.  This was driven principally by theperformance of Bankshares’ previously disclosed investments in hedgefunds-of-funds related to the investment and wealth management business, whichare designated as assets held for sale. Changes in their fair value are reflected in the income statement as acomponent of “other investment” income. After four successive quarters of strong performance, these investmentsgenerated a loss of $0.7 million in the second quarter

 

20

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of 2004 versus a gain of$3.0 million in the first quarter.  Thisled to a linked-quarter decline in the net interest margin from 4.37% to 4.24%,with the performance of the hedge fund investments accounting for 12 bp of thedecline.  In the first quarter of 2004,the hedge fund investments contributed 7 bps to the net interest margin.  In the second quarter these investmentsadversely affected the margin by 5 bps. Bankshares has begun to redeem these investments and will continue to doso gradually over time. MSD&T Banking segment’s net interest marginincreased 3 bp to 3.58% for the second quarter of 2004 from 3.55% in the firstquarter while the Community Banking’s net interest margin decreased 1 bp to4.46% for the current quarter from 4.47% in the first quarter of 2004. Helpingto offset the decline in the net interest margin was linked-quarter growth inaverage loans of 3.1%. Loans grew in all categories, with commercial loans andlease receivables up 3.6%; commercial real estate up 3.7%; construction up0.9%; residential real estate up 5.8%; and consumer up slightly. The averagebalance in the securities portfolio was down 1.1% from the first to the secondquarter of 2004.  Lower reinvestmentyields on maturing investment securities and prepayments of mortgage-relatedsecurities reduced yields in the investment portfolio. Average deposits were up3.3% on a linked-quarter basis, with increases in noninterest-bearing deposits (8.4%),savings (5.1%), checking plus interest (5.3%), and time deposits $100,000 andover (2.1%), more than offsetting declines in money market (down 1.6%) andother time deposits (down 1.2%). Based on current market conditions, whichinclude a recent slowing of mortgage refinancing activity and increase in theprime rate at June 30, 2004, management expects the net interest margin toimprove during the second half of 2004.

 

Net interest income forthe first six months of 2004 increased to $266.7 million or 19% over the $223.8million for the first six months of last year principally due to F&M.  The growth in net interest income wasattributable to 27% growth in average loans and 18% growth in averagesecurities. The positive impact of asset growth on interest income waspartially offset by a 17 bp decline in the net interest margin from 4.47% to4.30%.  Nearly two-thirds of the declinein the net interest margin was attributable to the reduced benefit derived fromthe investment of noninterest-bearing funds. This benefit fell from 45 bp in 2003 to 34 bp in 2004.

 

**Noninterest Income**

 
| ** **                          | ** ** | **For the 6 Months Ended** |        | **For the 3 Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------|-------------|----------------------------|------------|
| ** **                          | ** ** | **June 30,**               | ** **  | **% Change**               |       | **June 30,** | ** ** | **% Change** | ** ** |
| **(Dollars  in thousands)**         | ** ** | **2004**                   | ** **  | **2003**                   | ** ** | **2004/2003** |   | **2004** | ** ** | **2003** | ** ** | **2004/2003** | ** ** |
| Investment and wealth management    | ** ** | **$**                      | **44,919**  |                       | $          | 36,873 |   | 21.8 | % | **$** | **22,936** |   | $ | 19,508 |   | 17.6 | % |
| Service charges on deposit accounts | ** ** | **20,470**                 |        | 16,371                     |       | 25.0 |   | **10,351** |   | 8,311 |   | 24.5 |   |
| Mortgage banking related fees:      |       |                       |        |                       |       |   |   |   |   |   |   |   |   |
| Commercial                          | ** ** | **3,483**                  |        | 3,319                      |       | 4.9 |   | **1,563** |   | 1,693 |   | (7.7 | ) |
| Residential                         | ** ** | **1,750**                  |        | 1,576                      |       | 11.0 |   | **730** |   | 814 |   | (10.3 | ) |
| Total mortgage banking related fees | ** ** | **5,233**                  |        | 4,895                      |       | 6.9 |   | **2,293** |   | 2,507 |   | (8.5 | ) |
| Investment securities gains         | ** ** | **535**                    |        | 7,351                      |       | (92.7 | ) | **590** |   | 6,536 |   | (91.0 | ) |
| Other income:                       |       |                       |        |                       |       |   |   |   |   |   |   |   |   |
| Electronic banking fees             | ** ** | **10,351**                 |        | 7,598                      |       | 36.2 |   | **5,951** |   | 4,145 |   | 43.6 |   |
| Charges and fees on loans           | ** ** | **5,293**                  |        | 4,518                      |       | 17.2 |   | **2,835** |   | 2,069 |   | 37.0 |   |
| Insurance                           | ** ** | **7,095**                  |        | 332                        |       | — |   | **3,267** |   | 175 |   | — |   |
| Bank-owned life insurance           | ** ** | **1,579**                  |        | 868                        |       | 81.9 |   | **785** |   | 439 |   | 78.8 |   |
| All other income                    | ** ** | **5,960**                  |        | 4,484                      |       | 32.9 |   | **2,542** |   | 1,747 |   | 45.5 |   |
| Total other income                  | ** ** | **30,278**                 |        | 17,800                     |       | 70.1 |   | **15,380** |   | 8,575 |   | 79.4 |   |
| Total                               | ** ** | **$**                      | **101,435** |                       | $          | 83,290 |   | 21.8 | % | **$** | **51,550** |   | $ | 45,437 |   | 13.5 | % |

 

Noninterest income forthe quarter ended June 30, 2004 increased by $6 million, or 13%, to $51.6million compared to $45.4 million for the same period in 2003. Noninterestincome increased 3% from the first quarter of 2004. The table above shows themajor components of noninterest income. Investment and wealth management revenue represents the largest sourceof noninterest income and increased 18% over the prior year and 4% over thefirst quarter of 2004. Factors having a positive impact on IWM revenues werestrong equity markets and increased new sales across both mutual funds andseparately managed accounts.

 

Service charges ondeposit accounts increased in line with the growth in deposit balances. For thesecond quarter of 2004 compared to the second quarter of 2003, the $2.0million, or 25%, growth in service charge income was largely attributable tothe F&M acquisition. Service charges on deposits increased modestlycompared to the first quarter of 2004 due to deposit growth.

 

Mortgagebanking-related fees decreased 9% in the second quarter of 2004 compared to thesecond quarter of 2003 and decreased 22% from the first quarter of 2004 dueprimarily to normal seasonal fluctuations, a general slowdown in refinancingactivities and the integration of F&M’s mortgage banking business into WellsFargo Ventures LLC.  Bankshares’ mortgagebanking revenue is comprised of loan activities of Mercantile MortgageCorporation’s commercial mortgage subsidiary, Columbia National Real EstateFinancing LLC, and its residential mortgage joint venture with Wells FargoVentures LLC.

 

21

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Last year $6.5 million ininvestment securities gains resulted from sales of equity securities held inthe available-for-sale portfolios and the balance related to the continuedrestructuring of the bond portfolios. The gain in the second quarter of 2003 was generated as part of arepositioning of the balance sheet for interest rate changes that adjustedportfolio yields and duration.  Theincreases in other income for the three months ended June 30, 2004 compared tothe three months ended June 30, 2003 include several categories. Electronicbanking fees, which consist of merchant card processing fees, foreign ATM feesand check card fees increased $1.8 million or 44%. These fees are seasonal andalso benefited from the F&M acquisition. Charges and fees on loansconsisting of letters of credit fees, late fees and other assessed loan feesincreased $0.8 million or 37%.  Insurancerevenues, which are derived from fee income related to the sale and servicingof insurance products, increased $3.1 million primarily due to the F&Macquisition. All other income increased$0.8 million or 46%, which consisted of revenues from various sources, such assafe deposit box rent, travelers’ checks, money orders and bill collectionfees. Included in all other income in the second quarter of 2004 is $0.3million in gains from the disposition of bank-owned buildings, which wasexcluded from cash operating earnings. On a linked-quarter basis a seasonally-relateddecline in insurance fee income and a decline in all other income was more thanoffset by increases in electronic banking fees and charges and fees on loans.

 

Forthe six months ended June 30, 2004, noninterest income increased by $18.1million or 22%, to $101.4 million compared to $83.3 million for the same periodin 2003.  This increase was largely dueto the F&M acquisition and a 22% increase in IWM fees, which was partiallyoffset by the $6.8 million decrease in investment securities gains.

 

**Noninterest Expense**

 
| ** **                             | ** ** | **For the 6 Months Ended** |        | **For the 3 Months Ended** | ** ** |
|----------------------------------------|------------|----------------------------|-------------|----------------------------|------------|
| ** **                             | ** ** | **June 30,**               | ** **  | **% Change**               |       | **June 30,** | ** ** | **% Change** | ** ** |
| **(Dollars  in thousands)**            | ** ** | **2004**                   | ** **  | **2003**                   | ** ** | **2004/2003** |   | **2004** | ** ** | **2003** | ** ** | **2004/2003** | ** ** |
| Salaries                               | ** ** | **$**                      | **89,477**  |                       | $          | 70,732 |   | 26.5 | % | **$** | **44,689** |   | $ | 36,317 |   | 23.1 | % |
| Employee benefits                      | ** ** | **23,441**                 |        | 18,747                     |       | 25.0 |   | **10,928** |   | 9,319 |   | 17.3 |   |
| Net occupancy expense of bank premises | ** ** | **11,879**                 |        | 8,315                      |       | 42.9 |   | **5,819** |   | 4,219 |   | 37.9 |   |
| Furniture and equipment expense        | ** ** | **14,937**                 |        | 13,542                     |       | 10.3 |   | **7,573** |   | 6,743 |   | 12.3 |   |
| Communication and supplies             | ** ** | **8,499**                  |        | 6,617                      |       | 28.4 |   | **4,195** |   | 3,181 |   | 31.9 |   |
| Other expenses:                        |       |                       |        |                       |       |   |   |   |   |   |   |   |   |
| Professional services                  | ** ** | **8,830**                  |        | 7,041                      |       | 25.4 |   | **4,996** |   | 4,962 |   | 0.7 |   |
| Advertising and promotional expense    | ** ** | **3,838**                  |        | 3,711                      |       | 3.4 |   | **2,135** |   | 2,247 |   | (5.0 | ) |
| Electronic banking expense             | ** ** | **4,414**                  |        | 3,434                      |       | 28.5 |   | **2,485** |   | 1,851 |   | 34.3 |   |
| Amortization of intangible assets      | ** ** | **4,088**                  |        | 1,409                      |       | 190.1 |   | **2,056** |   | 848 |   | 142.5 |   |
| Outsourcing expense                    | ** ** | **2,686**                  |        | 1,959                      |       | 37.1 |   | **1,227** |   | 1,010 |   | 21.5 |   |
| All other expenses                     | ** ** | **14,664**                 |        | 11,323                     |       | 29.5 |   | **7,264** |   | 6,352 |   | 14.4 |   |
| Total other expense                    | ** ** | **38,520**                 |        | 28,877                     |       | 33.4 |   | **20,163** |   | 17,270 |   | 16.8 |   |
| Total                                  | ** ** | **$**                      | **186,753** |                       | $          | 146,830 |   | 27.2 | % | **$** | **93,367** |   | $ | 77,049 |   | 21.2 | % |

 

Noninterest expense forthe three months ended June 30, 2004 increased by $16.3 million, or 21%, to$93.4 million compared to $77.0 million for the three months ended June 30,2003.  The table above shows the majorcomponents of noninterest expense.  Theprincipal reason for the year-over-year increase in each noninterest expensecategory was the acquisitions of F&M. On a linked-quarter basis all majorcategories of noninterest expense reflected declines except for furniture &equipment expenses and other expenses resulting in a slight decline in totalnoninterest expenses for the quarter.

 

Management continues tofocus on expense control and is encouraged by the progress made to date.  While total noninterest expenses were downslightly from the first to the second quarter of 2004, certain additional expensesrelated to directors’ deferred compensation ($0.5 million), the consolidationof bank affiliates ($0.4 million), and certain employee separation costs ($0.8million) offset the stronger underlying trend of reduced expenses.  Moreover, volume-driven increases inelectronic banking costs accounted for $0.6 million of additional expenseduring the second quarter of 2004, which coincides with an increase inelectronic banking fee income.

 

As a result of the higherlevel of expenses, the efficiency ratio, a key measure of expense management, increasedover 2003. The efficiency ratio is computed by dividing noninterest expenses bythe sum of net interest income on a tax-equivalent basis and noninterestincome. Bankshares’ efficiency ratio was 50.12% compared to 48.24% for thethree months ended June 30, 2004 and 2003, respectively. A large portion of theincreased expenses is due to the acquisition of F&M.  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 49.03%, compared to 49.24%

 

22

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for the three monthsended June 30, 2004 and 2003, respectively. For the reconciliation of GAAP tonon-GAAP measures, see page 33 in this filing.

 

Employee-related expenses,which include salaries, benefits and incentive compensation, were the largestcomponent at 60% of noninterest expenses. F&M accounted for a substantial portion of the $10.0 millionincrease in employee-related expenses for the second quarter of 2004 comparedto the same period in 2003. Salaries and benefit expenses for the secondquarter of 2004 compared to the first quarter of 2004, declined $1.7 million.

 

Net occupancy expense,which includes depreciation, rents, maintenance and utilities, increased due tothe additional branch and corporate office locations related to the F&Macquisition.  On a linked-quarter basisnet occupancy expense decreased with a reduction in the number of facilitiesoperated by F&M.

 

Furniture and equipmentexpenses include premises depreciation, rental and maintenance expenseassociated with the upkeep and improvement of hardware and computer software.Furniture and equipment increased due to normal increases in software licenseand maintenance fees associated with the core banking system.

 

Communications andsupplies 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 F&M acquisition.

 

Other expenses consist ofprofessional services, marketing, electronic banking and several othercategories such as travel and membership, amortization, licensing, insuranceand sundry losses. The increases for the three months ended June 30, 2004compared to the three months ended June 30, 2003 are attributable to theF&M acquisition. Of the $2.9 million increase in other expenses for thesecond quarter of 2004 compared to the second quarter of 2003, $1.2 million isassociated with the increased amortization of intangible assets resulting fromthe acquisition of F&M.  Otherexpenses increased $1.8 million, over the first quarter of 2004. This increasefrom the previous quarter is principally due to higher professional fees of$1.1 million. This included a $0.5 million increase relating to directorsdeferred compensation. At the Annual Meeting, shareholders approved a change tothe Directors Deferred Compensation Plan that will substantially reduce expensevolatility in future periods. Professional fees also included $0.4 millionrelating to the consolidation of 11 bank affiliates into four, leaving theorganization with 13 bank affiliates. Management expects to incur additional legal fees due to pending legalproceedings.  Other expenses also increasedas a result of advertising expenses related to planned promotional campaigns;increases in electronic banking transaction costs that were more than offset byincreases in electronic banking revenues; and $0.8 million in certain employeeseparation costs.

 

Noninterest expense forthe six months ended June 30, 2004 increased to $186.8 million or 27% over the$146.8 million for the six months ended June 30, 2003. The increase in eachcategory was largely attributable to the F&M acquisition.

 

**Analysis of Financial Condition**

 

At June 30, 2004 comparedto December 31, 2003, total assets increased 3% or $434.7 million.  Total loans increased 5% or $490.0 million.Loans grew in nearly every category in this period except for the consumer portfolio,which decreased less than 1% and the planned run-off in lease receivables.  Total investment securities decreased 3% or$107.4 million.

 

Total deposits at June30, 2004, were $10.6 billion, an increase of 4% or $381.1 million over December31, 2003.  Interest-bearing deposits,which represent 71% of total deposits increased 1%, while noninterest-bearingdeposits increased 11% from the end of last year. A decline in money market andtime deposits of $100,000 and over was more than offset by increases in all ofthe other deposit categories.

 

At June 30, 2004 comparedto June 30, 2003, total assets increased 23% or $2.6 billion. Total loansincreased 29% or $2.2 billion and total investment securities increased 12% or$0.3 billion. These substantial increases are due principally to theacquisition of F&M, which accounted for approximately 80% of the growth intotal assets.

 

At June 30, 2004, totaldeposits increased 23% or $2.0 billion compared to one year earlier.  F&M added approximately 80% to the totaldeposit growth.  The additional growth indeposits was in core deposits from customers in the local markets. Theaffiliate banking structure 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.

 

Shareholders’ equity atJune 30, 2004 was $1.8 billion. Bankshares has authorization enabling it to repurchase up toapproximately 0.5 million additional shares. In April, Bankshares repurchased 1.0 million shares at a cost of $44.1million by entering into a privately negotiated agreement for the acceleratedpurchase of these shares. Since the share repurchase program began in themid-1990’s, Management has generally targeted 40% of net income for cashdividends to shareholders and 30% of net income for potential

 

23

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share repurchases.  Effective at the June 2004 Board meeting, thequarterly dividend rate was increased 6% to $.35 from $.33 per share. At June30, 2004 and December 31, 2003, the cash dividend payout ratio was 48.23% and47.78% 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 our 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. Aloan may be put on nonaccrual status sooner than this standard if, inmanagement’s judgment, such action is warranted.

 

During the six monthsended June 30, 2004, nonperforming assets decreased $10.2 million to $40.3million from $50.5 million at December 31, 2003.  Nonaccrual loans were $39.9 million at June30, 2004 and other real estate owned, the other component of nonperformingassets, was $0.4 million.  Nonperformingassets as a percent of period-end loans and other real estate owned was .41% atJune 30, 2004 and .55% at December 31, 2003, respectively.  The decrease in nonperforming loans was dueprimarily to improvement in credit quality at MSD&T. Credit quality at theCommunity Banks also continued to improve.

 

At June 30, 2004 andDecember 31, 2003, monitored loans, or loans with characteristics suggestingthat they could be classified as nonperforming in the near future, were $23.9million and $28.4 million, respectively. Two loans at MSD&T contributed$17.2 million and one loan at The Citizens National Bank affiliate contributed$5.3 million to the current total. The MSD&T loans are secured by twocommercial aircraft, which are leased to a regional commercial airline. In lightof the prevailing conditions in the commercial airline industry, management hasincluded these loans in the “monitored” status. The amount of loans past due30-89 days decreased from $43.6 million at December 31, 2003 to $33.1 millionat June 30, 2004.

 

24

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

 
|   | **(Dollars  in thousands)**                                                        | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** | **June 30,  2003** | ** ** |   |
|--------|------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|--------------------|------------|--------|
|   | Nonaccrual loans*(1)*                                                              |       |               |       |                   |       |               |       |   |
|   | Commercial                                                                         |       | **$**              | **34,002** | ** **             | $          | 36,569             |       | $      | 26,919 |   |   |
|   | Commercial real estate                                                             |       | **2,197**          | ** ** | 7,363                  |       | 3,798              |       |   |
|   | Construction                                                                       |       | **155**            | ** ** | 651                    |       | 1,178              |       |   |
|   | Residential real estate                                                            |       | **2,518**          | ** ** | 3,721                  |       | 4,001              |       |   |
|   | Consumer                                                                           |       | **346**            | ** ** | 1,224                  |       | 178                |       |   |
|   | Lease financing                                                                    |       | **670**            | ** ** | 824                    |       | 1,694              |       |   |
|   | Total                                                                              |       | **39,888**         | ** ** | 50,352                 |       | 37,768             |       |   |
|   | Renegotiated loans*(1)*                                                            |       | **—**         | ** ** | —                 |       | —             |       |   |
|   | Loans contractually past due 90 days or more and still accruing  interest          |       | **—**         | ** ** | —                 |       | —             |       |   |
|   | Total nonperforming loans                                                          |       | **39,888**         | ** ** | 50,352                 |       | 37,768             |       |   |
|   | Other real estate owned                                                            |       | **402**            | ** ** | 191                    |       | 376                |       |   |
|   | Total nonperforming assets                                                         |       | **$**              | **40,290** | ** **             | $          | 50,543             |       | $      | 38,144 |   |   |
|   | Nonperforming loans as a percent of period-end loans                               |       | **0.41**           | **%**      | 0.54                   | %          | 0.50               | %          |   |
|   | Nonperforming assets as a percent of period-end loans and other real  estate owned |       | **0.41**           | **%**      | 0.55                   | %          | 0.50               | %          |   |
|   |
|        |                                                                                    |            |                    |            |                        |            |                    |            |        |  |  |  |

(1)          Aggregate gross interestincome of $1.4 million, $4.1 million and $1.5 million for the first half of2004, the year 2003 and the first half of 2003, respectively, on nonaccrual andrenegotiated loans, would have been recorded if these loans had been accruingon their original terms throughout the period or since origination if held forpart of the period.  The amount ofinterest income on the nonaccrual and renegotiated loans that was recordedtotaled $0.5 million, $2.1 million and $0.6 million for the first six months of2004, the year 2003 and the first six months of 2003, respectively.

 

**Note:**Bankshareswas monitoring loans estimated to aggregate $23.9 million at June 30, 2004,$26.6 million at March 31, 2004 and $28.4 million at December 31, 2003, notclassified as nonaccrual or renegotiated loans. These loans had characteristics that indicated they might result in suchclassification in the future.

 

**Allowance and Provision for LoanLosses**

 

Each Bankshares’affiliate is required to maintain an allowance for loan losses adequate toabsorb losses inherent in the loan portfolio. Each affiliate’s reserve isdedicated to that affiliate only and is not available to absorb losses fromanother affiliate.   Management at eachaffiliate, along with Bankshares’ management, conducts a regular review toassure that adequacy.  On a periodicbasis, significant credit exposures, nonperforming loans, impaired loans,historical losses by loan type and various statistical measurements of assetquality are examined to assure the adequacy of the allowance for loan losses.Management believes that the allowance for loan losses is at an adequate levelto 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 secondquarter of 2004 was $2.4 million, a 23% decrease from the same period last yearand a 3% decrease from the first quarter of 2004. The decline in the provisionreflects a continued improvement in the economy and stable credit qualitywithin Bankshares’ Community Banks. The Community Banks’ loan portfolios aremore heavily weighted toward consumer and residential real estate loans.Potential losses in these portfolios are more predictable and quantifiable,generally resulting in a lower required allowance. Net charge-offs were $0.6million for the second quarter of 2004, $1.1 million for the first quarter of2004 and $3.5 million for the fourth quarter of 2003. The allowance for loanlosses as a percent of period-end loans decreased to 1.62% at June 30, 2004from 1.66% at March 31, 2004 and 1.68% at December 31, 2003.

 

25

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

 
| ** **                                               | ** ** | **For the 6 Months Ended June 30,** |          | **For the 3 Months Ended June 30,** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------|---------------|-------------------------------------|------------|
| **(Dollars  in thousands)**                              | ** ** | **2004**                            | ** **    | **2003**                            |       | **2004** | ** ** | **2003** | ** ** |
| Allowance balance - beginning                            | ** ** | **$**                               | **155,337**   | ** **                          | $          | 138,601 |   | **$** | **156,635** | ** ** | $ | 140,427 |   |
| Charge-offs:                                             |       |                                | ** **    |                                |       |   | ** ** |   |   |
| Commercial                                               | ** ** | **(945**                            | **)**         | (719                                | )          | **(255** | **)** | (613 | ) |
| Commercial real estate                                   | ** ** | **(28**                             | **)**         | (342                                | )          | **—** | ** ** | (1 | ) |
| Construction                                             | ** ** | **—**                          | ** **    | —                              |       | **—** | ** ** | — |   |
| Residential real estate                                  | ** ** | **(129**                            | **)**         | (50                                 | )          | **(28** | **)** | (50 | ) |
| Consumer                                                 | ** ** | **(2,377**                          | **)**         | (1,573                              | )          | **(1,260** | **)** | (722 | ) |
| Lease financing                                          | ** ** | **—**                          | ** **    | (1,188                              | )          | **—** | ** ** | (547 | ) |
| Total                                                    | ** ** | **(3,479**                          | **)**         | (3,872                              | )          | **(1,543** | **)** | (1,933 | ) |
| Recoveries:                                              |       |                                | ** **    |                                |       |   | ** ** |   |   |
| Commercial                                               | ** ** | **337**                             | ** **    | 409                                 |       | **237** | ** ** | 205 |   |
| Commercial real estate                                   | ** ** | **26**                              | ** **    | 117                                 |       | **8** | ** ** | 99 |   |
| Construction                                             | ** ** | **4**                               | ** **    | 135                                 |       | **—** | ** ** | — |   |
| Residential real estate                                  | ** ** | **191**                             | ** **    | 39                                  |       | **139** | ** ** | 35 |   |
| Consumer                                                 | ** ** | **1,236**                           | ** **    | 765                                 |       | **602** | ** ** | 377 |   |
| Lease financing                                          | ** ** | **—**                          | ** **    | —                              |       | **—** | ** ** | — |   |
| Total                                                    | ** ** | **1,794**                           | ** **    | 1,465                               |       | **986** | ** ** | 716 |   |
| Net charge-offs                                          | ** ** | **(1,685**                          | **)**         | (2,407                              | )          | **(557** | **)** | (1,217 | ) |
| Provision for loan losses                                | ** ** | **4,779**                           | ** **    | 6,067                               |       | **2,353** | ** ** | 3,051 |   |
| Allowance balance - ending                               | ** ** | **$**                               | **158,431**   | ** **                          | $          | 142,261 |   | **$** | **158,431** | ** ** | $ | 142,261 |   |
| Average loans                                            | ** ** | **$**                               | **9,481,159** | ** **                          | $          | 7,437,036 |   | **$** | **9,623,884** | ** ** | $ | 7,513,576 |   |
| Percent of net charge-offs (annualized) to average loans | ** ** | **0.04**                            | **%**         | 0.07                                | %          | **0.02** | **%** | 0.06 | % |
| Period-end loans                                         | ** ** | **$**                               | **9,762,110** | ** **                          | $          | 7,560,931 |   |   | ** ** |   |   |
| Percent of allowance for loan losses to period-end loans | ** ** | **1.62**                            | **%**         | 1.88                                | %          |   | ** ** |   |   |

 

**Interest Rate Risk**

 

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

 

EARNINGS SIMULATION MODELPROJECTIONS

The following tablesummarizes the effect a positive 100 and 200 bp change and a negative 50 bpchange in interest rates would have on Bankshares’ net interest income over thenext 12 months.

 
| ** **                                    | ** ** | **Calculated increase /  (decrease) in  projected net interest income** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| **Change in  interest rates  (basis points)** | ** ** | **June 30,  2004**                                                      | ** ** | **December 31,  2003** | ** ** |
| + 200                                         |       |                                                                    | **5.4**    | **%** | 4.6 | % |
| + 100                                         |       |                                                                    | **3.2**    | **%** | 2.4 | % |
| - 50                                          |       |                                                                    | **(2.5**   | **)%** | (2.1 | )% |

 

Bankshares’ interestsensitivity has become modestly more asset sensitive since December 31, 2003.Based on its most recent simulation model, Bankshares’ net interest incomewould increase by $15.6 million and $26.4 million if interest rates were tomove up gradually over the next six months by 100 bp or 200 bp, respectively. Adownward movement of 50 bp would reduce net interest income by $12.3 million.In response to action by the Federal Reserve to increase short-term interestrates, Bankshares raised its prime interest rate by 25 bp on June 30, 2004.Bankshares has approximately $3.6 billion in loans that will reprice daily ormonthly as prime rate changes. The 25 bp increase is expected to yieldapproximately $4.5 million in additional income from these loans through theremainder of 2004. The effects of a rising rate environment on interest expenseare less predictable due to customer behavior that shifts the mix. Currenttrends have seen very strong growth in noninterest bearing demand depositaccounts, while money market accounts and certificates of deposit havedecreased. As rates begin to rise, management expects, based on Bankshares’interest sensitivity position, that the margin and net interest income willexpand.

 

26

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**Market Risk**

 

Market risk is defined asthe impact of changes in market values of assets and liabilities as interestrates and equity markets fluctuate. Changes in market values also impact thefee income earned by IWM, where a significant portion of the fee schedule istied to current asset values under management or administration. Bankshares hasdesignated substantially all of its investment portfolio as available-for-saleand in accordance with financial reporting standards, this portfolio isreported at fair value. Changes in fair value, net of tax, are reflected as acomponent of shareholders’ equity. Bankshares’ maintenance of capital ratioswell above regulatory requirements (see Footnote No. 9) provides managementwith the flexibility to utilize the available-for-sale portfolio for liquidityand interest rate risk management needs, even during a period when valuationsare depressed. Maintaining a fairly short duration in the portfolio alsomitigates 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. Core depositsand the available-for-sale investment portfolio are key elements in meetingthis objective. For the three months ended June 30, 2004, core deposits (totaldeposits less certificates of deposit of $100,000 and over), averaged $9.1billion compared to $8.8 billion for the first quarter of 2004 and $8.9 billionfor the fourth 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 depositrelationships tied to the overnight cash management program offered tocustomers.

 

By limiting the maturityof securities and maintaining a conservative investment posture, management canrely on the investment portfolio to help meet any short-term funding needs.U.S. Treasury and agency securities, which provide the greatest liquidity,averaged $1.5 billion in the second quarter of 2004, a 1% decrease from theaverage of $1.6 billion for the first quarter of 2004 and a 5% decrease fromthe average of $1.6 billion for the fourth quarter 2003. 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 million.For more information see “Risk Management — Liquidity Risk” in the MercantileBankshares Corporation’s 2003 Annual Report on Form 10-K.

 

Inthe normal course of business, Bankshares routinely evaluates alternativesources of funding and liquidity.  Withthe current strong demand by real estate investors for stable commercial officeproperties, management is exploring the merits of a potential sale/leasebacktransaction of its headquarters facility at Two Hopkins Plaza, Baltimore,MD.  Such a transaction would enhanceBankshares’ liquidity through the cash generated on the sale and a reducedinvestment in bank premises. Management is in the final stages of negotiationswith an outside party.

 

**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 file 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                       |       | $                         | 833        |   |
| 2005                       |       | 5,000                     |       |
| 2006                       |       | 5,000                     |       |
| 2007                       |       | 5,000                     |       |
| 2008                       |       | 5,000                     |       |
| 2009                       |       | 5,000                     |       |
| Thereafter                 |       | 9,167                     |       |
| Total                      |       | $                         | 35,000     |   |

 

27

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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 to excludeintangible assets and the amortization of intangible assets related to theconsummation of mergers. These operating earnings measures may also excludeother significant gains, losses or expenses that are not considered componentsof core earnings. Since these items and their impact on Bankshares’ performanceare difficult to predict, management believes presentations of financialmeasures excluding the impact of these items provide useful supplementalinformation that is essential to a proper understanding of the operatingresults and financial position of Bankshares core businesses. These disclosuresshould not be viewed as a substitute for results determined in accordance withGAAP, nor are they necessarily comparable to operating earnings performancemeasures that may 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 mayultimately vary from the statements made in this report.  In addition, the following factors, amongothers, could cause actual results to differ materially from the anticipatedresults or expectations expressed in the forward-looking statements: Regulatoryapprovals for the transactions occurring in connection with the reorganizationcould be delayed or more burdensome to obtain than currently expected resultingin, among other things, an effective date later than July 2004; administrativeand operational efficiencies may not improve to the degree projected; andcompetitive pressures and regulatory complexities that affect our banks may bestronger than expected.

 

28

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**Supplemental Information byQuarter**

**Select Financial Data**

(in thousands, except per share data)

 
| ** **                                                                            | ** ** | **2Q 04**      | ** **    | **1Q 04**  | ** ** | **4Q 03**  | ** ** | **3Q 03**  | ** ** | **2Q 03**  | ** ** | **2Q 04  vs  1Q 04** | ** ** | **2Q 04  vs  2Q 03** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|---------------|------------|------------|------------|------------|------------|------------|------------|------------|----------------------|------------|----------------------|------------|
| **OPERATING RESULTS**                                                                 |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Net interest income (1)                                                               | ** ** | **$**          | **133,060**   | ** ** | $          | 133,674    |       | $          | 133,249    |       | $          | 122,232              |       | $                    | 112,723    |   | (0.5 | )% | 18.0 | % |
| Net interest income - taxable equivalent (1)                                          | ** ** | **134,735**    | ** **    | 135,399    |       | 135,130    |       | 123,989    |       | 114,297    |       | (0.5                 | )          | 17.9                 |       |
| Provision for loan losses                                                             | ** ** | **2,353**      | ** **    | 2,426      |       | 3,033      |       | 3,005      |       | 3,051      |       | (3.0                 | )          | (22.9                | )          |
| Net income                                                                            | ** ** | **56,313**     | ** **    | 55,697     |       | 50,645     |       | 47,173     |       | 50,010     |       | 1.1                  |       | 12.6                 |       |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| **PER COMMON SHARE DATA**                                                             |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Basic net income                                                                      | ** ** | **$**          | **.71**       | ** ** | $          | .70        |       | $          | .64        |       | $          | .64                  |       | $                    | .73        |   | 1.4 | % | (2.7 | )% |
| Diluted net income                                                                    | ** ** | **.71**        | ** **    | .69        |       | .63        |       | .63        |       | .72        |       | 2.9                  |       | (1.4                 | )          |
| Dividends paid                                                                        | ** ** | **.35**        | ** **    | .33        |       | .33        |       | .33        |       | .33        |       | 6.1                  |       | 6.1                  |       |
| Book value at period end                                                              | ** ** | **23.28**      | ** **    | 23.61      |       | 23.08      |       | 22.89      |       | 19.91      |       | (1.4                 | )          | 16.9                 |       |
| Market value at period end                                                            | ** ** | **46.82**      | ** **    | 42.93      |       | 45.58      |       | 40.00      |       | 39.35      |       | 9.1                  |       | 19.0                 |       |
| Market range:                                                                         |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| High                                                                                  | ** ** | **47.93**      | ** **    | 46.01      |       | 45.95      |       | 42.49      |       | 41.30      |       | 4.2                  |       | 16.1                 |       |
| Low                                                                                   | ** ** | **40.31**      | ** **    | 41.50      |       | 39.76      |       | 38.91      |       | 33.90      |       | (2.9                 | )          | 18.9                 |       |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| **AVERAGE  BALANCE SHEET DATA**                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Total loans                                                                           | ** ** | **$**          | **9,623,884** | ** ** | $          | 9,338,433  |       | $          | 9,129,330  |       | $          | 8,331,265            |       | $                    | 7,513,576  |   | 3.1 | % | 28.1 | % |
| Total earning assets                                                                  | ** ** | **12,775,183** | ** **    | 12,475,851 |       | 12,523,854 |       | 11,750,966 |       | 10,465,457 |       | 2.4                  |       | 22.1                 |       |
| Total assets                                                                          | ** ** | **13,939,185** | ** **    | 13,618,193 |       | 13,666,099 |       | 12,622,100 |       | 11,033,724 |       | 2.4                  |       | 26.3                 |       |
| Total deposits                                                                        | ** ** | **10,398,257** | ** **    | 10,066,645 |       | 10,168,699 |       | 9,388,714  |       | 8,313,714  |       | 3.3                  |       | 25.1                 |       |
| Shareholders’ equity                                                             | ** ** | **1,851,761**  | ** **    | 1,848,461  |       | 1,811,742  |       | 1,550,937  |       | 1,324,293  |       | 0.2                  |       | 39.8                 |       |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| **STATISTICS AND RATIOS  (Net income annualized)**                               |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Return on average assets                                                              | ** ** | **1.62**       | **%**         | 1.64       | %          | 1.47       | %          | 1.48       | %          | 1.82       | %          |                 |       |                 |       |
| Return on average equity (2)                                                          | ** ** | **12.23**      | ** **    | 12.12      |       | 11.09      |       | 12.07      |       | 15.15      |       |                 |       |                 |       |
| Return on average tangible equity (2)                                                 | ** ** | **18.14**      | ** **    | 18.01      |       | 16.49      |       | 15.70      |       | 17.05      |       |                 |       |                 |       |
| Average equity to average assets (2)                                                  | ** ** | **13.28**      | ** **    | 13.57      |       | 13.26      |       | 12.29      |       | 12.00      |       |                 |       |                 |       |
| Average tangible equity to average tangible  assets (2)                               | ** ** | **9.55**       | ** **    | 9.75       |       | 9.51       |       | 9.91       |       | 10.91      |       |                 |       |                 |       |
| Net interest rate spread - taxable equivalent                                         | ** ** | **3.91**       | ** **    | 4.03       |       | 3.93       |       | 3.81       |       | 3.94       |       |                 |       |                 |       |
| Net interest margin on earning assets - taxable  equivalent                           | ** ** | **4.24**       | ** **    | 4.37       |       | 4.28       |       | 4.19       |       | 4.38       |       |                 |       |                 |       |
| Efficiency ratio (1),(3)                                                              | ** ** | **50.12**      | ** **    | 50.40      |       | 54.47      |       | 53.67      |       | 48.24      |       |                 |       |                 |       |
| Operating efficiency ratio (1),(3)                                                    | ** ** | **49.03**      | ** **    | 49.24      |       | 50.92      |       | 51.14      |       | 49.24      |       |                 |       |                 |       |
| Dividend payout ratio                                                                 | ** ** | **49.30**      | ** **    | 47.14      |       | 51.56      |       | 51.56      |       | 45.21      |       |                 |       |                 |       |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Bank offices                                                                          | ** ** | **229**        | ** **    | 229        |       | 227        |       | 236        |       | 187        |       | —               |       | 42                   |       |
| Employees                                                                             | ** ** | **3,508**      | ** **    | 3,575      |       | 3,565      |       | 3,642      |       | 3,035      |       | (67                  | )          | 473                  |       |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| **CREDIT QUALITY DATA AT PERIOD  END**                                                |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Net charge-offs                                                                       | ** ** | **$**          | **557**       | ** ** | $          | 1,128      |       | $          | 3,450      |       | $          | 2,717                |       | $                    | 1,217      |   | (50.6 | )% | (54.2 | )% |
| Nonaccrual loans                                                                      | ** ** | **39,888**     | ** **    | 48,007     |       | 50,352     |       | 51,001     |       | 37,768     |       | (16.9                | )          | 5.6                  |       |
| Restructured loans                                                                    | ** ** | **—**     | ** **    | —     |       | —     |       | —     |       | —     |       | —               |       | —               |       |
| Total nonperforming loans                                                             | ** ** | **39,888**     | ** **    | 48,007     |       | 50,352     |       | 51,001     |       | 37,768     |       | (16.9                | )          | 5.6                  |       |
| Other real estate owned, net                                                          | ** ** | **402**        | ** **    | 134        |       | 191        |       | 397        |       | 376        |       | 200.0                |       | 6.9                  |       |
| Total nonperforming assets                                                            | ** ** | **40,290**     | ** **    | 48,141     |       | 50,543     |       | 51,398     |       | 38,144     |       | (16.3                | )          | 5.6                  |       |
|                                                                                  |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| **CREDIT QUALITY RATIOS**                                                             |       |           | ** **    |       |       |       |       |       |       |       |       |                 |       |                 |       |
| Provision for loan losses (annualized) as a  percent of period-end loans              | ** ** | **.10**        | **%**         | .10        | %          | .13        | %          | .13        | %          | .16        | %          |                 |       |                 |       |
| Net charge-offs (annualized) as a percent of  period-end loans                        | ** ** | **.02**        | ** **    | .05        |       | .15        |       | .12        |       | .06        |       |                 |       |                 |       |
| Nonperforming loans as a percent of period-end  loans                                 | ** ** | **.41**        | ** **    | .51        |       | .54        |       | .57        |       | .50        |       |                 |       |                 |       |
| Allowance for loan losses as a percent of  period-end loans                           | ** ** | **1.62**       | ** **    | 1.66       |       | 1.68       |       | 1.73       |       | 1.88       |       |                 |       |                 |       |
| Allowance for loan losses as a percent of  nonperforming loans                        | ** ** | **397.19**     | ** **    | 326.28     |       | 308.50     |       | 305.39     |       | 376.67     |       |                 |       |                 |       |
| 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    | ** ** | **.41**        | ** **    | .51        |       | .55        |       | .57        |       | .50        |       |                 |       |                 |       |
| Nonperforming assets as a percent of total  assets                                    | ** ** | **.29**        | ** **    | .34        |       | .37        |       | .37        |       | .33        |       |                 |       |                 |       |

 

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(1),(2),(3)  See Reconciliation of Non-GAAP measures onpage 33 for additional information.

 

29

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**Statements of Consolidated Income**

(in thousands, except per share data)

 
| ** **                                               | ** ** | **2Q 04**   | ** **  | **1Q 04**  | ** ** | **4Q 03** | ** ** | **3Q 03** | ** ** | **2Q 03** | ** ** | **2Q 04  vs  1Q 04** | ** ** | **2Q 04  vs  2Q 03** | ** ** |
|----------------------------------------------------------|------------|-------------|-------------|------------|------------|-----------|------------|-----------|------------|-----------|------------|----------------------|------------|----------------------|------------|
| **INTEREST INCOME**                                      |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Interest and fees on loans                               | ** ** | **$**       | **132,116** | ** ** | $          | 129,060   |       | $         | 129,288    |      | $          | 120,137              |       | $                    | 111,962    |   | 2.4 | % | 18.0 | % |
| Interest and dividends on investment  securities:        |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Taxable interest income                                  | ** ** | **26,165**  | ** **  | 27,401     |       | 28,660    |       | 27,285    |       | 26,638    |       | (4.5                 | )          | (1.8                 | )          |
| Tax-exempt interest income                               | ** ** | **820**     | ** **  | 877        |       | 999       |       | 783       |       | 497       |       | (6.5                 | )          | 65.0                 |       |
| Dividends                                                | ** ** | **300**     | ** **  | 261        |       | 114       |       | 212       |       | 199       |       | 14.9                 |       | 50.8                 |       |
| Other investment income                                  | ** ** | **(372**    | **)**       | 3,341      |       | 2,578     |       | 1,508     |       | 2,318     |       | (111.1               | )          | (116.0               | )          |
| ** **                                               |       | **26,913**  | ** **  | 31,880     |       | 32,351    |       | 29,788    |       | 29,652    |       | (15.6                | )          | (9.2                 | )          |
| Other interest income                                    | ** ** | **589**     | ** **  | 175        |       | 630       |       | 1,291     |       | 1,314     |       | 236.6                |       | (55.2                | )          |
| Total interest income                                    | ** ** | **159,618** | ** **  | 161,115    |       | 162,269   |       | 151,216   |       | 142,928   |       | (0.9                 | )          | 11.7                 |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **INTEREST EXPENSE**                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Interest on deposits                                     | ** ** | **19,873**  | ** **  | 20,767     |       | 22,298    |       | 22,313    |       | 23,450    |       | (4.3                 | )          | (15.3                | )          |
| Interest on short-term borrowings                        | ** ** | **1,480**   | ** **  | 1,419      |       | 1,287     |       | 1,303     |       | 1,469     |       | 4.3                  |       | 0.7                  |       |
| Interest on long-term debt                               | ** ** | **5,205**   | ** **  | 5,255      |       | 5,435     |       | 5,368     |       | 5,286     |       | (1.0                 | )          | (1.5                 | )          |
| Total interest expense                                   | ** ** | **26,558**  | ** **  | 27,441     |       | 29,020    |       | 28,984    |       | 30,205    |       | (3.2                 | )          | (12.1                | )          |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NET INTEREST INCOME**                                  | ** ** | **133,060** | ** **  | 133,674    |       | 133,249   |       | 122,232   |       | 112,723   |       | (0.5                 | )          | 18.0                 |       |
| Provision for loan losses                                | ** ** | **2,353**   | ** **  | 2,426      |       | 3,033     |       | 3,005     |       | 3,051     |       | (3.0                 | )          | (22.9                | )          |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NET INTEREST INCOME AFTER  PROVISION FOR LOAN LOSSES** | ** ** | **130,707** | ** **  | 131,248    |       | 130,216   |       | 119,227   |       | 109,672   |       | (0.4                 | )          | 19.2                 |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NONINTEREST INCOME**                                   |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Investment and wealth management                         | ** ** | **22,936**  | ** **  | 21,983     |       | 21,483    |       | 20,577    |       | 19,508    |       | 4.3                  |       | 17.6                 |       |
| Service charges on deposit accounts                      | ** ** | **10,351**  | ** **  | 10,119     |       | 10,840    |       | 9,701     |       | 8,311     |       | 2.3                  |       | 24.5                 |       |
| Mortgage banking related fees                            | ** ** | **2,293**   | ** **  | 2,940      |       | 2,813     |       | 3,403     |       | 2,507     |       | (22.0                | )          | (8.5                 | )          |
| Investment securities gains and (losses)                 | ** ** | **590**     | ** **  | (55        | )          | 122       |       | (336      | )          | 6,536     |       | —               |       | (91.0                | )          |
| Other income                                             | ** ** | **15,380**  | ** **  | 14,898     |       | 12,140    |       | 12,558    |       | 8,575     |       | 3.2                  |       | 79.4                 |       |
| Total noninterest income                                 | ** ** | **51,550**  | ** **  | 49,885     |       | 47,398    |       | 45,903    |       | 45,437    |       | 3.3                  |       | 13.5                 |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NONINTEREST EXPENSES**                                 |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Salaries                                                 | ** ** | **44,689**  | ** **  | 44,788     |       | 45,724    |       | 43,870    |       | 36,317    |       | (0.2                 | )          | 23.1                 |       |
| Employee benefits                                        | ** ** | **10,928**  | ** **  | 12,513     |       | 8,826     |       | 10,144    |       | 9,319     |       | (12.7                | )          | 17.3                 |       |
| Net occupancy expense of bank premises                   | ** ** | **5,819**   | ** **  | 6,060      |       | 7,305     |       | 5,136     |       | 4,219     |       | (4.0                 | )          | 37.9                 |       |
| Furniture and equipment expenses                         | ** ** | **7,573**   | ** **  | 7,364      |       | 9,636     |       | 8,432     |       | 6,743     |       | 2.8                  |       | 12.3                 |       |
| Communications and supplies                              | ** ** | **4,195**   | ** **  | 4,304      |       | 4,682     |       | 3,889     |       | 3,181     |       | (2.5                 | )          | 31.9                 |       |
| Other expenses                                           | ** ** | **20,163**  | ** **  | 18,357     |       | 23,255    |       | 19,718    |       | 17,270    |       | 9.8                  |       | 16.8                 |       |
| Total noninterest expenses                               | ** ** | **93,367**  | ** **  | 93,386     |       | 99,428    |       | 91,189    |       | 77,049    |       | —               |       | 21.2                 |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Income before income taxes                               | ** ** | **88,890**  | ** **  | 87,747     |       | 78,186    |       | 73,941    |       | 78,060    |       | 1.3                  |       | 13.9                 |       |
| Applicable income taxes                                  | ** ** | **32,577**  | ** **  | 32,050     |       | 27,541    |       | 26,768    |       | 28,050    |       | 1.6                  |       | 16.1                 |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NET INCOME**                                           | ** ** | **$**       | **56,313**  | ** ** | $          | 55,697    |       | $         | 50,645     |      | $          | 47,173               |       | $                    | 50,010     |   | 1.1 |   | 12.6 |   |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Weighted average shares outstanding                      | ** ** | **79,119**  | ** **  | 79,725     |       | 79,554    |       | 74,253    |       | 68,860    |       | (0.8                 | )          | 14.9                 |       |
| Adjusted weighted average shares outstanding             | ** ** | **79,751**  | ** **  | 80,258     |       | 80,196    |       | 74,840    |       | 69,318    |       | (0.6                 | )          | 15.1                 |       |
|                                                     |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| **NET INCOME PER COMMON SHARE:**                         |       |        | ** **  |       |       |      |       |      |       |      |       |                 |       |                 |       |
| Basic                                                    |       | $           | .71         | ** ** | $          | .70       |       | $         | .64        |      | $          | .64                  |       | $                    | .73        |   | 1.4 |   | (2.7 | ) |
| Diluted                                                  |       | $           | .71         | ** ** | $          | .69       |       | $         | .63        |      | $          | .63                  |       | $                    | .72        |   | 2.9 |   | (1.4 | ) |

 

30

----

 

**Statements of ConsolidatedNoninterest Income and Noninterest Expenses**

(in thousands)

 
| **Noninterest Income**                   | ** ** | **2Q 04**  | ** ** | **1Q 04** | ** ** | **4Q 03** | ** ** | **3Q 03** | ** ** | **2Q 03** | ** ** | **2Q 04  vs  1Q 04** | ** ** | **2Q 04  vs  2Q 03** | ** ** |
|------------------------------------------|------------|------------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|----------------------|------------|----------------------|------------|
| Investment and wealth management         | ** ** | **$**      | **22,936** |      | $          | 21,983    |       | $         | 21,483     |      | $          | 20,577               |       | $                    | 19,508     |   | 4.3 | % | 17.6 | % |
| Service charges on deposit accounts      | ** ** | **10,351** |       | 10,119    |       | 10,840    |       | 9,701     |       | 8,311     |       | 2.3                  |       | 24.5                 |       |
| Mortgage banking related fees:           |       |       |       |      |       |      |       |      |       |      |       |                 |       |                 |       |
| Commercial                               | ** ** | **1,563**  |       | 1,920     |       | 1,555     |       | 1,773     |       | 1,693     |       | (18.6                | )          | (7.7                 | )          |
| Residential                              | ** ** | **730**    |       | 1,020     |       | 1,258     |       | 1,630     |       | 814       |       | (28.4                | )          | (10.3                | )          |
| Total mortgage banking related fees      | ** ** | **2,293**  |       | 2,940     |       | 2,813     |       | 3,403     |       | 2,507     |       | (22.0                | )          | (8.5                 | )          |
| Investment securities gains and (losses) | ** ** | **590**    |       | (55       | )          | 122       |       | (336      | )          | 6,536     |       | —               |       | (91.0                | )          |
| Other income:                            |       |       |       |      |       |      |       |      |       |      |       |                 |       |                 |       |
| Electronic banking fees                  | ** ** | **5,951**  |       | 4,400     |       | 4,083     |       | 5,133     |       | 4,145     |       | 35.3                 |       | 43.6                 |       |
| Charges and fees on loans                | ** ** | **2,835**  |       | 2,458     |       | 2,602     |       | 2,430     |       | 2,069     |       | 15.3                 |       | 37.0                 |       |
| Insurance                                | ** ** | **3,267**  |       | 3,828     |       | 2,670     |       | 1,653     |       | 175       |       | (14.7                | )          | —               |       |
| Bank-owned life insurance                | ** ** | **785**    |       | 794       |       | 576       |       | 559       |       | 439       |       | (1.1                 | )          | 78.8                 |       |
| All other income                         | ** ** | **2,542**  |       | 3,418     |       | 2,209     |       | 2,783     |       | 1,747     |       | (25.6                | )          | 45.5                 |       |
| Total other income                       | ** ** | **15,380** |       | 14,898    |       | 12,140    |       | 12,558    |       | 8,575     |       | 3.2                  |       | 79.4                 |       |
| Total                                    | ** ** | **$**      | **51,550** |      | $          | 49,885    |       | $         | 47,398     |      | $          | 45,903               |       | $                    | 45,437     |   | 3.3 | % | 13.5 | % |

 
| **Noninterest Expenses**               | ** ** | **2Q 04**  | ** ** | **1Q 04** | ** ** | **4Q 03** | ** ** | **3Q 03** | ** ** | **2Q 03** | ** ** | **2Q 04  vs  1Q 04** | ** ** | **2Q 04  vs  2Q 03** | ** ** |
|----------------------------------------|------------|------------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|----------------------|------------|----------------------|------------|
| Salaries                               | ** ** | **$**      | **44,689** |      | $          | 44,788    |       | $         | 45,724     |      | $          | 43,870               |       | $                    | 36,317     |   | (0.2% | ) | 23.1 | % |
| Employee benefits                      | ** ** | **10,928** |       | 12,513    |       | 8,826     |       | 10,144    |       | 9,319     |       | (12.7                | )          | 17.3                 |       |
| Net occupancy expense of bank premises | ** ** | **5,819**  |       | 6,060     |       | 7,305     |       | 5,136     |       | 4,219     |       | (4.0                 | )          | 37.9                 |       |
| Furniture and equipment expenses       | ** ** | **7,573**  |       | 7,364     |       | 9,636     |       | 8,432     |       | 6,743     |       | 2.8                  |       | 12.3                 |       |
| Communications and supplies            | ** ** | **4,195**  |       | 4,304     |       | 4,682     |       | 3,889     |       | 3,181     |       | (2.5                 | )          | 31.9                 |       |
| Other expenses:                        |       |       |       |      |       |      |       |      |       |      |       |                 |       |                 |       |
| Professional services                  | ** ** | **4,996**  |       | 3,834     |       | 7,080     |       | 5,380     |       | 4,962     |       | 30.3                 |       | 0.7                  |       |
| Advertising and promotional expenses   | ** ** | **2,135**  |       | 1,703     |       | 3,275     |       | 2,168     |       | 2,247     |       | 25.4                 |       | (5.0                 | )          |
| Electronic banking expenses            | ** ** | **2,485**  |       | 1,929     |       | 1,791     |       | 2,432     |       | 1,851     |       | 28.8                 |       | 34.3                 |       |
| Amortization of intangible assets      | ** ** | **2,056**  |       | 2,032     |       | 1,847     |       | 1,688     |       | 848       |       | 1.2                  |       | 142.5                |       |
| Outsourcing expenses                   | ** ** | **1,227**  |       | 1,459     |       | 1,136     |       | 1,049     |       | 1,010     |       | (15.9                | )          | 21.5                 |       |
| All other expenses                     | ** ** | **7,264**  |       | 7,400     |       | 8,126     |       | 7,001     |       | 6,352     |       | (1.8                 | )          | 14.4                 |       |
| Total other expenses                   | ** ** | **20,163** |       | 18,357    |       | 23,255    |       | 19,718    |       | 17,270    |       | 9.8                  |       | 16.8                 |       |
| Total                                  | ** ** | **$**      | **93,367** |      | $          | 93,386    |       | $         | 99,428     |      | $          | 91,189               |       | $                    | 77,049     |   | — | % | 21.2 | % |

 

31

----

 

**Consolidated Average BalanceSheets**

(in thousands)

 
| ** **                                | ** ** | ** **           | ** **     | ** **        | ** ** | ** **           | ** ** | ** **        | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **        | ** ** | ** **           | ** ** | ** **        | ** ** | **Average Balance** | ** ** |
|-------------------------------------------|------------|----------------------|----------------|-------------------|------------|----------------------|------------|-------------------|------------|----------------------|------------|----------------------|------------|----------------------|------------|-------------------|------------|----------------------|------------|-------------------|------------|---------------------|------------|
| ** **                                | ** ** | **2Q04**             | ** **     | **1Q04**          | ** ** | **4Q03**             | ** ** | **3Q03**          | ** ** | **2Q03**             | ** ** | **2Q 04  vs  1Q 04** | ** ** | **2Q 04  vs  2Q 03** | ** ** |
|                                      | ** ** | **Average  Balance** | ** **     | **Yield*/  Rate** | ** ** | **Average  Balance** | ** ** | **Yield*/  Rate** | ** ** | **Average  Balance** | ** ** | **Yield*/  Rate**    | ** ** | **Average  Balance** | ** ** | **Yield*/  Rate** | ** ** | **Average  Balance** | ** ** | **Yield*/  Rate** | ** ** | ** **          | ** ** | ** ** | ** ** |
| Earning assets                            | ** ** | ** **           | ** **     | ** **        | ** ** | ** **           | ** ** | ** **        | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **        | ** ** | ** **           | ** ** | ** **        | ** ** | ** **          | ** ** | ** ** | ** ** |
| Loans: **                                 | ** ** | ** **           | ** **     | ** **        | ** ** | ** **           | ** ** | ** **        | ** ** | ** **           | ** ** | ** **           | ** ** | ** **           | ** ** | ** **        | ** ** | ** **           | ** ** | ** **        | ** ** | ** **          | ** ** | ** ** | ** ** |
| Commercial                                | ** ** | **$**                | **2,727,051**  | ** **        | **5.13**   | %                    | $          | 2,632,605         |       | 5.14                 | %          | $                    | 2,628,283  |                 | 5.13       | %                 | $          | 2,508,721            |       | 5.28              | %          | $                   | 2,411,227  |   | 5.57 | % | 3.6 | % | 13.1 | % |
| Commercial real estate                    | ** ** | **2,871,615**        | ** **     | **5.83**          |       | 2,768,779            |       | 5.91              |       | 2,664,891            |       | 6.00                 |       | 2,391,892            |       | 6.02              |       | 2,116,259            |       | 6.31              |       | 3.7                 |       | 35.7 |   |
| Construction                              | ** ** | **1,113,301**        | ** **     | **5.21**          |       | 1,103,901            |       | 5.18              |       | 1,053,049            |       | 5.25                 |       | 969,251              |       | 5.34              |       | 870,955              |       | 5.51              |       | 0.9                 |       | 27.8 |   |
| Residential real estate                   | ** ** | **1,437,331**        | ** **     | **5.91**          |       | 1,358,975            |       | 6.06              |       | 1,309,345            |       | 6.13                 |       | 1,205,020            |       | 6.28              |       | 1,089,772            |       | 6.63              |       | 5.8                 |       | 31.9 |   |
| Consumer                                  | ** ** | **1,474,586**        | ** **     | **5.81**          |       | 1,474,173            |       | 5.79              |       | 1,473,762            |       | 5.94                 |       | 1,256,381            |       | 6.18              |       | 1,025,363            |       | 6.42              |       | —              |       | 43.8 |   |
| Total loans                               | ** ** | **9,623,884**        | ** **     | **5.57**          |       | 9,338,433            |       | 5.61              |       | 9,129,330            |       | 5.67                 |       | 8,331,265            |       | 5.78              |       | 7,513,576            |       | 6.04              |       | 3.1                 |       | 28.1 |   |
|                                      |       |                 |           |              |       |                 |       |              |       |                 |       |                 |       |                 |       |              |       |                 |       |              |       |                |       |   |   |
| Federal funds sold, et al                 | ** ** | **95,504**           | ** **     | **2.48**          |       | 47,791               |       | 1.47              |       | 215,329              |       | 1.15                 |       | 413,675              |       | 1.19              |       | 313,844              |       | 1.68              |       | 99.8                |       | (69.6 | ) |
| Securities: ***                           |       |                 |           |              |       |                 |       |              |       |                 |       |                 |       |                 |       |              |       |                 |       |              |       |                |       |   |   |
| Taxable securities                        |       |                 |           |              |       |                 |       |              |       |                 |       |                 |       |                 |       |              |       |                 |       |              |       |                |       |   |   |
| U.S. Treasury and gov.  agencies          | ** ** | **1,543,661**        | ** **     | **3.74**          |       | 1,560,700            |       | 3.89              |       | 1,629,554            |       | 4.01                 |       | 1,629,544            |       | 4.19              |       | 1,741,380            |       | 4.32              |       | (1.1                | )          | (11.4 | ) |
| Mortgage-backed                           | ** ** | **1,254,512**        | ** **     | **3.78**          |       | 1,277,802            |       | 3.87              |       | 1,275,875            |       | 3.79                 |       | 1,150,073            |       | 3.48              |       | 760,630              |       | 4.15              |       | (1.8                | )          | 64.9 |   |
| Other investments                         | ** ** | **159,282**          | ** **     | **(.17**          | )          | 146,592              |       | 9.90              |       | 142,405              |       | 7.51                 |       | 120,093              |       | 5.70              |       | 98,277               |       | 10.38             |       | 8.7                 |       | 62.1 |   |
| Tax-exempt securities                     |       |                 |           |              |       |                 |       |              |       |                 |       |                 |       |                 |       |              |       |                 |       |              |       |                |       |   |   |
| States and political  subdivisions        | ** ** | **98,182**           | ** **     | **5.55**          |       | 104,375              |       | 5.59              |       | 117,374              |       | 5.59                 |       | 84,944               |       | 6.05              |       | 37,412               |       | 8.82              |       | (5.9                | )          | 162.4 |   |
| Total securities                          | ** ** | **3,055,637**        | ** **     | **3.61**          |       | 3,089,469            |       | 4.23              |       | 3,165,208            |       | 4.14                 |       | 2,984,654            |       | 4.03              |       | 2,637,699            |       | 4.56              |       | (1.1                | )          | 15.8 |   |
| Interest-bearing deposits in  other banks | ** ** | **158**              | ** **     | **1.06**          |       | 158                  |       | 1.09              |       | 13,987               |       | .23                  |       | 21,372               |       | .85               |       | 338                  |       | 3.50              |       | —              |       | (53.3 | ) |
| Total earning assets                      | ** ** | **12,775,183**       | ** **     | **5.08**          |       | 12,475,851           |       | 5.25              |       | 12,523,854           |       | 5.20                 |       | 11,750,966           |       | 5.16              |       | 10,465,457           |       | 5.54              |       | 2.4                 |       | 22.1 |   |
|                                      |       |                 |           |              |       |                 |       |              |       |                 |       |                 |       |                 |       |              |       |                 |       |              |       |                |       |   |   |
| Cash and due from banks                   | ** ** | **298,440**          |           |              |       | 285,524              |       |              |       | 298,581              |       |                 |       | 295,289              |       |              |       | 243,728              |       |              |       | 4.5                 |       | 22.4 |   |
| Bank premises and equipment,  net         | ** ** | **141,757**          |           |              |       | 141,632              |       |              |       | 139,022              |       |                 |       | 124,275              |       |              |       | 104,825              |       |              |       | 0.1                 |       | 35.2 |   |
| Other assets                              | ** ** | **881,921**          |           |              |       | 871,583              |       |              |       | 861,348              |       |                 |       | 602,614              |       |              |       | 361,951              |       |              |       | 1.2                 |       | 143.7 |   |
| Less: allowance for loan  losses          | ** ** | **(158,116**         | )              |              |       | (156,397             | )          |              |       | (156,706             | )          |                 |       | (151,044             | )          |              |       | (142,237             | )          |              |       | 1.1                 |       | 11.2 |   |
| Total assets                              | ** ** | **$**                | **13,939,185** |              |       |                 | $          | 13,618,193        |       |                 |       | $                    | 13,666,099 |                 |       |              | $          | 12,622,100           |       |              |       | $                   | 11,033,724 |   |   |   | 2.4 |   | 26.3 |   |
|                                      |       |                 |           |              |       |                 |       |              |       |                 |       |                 |       |                 |       |              |       |                 |       |              |       |                |       |   |   |
| Interest-bearing liabilities              |       |                 |           |              |       |                 |       |              |       |                 |       |                 |       |                 |       |              |       |                 |       |              |       |                |       |   |   |
| Deposits:                                 |       |                 |           |              |       |                 |       |              |       |                 |       |                 |       |                 |       |              |       |                 |       |              |       |                |       |   |   |
|                                           |            |                      |                |                   |            |                      |            |                   |            |                      |            |                      |            |                      |            |                   |            |                      |            |                   |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |
| Savings                                            | ** ** | **$**          | **1,434,288**  | ** ** | **.29** |       | $      | 1,364,181  |   | .29        |   | $      | 1,341,697  |       | .30    |   | $      | 1,218,813  |   | .30    |   | $      | 1,078,760  |   | .51    |   | 5.1 |   | 33.0 |   |
|----------------------------------------------------|------------|----------------|----------------|------------|---------|------------|--------|------------|--------|------------|--------|--------|------------|------------|--------|--------|--------|------------|--------|--------|--------|--------|------------|--------|--------|--------|-----|--------|------|--------|
| Checking plus interest                             | ** ** | **1,302,313**  | ** **     | **.15**    |    | 1,236,552  |   | .15        |   | 1,217,573  |   | .16    |       | 1,119,989  |   | .16    |   | 993,268    |   | .22    |   | 5.3    |       | 31.1   |   |
| Money market                                       | ** ** | **1,564,295**  | ** **     | **.54**    |    | 1,590,460  |   | .60        |   | 1,606,119  |   | .62    |       | 1,431,262  |   | .61    |   | 1,201,044  |   | .81    |   | (1.6   | )          | 30.2   |   |
| Time deposits $100,000 and  over                   | ** ** | **1,315,119**  | ** **     | **1.82**   |    | 1,287,695  |   | 1.99       |   | 1,316,951  |   | 2.08   |       | 1,270,016  |   | 2.20   |   | 1,277,652  |   | 2.37   |   | 2.1    |       | 2.9    |   |
| Other time deposits                                | ** ** | **1,955,632**  | ** **     | **2.12**   |    | 1,979,433  |   | 2.15       |   | 2,038,739  |   | 2.21   |       | 1,942,113  |   | 2.39   |   | 1,708,177  |   | 2.72   |   | (1.2   | )          | 14.5   |   |
| Total interest-bearing  deposits                   | ** ** | **7,571,647**  | ** **     | **1.06**   |    | 7,458,321  |   | 1.12       |   | 7,521,079  |   | 1.18   |       | 6,982,193  |   | 1.27   |   | 6,258,901  |   | 1.50   |   | 1.5    |       | 21.0   |   |
| Short-term borrowings                              | ** ** | **910,854**    | ** **     | **.65**    |    | 919,388    |   | .62        |   | 907,914    |   | .56    |       | 944,979    |   | .55    |   | 771,892    |   | .76    |   | (0.9   | )          | 18.0   |   |
| Long-term debt                                     | ** ** | **648,576**    | ** **     | **3.23**   |    | 649,058    |   | 3.26       |   | 649,516    |   | 3.32   |       | 611,801    |   | 3.48   |   | 527,223    |   | 4.02   |   | (0.1   | )          | 23.0   |   |
| Total interest-bearing funds                       | ** ** | **9,131,077**  | ** **     | **1.17**   |    | 9,026,767  |   | 1.22       |   | 9,078,509  |   | 1.27   |       | 8,538,973  |   | 1.35   |   | 7,558,016  |   | 1.60   |   | 1.2    |       | 20.8   |   |
|                                               |       |           |           |       |    |       |   |       |   |       |   |   |       |       |   |   |   |       |   |   |   |   |       |   |   |
| Noninterest-bearing deposits                       | ** ** | **2,826,610**  |           |       |    | 2,608,324  |   |       |   | 2,647,620  |   |   |       | 2,406,521  |   |   |   | 2,054,813  |   |   |   | 8.4    |       | 37.6   |   |
| Other liabilities and  accrued expenses            | ** ** | **129,737**    |           |       |    | 134,641    |   |       |   | 128,228    |   |   |       | 125,669    |   |   |   | 96,602     |   |   |   | (3.6   | )          | 34.3   |   |
| Total liabilities                                  | ** ** | **12,087,424** |           |       |    | 11,769,732 |   |       |   | 11,854,357 |   |   |       | 11,071,163 |   |   |   | 9,709,431  |   |   |   | 2.7    |       | 24.5   |   |
| Shareholders’ equity                          | ** ** | **1,851,761**  |           |       |    | 1,848,461  |   |       |   | 1,811,742  |   |   |       | 1,550,937  |   |   |   | 1,324,293  |   |   |   | 0.2    |       | 39.8   |   |
| Total liabilities &  shareholders’ equity | ** ** | **$**          | **13,939,185** |       |    |       | $      | 13,618,193 |   |       |   | $      | 13,666,099 |       |   |   | $      | 12,622,100 |   |   |   | $      | 11,033,724 |   |   |   | 2.4 |   | 26.3 |   |
|                                               |       |           |           |       |    |       |   |       |   |       |   |   |       |       |   |   |   |       |   |   |   |   |       |   |   |
| Net interest rate spread                           | ** ** | ** **     |           | **3.91**   | %       |       |   | 4.03       | %      |       |   | 3.93   | %          |       |   | 3.81   | %      |       |   | 3.94   | %      |   |       |   |   |
| Effect of  noninterest-bearing funds               | ** ** | ** **     |           | **.33**    |    |       |   | .34        |   |       |   | .35    |       |       |   | .38    |   |       |   | .44    |   |   |       |   |   |
| Net interest margin on  earning assets             | ** ** | ** **     |           | **4.24**   | %       |       |   | 4.37       | %      |       |   | 4.28   | %          |       |   | 4.19   | %      |       |   | 4.38   | %      |   |       |   |   |

 

----

* Presented on atax-equivalent basis using the statutory federal corporate income tax rate of35% (see reconciliation of non-GAAP measures on page 33)

** Nonaccrual loans areincluded in average loans

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

 

32

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

 
| **(In thousands, except per share data)** | ** ** | **YTD  2004** | ** ** | **YTD  2003** | ** ** | **2 Q 04** | ** ** | **1 Q 04** | ** ** | **4 Q 03** | ** ** | **3 Q 03** | ** ** | **2 Q 03** | ** ** |
|-------------------------------------------|------------|---------------|------------|---------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|

 

(1)          The net interest marginand efficiency ratios are presented on a fully tax-equivalent (“FTE”) andannualized basis. The FTE basis adjusts for the tax-favored status of incomefrom certain loans and investments. Management believes this measure to be the preferred industrymeasurement of the net interest income and provides a relevant comparisonbetween taxable and non-taxable investments.

 
| Net interest income (GAAP  basis)         |   | $     | 266,734 |   | $      | 223,849 |   | $     | 133,060 |   | $      | 133,674 |   | $     | 133,249 |   | $ | 122,232 |   | $ | 112,723 |   |
|-------------------------------------------|--------|-------|---------|--------|--------|---------|--------|-------|---------|--------|--------|---------|--------|-------|---------|--------|---|---------|--------|---|---------|--------|
| Taxable-equivalent  adjustment            |   | 3,400 |    | 3,122  |   | 1,675   |   | 1,725 |    | 1,881  |   | 1,757   |   | 1,574 |    |
| Net interest income -  taxable equivalent |   | $     | 270,134 |   | $      | 226,971 |   | $     | 134,735 |   | $      | 135,399 |   | $     | 135,130 |   | $ | 123,989 |   | $ | 114,297 |   |

 

(2)          Management excludes thebalance of intangible assets and their amortization expense from itscalculation of return on average tangible assets, return on average tangibleequity and average tangible equity to average tangible assets. This adjustmentallows management to review the core operating results and core capital positionof the Company. This is consistent with the treatment by bank regulatoryagencies which exclude goodwill and other intangible assets from theircalculation of risk-based capital ratios.

 
| Return on average assets  (GAAP basis)                          |   | 1.63   | %      | 1.85   | %      | 1.62   | %      | 1.64   | %      | 1.47   | %      | 1.48   | %      | 1.82   | %      |
|-----------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding average  intangible Assets and amortization |   | 0.11   |   | 0.04   |   | 0.11   |   | 0.12   |   | 0.10   |   | 0.08   |   | 0.04   |   |
| Return on average tangible  assets                              |   | 1.74   | %      | 1.89   | %      | 1.73   | %      | 1.76   | %      | 1.57   | %      | 1.56   | %      | 1.86   | %      |
|                                                            |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Return on average equity  (GAAP basis)                          |   | 12.18  | %      | 15.24  | %      | 12.23  | %      | 12.12  | %      | 11.09  | %      | 12.07  | %      | 15.15  | %      |
| Impact of excluding average  intangible Assets and amortization |   | 5.92   |   | 1.78   |   | 5.91   |   | 5.89   |   | 5.40   |   | 3.63   |   | 1.90   |   |
| Return on average tangible  equity                              |   | 18.10  | %      | 17.02  | %      | 18.14  | %      | 18.01  | %      | 16.49  | %      | 15.70  | %      | 17.05  | %      |
|                                                            |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Average equity to average  assets (GAAP basis)                  |   | 13.42  | %      | 12.15  | %      | 13.28  | %      | 13.57  | %      | 13.26  | %      | 12.29  | %      | 12.00  | %      |
| Impact of excluding average  intangible Assets and amortization |   | (3.78  | )      | (1.05  | )      | (3.73  | )      | (3.82  | )      | (3.75  | )      | (2.38  | )      | (1.09  | )      |
| Average tangible equity to  average tangible assets             |   | 9.64   | %      | 11.10  | %      | 9.55   | %      | 9.75   | %      | 9.51   | %      | 9.91   | %      | 10.91  | %      |

 

When computing the cashoperating efficiency ratio and cash operating earnings, management excludes theamortization of intangible assets, restructuring charges, merger-relatedexpenses, gains on building sales and gains and losses from sales of investmentsecurities in order to assess the core operating results of the Company andbecause of the uncertainty as to timing and amount of gain or losses to berecognized.

 

(3)          The efficiency ratio ismeasured by dividing noninterest expenses by the sum of net interest income ona FTE basis and noninterest income.

 
| Efficiency ratio (GAAP  basis)       |   | 50.26  | %      | 47.32  | %      | 50.12  | %      | 50.40  | %      | 54.47  | %      | 53.67  | %      | 48.24  | %      |
|--------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Impact of excluding:                 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities gains and  (losses)       |   | 0.07   |   | 1.11   |   | 0.16   |   | (0.01  | )      | 0.04   |   | (0.10  | )      | 2.05   |   |
| Gains on building sales              |   | 0.13   |   | 0.04   |   | 0.08   |   | 0.17   |   | — |   | — |   | 0.02   |   |
| Amortization of deposit  intangibles |   | (0.74  | )      | (0.23  | )      | (0.73  | )      | (0.74  | )      | (0.60  | )      | (0.69  | )      | (0.23  | )      |
| Amortization of other  intangibles   |   | (0.36  | )      | (0.21  | )      | (0.37  | )      | (0.36  | )      | (0.40  | )      | (0.30  | )      | (0.32  | )      |
| Restructuring charges                |   | (0.11  | )      | — |   | (0.23  | )      | — |   | — |   | — |   | — |   |
| Merger-related expenses              |   | (0.11  | )      | (0.27  | )      | — |   | (0.22  | )      | (2.59  | )      | (1.44  | )      | (0.52  | )      |
| Cash operating efficiency  ratio     |   | 49.14  | %      | 47.76  | %      | 49.03  | %      | 49.24  | %      | 50.92  | %      | 51.14  | %      | 49.24  | %      |

 

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

 
| Net income (GAAP basis)                                |   | $      | 112,010 |   | $      | 98,996 |   | $      | 56,313 |   | $      | 55,697 |   | $      | 50,645 |   | $ | 47,173 |   | $ | 50,010 |   |
|--------------------------------------------------------|--------|--------|---------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|---|--------|--------|---|--------|--------|
| Less: Securities (gains) and  losses, net of tax       |   | (323   | )       | (4,444 | )      | (357   | )      | 33     |   | (74    | )      | 203    |   | (3,951 | )      |
| Gains on building sales                                |   | (583   | )       | (138   | )      | (189   | )      | (394   | )      | — |   | — |   | (52    | )      |
| Plus: Amortization of  deposit intangibles, net of tax |   | 1,653  |    | 442    |   | 826    |   | 826    |   | 670    |   | 708    |   | 221    |   |
| Amortization of other  intangibles, net of tax         |   | 819    |    | 409    |   | 417    |   | 402    |   | 446    |   | 311    |   | 292    |   |
| Restructuring charges, net  of tax                     |   | 251    |    | — |   | 251    |   | — |   | — |   | — |   | — |   |
| Merger-related expenses, net  of tax                   |   | 248    |    | 518    |   | — |   | 248    |   | 2,847  |   | 1,481  |   | 487    |   |
| Cash operating earnings                                |   | $      | 114,075 |   | $      | 95,783 |   | $      | 57,261 |   | $      | 56,812 |   | $      | 54,534 |   | $ | 49,876 |   | $ | 47,007 |   |
|                                                   |   |   |    |   |   |   |   |   |   |   |   |   |   |   |   |
| Diluted net income per share  (GAAP basis)             |   | $      | 1.40    |   | $      | 1.43   |   | $      | 0.71   |   | $      | 0.69   |   | $      | 0.63   |   | $ | 0.63   |   | $ | 0.72   |   |
| Less: Securities (gains) and  losses, net of tax       |   | — |    | (0.08  | )      | — |   | — |   | — |   | — |   | (0.06  | )      |
| Gains on building sales                                |   | — |    | — |   | — |   | — |   | — |   | — |   | — |   |
| Plus: Amortization of deposit  intangibles, net of tax |   | 0.02   |    | 0.01   |   | 0.01   |   | 0.01   |   | 0.01   |   | 0.01   |   | — |   |
| Amortization of other  intangibles, net of tax         |   | 0.01   |    | 0.01   |   | — |   | 0.01   |   | 0.01   |   | 0.01   |   | 0.01   |   |
| Restructuring charges, net  of tax                     |   | — |    | — |   | — |   | — |   | — |   | — |   | — |   |
| Merger-related expenses, net  of tax                   |   | — |    | 0.01   |   | — |   | — |   | 0.04   |   | 0.02   |   | 0.01   |   |
| Diluted cash operating  earnings per share             |   | $      | 1.43    |   | $      | 1.38   |   | $      | 0.72   |   | $      | 0.71   |   | $      | 0.69   |   | $ | 0.67   |   | $ | 0.68   |   |

 

33

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**Item 3. Quantitative and QualitativeDisclosures 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. There wasno material change in such information as of June 30, 2004.

 

**Item 4. Controls and Procedures**

 

As of June 30, 2004,Bankshares’ management, under the supervision and with the participation of theCompany’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 theevaluation, the principal executive officer and principal financial officerconcluded that the Company’s disclosure controls and procedures are effective.There were no significant changes in the Company’s internal controls during thelast fiscal quarter.

 

**PART II – OTHER INFORMATION**

 

**Item 1. 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 $240million. 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.

 

**Item 2.    Changes in Securities, Use of Proceeds and Issuer Purchases ofEquity Securities**

 

(e)                                  IssuerPurchases of Equity Securities:

 
| ** **                           | ** ** | **(a)**                                | ** ** | **(b)**                            | ** ** | **(c)**                                                                             | ** ** | **(d)**                                                                                    | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|------------------------------------|------------|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **Total number  of shares  purchased** | ** ** | **Average  price paid  per share** | ** ** | **Number of  shares purchased  as part of  publicly  announced plans  or programs** | ** ** | **Maximum  number of  shares that may  yet be purchased  under the plan  or programs (1)** | ** ** |
| January 1, 2004 - January 31, 2004   |       | —                                 |       | $                                  | —     |                                                                                | —     |                                                                                       | 1,476,327  |   |
| February 1, 2004 - February 29, 2004 |       | —                                 |       | —                             |       | —                                                                              |       | 1,476,327                                                                                  |       |
| March 1, 2004 - March 31, 2004       |       | —                                 |       | —                             |       | —                                                                              |       | 1,476,327                                                                                  |       |
| April 1, 2004 - April 30, 2004       |       | 1,000,000                              |       | 44.11                              |       | 1,000,000                                                                           |       | 476,327                                                                                    |       |
| May 1, 2004 - May 31, 2004           |       | —                                 |       | —                             |       | —                                                                              |       | 476,327                                                                                    |       |
| June 1, 2004 - June 30, 2004         |       | —                                 |       | —                             |       | —                                                                              |       | 476,327                                                                                    |       |
| Total                                |       | 1,000,000                              |       | $                                  | 44.11      |                                                                                | 1,000,000  |                                                                                       |       |   |

 

----

(1)On December 11, 2001 Bankshares’ Board of Directors authorized the purchase of2 million shares of Mercantile Bankshares common stock.

 

34

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**Item 4.    Submission of Matters to a Vote of Security Holders**

 

Matters voted upon and considered at the AnnualMeeting of Shareholders held on May 11, 2004. There were 79,968,512 shares ofCommon Stock entitled to vote at the meeting and a total of 64,490,568 shares,or 80.8%, were represented at the meeting.

 

Elect the followingindividuals as directors of Bankshares to serve until the 2007 Annual Meetingof Stockholders and until successors are duly elected and qualify. The resultsof voting for election of directors were:

 
| ** **              | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|-------------------------|------------|------------|------------|--------------|------------|
| Cynthia A.  Archer      |       | 63,476,057 |       | 1,014,511    |       |
| Richard O.  Berndt      |       | 63,501,359 |       | 989,209      |       |
| Howard B. Bowen         |       | 63,925,667 |       | 564,901      |       |
| William R.  Brody, M.D. |       | 63,460,351 |       | 1,030,217    |       |
| Edward J. Kelly,  III   |       | 63,808,249 |       | 682,319      |       |
| Morton B. Plant         |       | 63,876,328 |       | 614,240      |       |

 

The following directors’terms of office continued after the meeting and were not up for reelection:

 

R. Carl Benna

Eddie C. Brown

George L. Bunting, Jr.

Anthony W. Deering

Darrell D. Friedman

Freeman A. Hrabowski, III

Robert A. Kinsley

Jenny G. Morgan

Christian H. Poindexter

Clayton S. Rose

James L. Shea

Donald J. Shepard

 

Ratifed the appointmentof PricewaterhouseCoopers LLP as Bankshares’ Independent Public Accountant for2004. The voting results of shares represented by proxy were:

 

| **For**    | ** ** | **Against** | ** ** | **Abstained** | ** ** | **Broker nonvotes** | ** ** |
|------------|------------|-------------|------------|---------------|------------|---------------------|------------|
| 62,585,378 |       | 1,420,400   |       | 484,790       |       | —              |       |

 

Approve the MercantileBankshares Corporation 1999 Omnibus Stock Plan, as amended. The results ofvoting regarding the 1999 Omnibus Stock Plan were:

 

| **For**    | ** ** | **Against** | ** ** | **Abstained** | ** ** | **Broker nonvotes** | ** ** |
|------------|------------|-------------|------------|---------------|------------|---------------------|------------|
| 45,088,196 |       | 5,435,231   |       | 1,210,452     |       | 12,756,689          |       |

 

Approve the MercantileBankshares Corporation and Affiliates Unfunded Deferred Compensation Plan forDirectors, as amended. The results of voting regarding the Unfunded DeferredCompensation Plan for Directors were:

 

| **For**    | ** ** | **Against** | ** ** | **Abstained** | ** ** | **Broker nonvotes** | ** ** |
|------------|------------|-------------|------------|---------------|------------|---------------------|------------|
| 45,003,956 |       | 5,419,240   |       | 1,310,682     |       | 12,756,690          |       |

 

**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

 

35

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(b)                                 Reportson Form 8-K

 

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

Form 8-K filed, dated April 26, 2004, Item 5. OtherEvents and Regulation FD Disclosure, announced that its Board of Directors hasdetermined that a significant majority are independent under the Nasdaq Rules.

Form 8-K filed, dated April 30, 2004, Item 5. OtherEvents and Regulation FD Disclosure, announced that it has initiated asignificant reorganization within its affiliate bank network

Form 8-K filed, dated June 8, 2004, Item 5. OtherEvents and Regulation FD Disclosure, announced quarterly cash dividend

 

**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)                                                    |
|           |   |                                                            |
| August 6, 2004 |   | /s/  Edward J. Kelly, III                                       |
| Date           |   | By:  Edward J. Kelly, III                                       |
|           |   | Chairman of the  Board,  President and  Chief Executive Officer |
|           |   |                                                            |
| August 6, 2004 |   | /s/  Terry L. Troupe                                            |
| Date           |   | By:  Terry L. Troupe                                            |
|           |   | Chief  Financial Officer                                        |
|           |   |                                                            |
| August 6, 2004 |   | /s/  William T. Skinner, Jr.                                    |
| Date           |   | By:  William T. Skinner, Jr.                                    |
|           |   | Controller                                                      |

 

36

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