**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 March 31, 2006** |
|                                              |
| **OR**                                            |
|                                              |
| **o**                                             | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from                 to                **

 

**Commission file number 0-5127**

 

**MERCANTILE BANKSHARES CORPORATION**

(Exact name of registrant as specified in its charter)

 

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

 

#### **2 Hopkins Plaza**

**Baltimore, Maryland 21201**

(Address of principal executive offices) (Zip Code)

 

**(410) 237-5900**

(Registrant’s telephone number, including area code)

 

**NONE**

(Former name, former address and former fiscal year, if changed sincelast report)

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý  No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated file” in Rule 12b-2 of the Exchange Act. (Check one).

 
| Large accelerated filer  ý | Accelerated filer o | Non-accelerated filer o |
|---------------------------------|---------------------|-------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o    No ý

 

As of April 28, 2006, 123,214,689shares of registrant’s Common Stock, $2 par value per share, were outstanding.

 

 

----

 

**MERCANTILEBANKSHARES CORPORATION**

Quarterly Report on Form 10-Q

March 31, 2006

 

**Table ofContents**

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

 

2

----

 

PART I – FINANCIAL INFORMATION

 

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

 

**MERCANTILEBANKSHARES CORPORATION**

**CONSOLIDATED BALANCESHEETS**

 
| ** **                                                                                                                                                                                                                                                         | ** ** | **March 31,** | ** **     | **December 31,** | ** ** | **March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|----------------|-----------------------|------------|--------------------|------------|
| **(Dollars in thousands, except per share data)**                                                                                                                                                                                    | ** ** | **2006**           | ** **     | **2005**              | ** ** | **2005**           | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                         |       |               |           |                  |       |               |       |
| Cash and due  from banks                                                                                                                                                                                                                                           | ** ** | **$**              | **317,376**    | ** **            | $          | 369,536            |       | $ | 304,969 |   |
| Interest-bearing  deposits in other banks                                                                                                                                                                                                                          | ** ** | **200**            | ** **     | 200                   |       | 158                |       |
| Federal funds  sold                                                                                                                                                                                                                                                | ** ** | **292,905**        | ** **     | 25,104                |       | 26,901             |       |
| Total cash and  cash equivalents                                                                                                                                                                                                                                   | ** ** | **610,481**        | ** **     | 394,840               |       | 332,028            |       |
| Trading account  securities at fair value                                                                                                                                                                                                                          | ** ** | **8,000**          | ** **     | —                |       | —             |       |
| Investment  securities available-for-sale (Note 4)                                                                                                                                                                                                                 | ** ** | **3,119,562**      | ** **     | 3,089,628             |       | 2,807,721          |       |
| Investment  securities held-to-maturity (Note 4) - fair value of $16,858 (March 2006),  $17,181 (December 2005) and $20,371 (March 2005)                                                                                                                           | ** ** | **16,448**         | ** **     | 16,659                |       | 19,704             |       |
| Total investment  securities                                                                                                                                                                                                                                       | ** ** | **3,136,010**      | ** **     | 3,106,287             |       | 2,827,425          |       |
| Loans  held-for-sale                                                                                                                                                                                                                                               | ** ** | **850**            | ** **     | 26,263                |       | 24,341             |       |
| Loans:                                                                                                                                                                                                                                                             |       |               | ** **     |                  |       |               |       |
| Commercial                                                                                                                                                                                                                                                         | ** ** | **2,899,242**      | ** **     | 2,957,301             |       | 2,854,186          |       |
| Commercial real  estate                                                                                                                                                                                                                                            | ** ** | **3,675,692**      | ** **     | 3,703,297             |       | 3,180,853          |       |
| Construction                                                                                                                                                                                                                                                       | ** ** | **1,740,413**      | ** **     | 1,607,095             |       | 1,347,365          |       |
| Residential real  estate                                                                                                                                                                                                                                           | ** ** | **1,856,250**      | ** **     | 1,802,373             |       | 1,735,492          |       |
| Home equity  lines                                                                                                                                                                                                                                                 | ** ** | **487,586**        | ** **     | 505,508               |       | 493,074            |       |
| Consumer                                                                                                                                                                                                                                                           | ** ** | **1,036,985**      | ** **     | 1,032,271             |       | 802,252            |       |
| Total loans                                                                                                                                                                                                                                                        | ** ** | **11,696,168**     | ** **     | 11,607,845            |       | 10,413,222         |       |
| Less: allowance  for loan losses                                                                                                                                                                                                                                   | ** ** | **(141,874**       | **)**          | (156,673              | )          | (149,017           | )          |
| Loans, net                                                                                                                                                                                                                                                         | ** ** | **11,554,294**     | ** **     | 11,451,172            |       | 10,264,205         |       |
| Bank premises  and equipment, less accumulated depreciation of $145,098 (March 2006),  $146,585 (December 2005) and $144,515 (March 2005)                                                                                                                          | ** ** | **137,713**        | ** **     | 137,419               |       | 141,135            |       |
| Other real  estate owned, net                                                                                                                                                                                                                                      | ** ** | **713**            | ** **     | 667                   |       | 145                |       |
| Goodwill, net                                                                                                                                                                                                                                                      | ** ** | **678,918**        | ** **     | 670,028               |       | 507,791            |       |
| Other intangible  assets, net (Note 8)                                                                                                                                                                                                                             | ** ** | **44,461**         | ** **     | 46,653                |       | 46,122             |       |
| Other assets                                                                                                                                                                                                                                                       | ** ** | **611,787**        | ** **     | 588,400               |       | 484,641            |       |
| Total assets                                                                                                                                                                                                                                                       | ** ** | **$**              | **16,783,227** | ** **            | $          | 16,421,729         |       | $ | 14,627,833 |   |
| **COMMITMENTS  and CONTINGENCIES**(Note 7)                                                                                                                                                                                                                         |       |               | ** **     |                  |       |               |       |
| **LIABILITIES**                                                                                                                                                                                                                                                    |       |               | ** **     |                  |       |               |       |
| Deposits:                                                                                                                                                                                                                                                          |       |               | ** **     |                  |       |               |       |
| Noninterest-bearing  deposits                                                                                                                                                                                                                                      | ** ** | **$**              | **3,385,892**  | ** **            | $          | 3,324,650          |       | $ | 3,098,666 |   |
| Interest-bearing  deposits                                                                                                                                                                                                                                         | ** ** | **9,187,664**      | ** **     | 8,752,700             |       | 7,872,610          |       |
| Total deposits                                                                                                                                                                                                                                                     | ** ** | **12,573,556**     | ** **     | 12,077,350            |       | 10,971,276         |       |
| Short-term  borrowings                                                                                                                                                                                                                                             | ** ** | **1,057,015**      | ** **     | 1,237,714             |       | 856,963            |       |
| Accrued expenses  and other liabilities                                                                                                                                                                                                                            | ** ** | **222,031**        | ** **     | 169,780               |       | 179,747            |       |
| Long-term debt                                                                                                                                                                                                                                                     | ** ** | **701,706**        | ** **     | 742,163               |       | 681,331            |       |
| Total  liabilities                                                                                                                                                                                                                                                 | ** ** | **14,554,308**     | ** **     | 14,227,007            |       | 12,689,317         |       |
| **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 - 123,474,125 (March  2006), 123,248,121 (December 2005) and 119,228,780 (March 2005); restricted  shares – 330,148 (March 2006), 249,090 (December 2005) and 253,395 (March  2005) | ** ** | **246,947**        | ** **     | 164,331               |       | 158,972            |       |
| Capital surplus                                                                                                                                                                                                                                                    | ** ** | **595,813**        | ** **     | 676,830               |       | 538,075            |       |
| Retained  earnings                                                                                                                                                                                                                                                 | ** ** | **1,428,288**      | ** **     | 1,386,405             |       | 1,264,634          |       |
| Accumulated  other comprehensive income (loss)                                                                                                                                                                                                                     | ** ** | **(42,129**        | **)**          | (32,844               | )          | (23,165            | )          |
| Total  shareholders’ equity                                                                                                                                                                                                                                   | ** ** | **2,228,919**      | ** **     | 2,194,722             |       | 1,938,516          |       |
| Total  liabilities and shareholders’ equity                                                                                                                                                                                                                   | ** ** | **$**              | **16,783,227** | ** **            | $          | 16,421,729         |       | $ | 14,627,833 |   |

 

See notes to consolidatedfinancial statements

 

3

----

 

**MERCANTILEBANKSHARES CORPORATION**

**STATEMENTS OF CONSOLIDATEDINCOME**

 
| ** **                                                                      | ** ** | **For the 3 months ended** | ** **  |
|---------------------------------------------------------------------------------|------------|------------------------------------------------|-------------|
| ** **                                                                      | ** ** | **March 31,**                             | ** **  |
| **(Dollars in thousands, except per share data)** | ** ** | **2006**                                       | ** **  | **2005** | ** ** |
| **INTEREST  INCOME**                                                            |       |                                           |        |   |   |
| Interest and  fees on loans                                                     | ** ** | **$**                                          | **196,055** |   | $ | 152,544 |   |
| Interest and  dividends on investment securities:                               |       |                                           |        |   |   |
| Taxable interest  income                                                        | ** ** | **29,795**                                     |        | 24,992 |   |
| Tax-exempt  interest income                                                     | ** ** | **778**                                        |        | 721 |   |
| Other investment  income                                                        | ** ** | **627**                                        |        | 644 |   |
| Total interest  and dividends on investment securities                          | ** ** | **31,200**                                     |        | 26,357 |   |
| Other interest  income                                                          | ** ** | **658**                                        |        | 344 |   |
| Total interest  income                                                          | ** ** | **227,913**                                    |        | 179,245 |   |
| **INTEREST  EXPENSE**                                                           |       |                                           |        |   |   |
| Interest on  deposits                                                           | ** ** | **49,243**                                     |        | 25,305 |   |
| Interest on  short-term borrowings                                              | ** ** | **11,023**                                     |        | 4,042 |   |
| Interest on  long-term debt                                                     | ** ** | **9,334**                                      |        | 6,815 |   |
| Total interest  expense                                                         | ** ** | **69,600**                                     |        | 36,162 |   |
| **NET  INTEREST INCOME**                                                        | ** ** | **158,313**                                    |        | 143,083 |   |
| Provision for  credit losses                                                    | ** ** | **—**                                     |        | 756 |   |
| **NET  INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES**                      | ** ** | **158,313**                                    |        | 142,327 |   |
| **NONINTEREST  INCOME**                                                         |       |                                           |        |   |   |
| Investment and  wealth management                                               | ** ** | **26,121**                                     |        | 24,057 |   |
| Service charges  on deposit accounts                                            | ** ** | **10,292**                                     |        | 10,426 |   |
| Mortgage banking  related fees                                                  | ** ** | **2,210**                                      |        | 2,283 |   |
| Investment  securities gains and (losses)                                       | ** ** | **(13**                                        | )           | 414 |   |
| Nonmarketable  investments                                                      | ** ** | **6,269**                                      |        | 5,271 |   |
| Other income                                                                    | ** ** | **15,727**                                     |        | 15,418 |   |
| Total  noninterest income                                                       | ** ** | **60,606**                                     |        | 57,869 |   |
| **NONINTEREST  EXPENSES**                                                       |       |                                           |        |   |   |
| Salaries                                                                        | ** ** | **49,099**                                     |        | 46,554 |   |
| Employee  benefits                                                              | ** ** | **14,735**                                     |        | 11,897 |   |
| Net occupancy  expense of bank premises                                         | ** ** | **7,771**                                      |        | 6,922 |   |
| Furniture and  equipment expenses                                               | ** ** | **8,305**                                      |        | 7,279 |   |
| Communications  and supplies                                                    | ** ** | **3,818**                                      |        | 4,040 |   |
| Other expenses                                                                  | ** ** | **22,987**                                     |        | 23,461 |   |
| Total  noninterest expenses                                                     | ** ** | **106,715**                                    |        | 100,153 |   |
| Income before  income taxes                                                     | ** ** | **112,204**                                    |        | 100,043 |   |
| Applicable  income taxes                                                        | ** ** | **41,445**                                     |        | 37,416 |   |
| **NET  INCOME**                                                                 | ** ** | **$**                                          | **70,759**  |   | $ | 62,627 |   |
| **NET  INCOME PER SHARE OF COMMON STOCK**(Note 3):                              |       |                                           |        |   |   |
| Basic                                                                           | ** ** | **$**                                          | **0.58**    |   | $ | 0.53 |   |
| Diluted                                                                         | ** ** | **$**                                          | **0.57**    |   | $ | 0.52 |   |
| **DIVIDENDS  PAID PER COMMON SHARE**                                            | ** ** | **$**                                          | **0.26**    |   | $ | 0.23 |   |

 

See notes to consolidatedfinancial statements

 

4

----

 

**MERCANTILEBANKSHARES CORPORATION**

**STATEMENTS OF CHANGES IN CONSOLIDATED SHAREHOLDERS’ EQUITY**

 

**For the 3 months ended March 31, 2006 and 2005**

 
| ** **                                                                                                     | ** ** | ** ** | ** **    | ** ** | ** ** | ** **  | ** ** | ** **   | ** **  | **Accumulated  Other** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------|---------------|------------|------------|-------------|------------|--------------|-------------|------------------------|------------|
| ** **                                                                                                     | ** ** | ** ** | ** **    | **Common** | ** ** | **Capital** | ** ** | **Retained** | ** **  | **Comprehensive**      | ** ** |
| **(Dollars in thousands, except per share data)**                                | ** ** | **Total**  | ** **    | **Stock**  | ** ** | **Surplus** | ** ** | **Earnings** | ** **  | **Income (Loss)** | ** ** |
| BALANCE,  DECEMBER 31, 2004                                                                                    |       | $          | 1,917,683     |       | $          | 158,601     |       | $            | 530,705     |                   | $          | 1,231,102 |   | $ | (2,725 | ) |
| Net income                                                                                                     |       | 62,627     |          |       |       |        |       | 62,627       |        |                   |       |
| Unrealized gains  (losses) on securities available-for-sale, net of reclassification  adjustment, net of taxes |       | (20,440    | )             |       |       |        |       |         |        | (20,440                | )          |
| Comprehensive  income                                                                                          |       | 42,187     |          |       |       |        |       |         |        |                   |       |
| Cash dividends  paid:                                                                                          |       |       |          |       |       |        |       |         |        |                   |       |
| Common stock  ($0.23 per share)                                                                                |       | (27,750    | )             |       |       |        |       | (27,750      | )           |                   |       |
| Issuance of  26,355 shares for dividend reinvestment and stock purchase plan                                   |       | 1,278      |          | 53         |       | 1,225       |       |         |        |                   |       |
| Issuance of  5,441 shares for employee stock purchase dividend reinvestment plan                               |       | 273        |          | 11         |       | 262         |       |         |        |                   |       |
| Issuance of  115,703 shares for employee stock option plan                                                     |       | 1,519      |          | 231        |       | 1,288       |       |         |        |                   |       |
| Directors’  deferred compensation plan:                                                                   |       |       |          |       |       |        |       |         |        |                   |       |
| Issuance of 884  shares                                                                                        |       | —     |          | 2          |       | (2          | )          |         |        |                   |       |
| Contribution                                                                                                   |       | 202        |          |       |       | 202         |       |         |        |                   |       |
| Dividend                                                                                                       |       | —     |          |       |       | 60          |       | (60          | )           |                   |       |
| Restricted stock  awards                                                                                       |       |       |          |       |       |        |       |         |        |                   |       |
| Issuance of  36,964 shares                                                                                     |       | 1,890      |          | 74         |       | 1,816       |       |         |        |                   |       |
| Deferred  compensation                                                                                         |       | (1,938     | )             |       |       |        |       | (1,938       | )           |                   |       |
| Amortization                                                                                                   |       | 653        |          |       |       |        |       | 653          |        |                   |       |
| Vested stock  options                                                                                          |       | 2,519      |          | —     |       | 2,519       |       | —       |        | —                 |       |
| BALANCE, MARCH  31, 2005                                                                                       |       | $          | 1,938,516     |       | $          | 158,972     |       | $            | 538,075     |                   | $          | 1,264,634 |   | $ | (23,165 | ) |
| BALANCE,  DECEMBER 31, 2005                                                                                    |       | $          | 2,194,722     |       | $          | 164,331     |       | $            | 676,830     |                   | $          | 1,386,405 |   | $ | (32,844 | ) |
| Net income                                                                                                     |       | 70,759     |          |       |       |        |       | 70,759       |        |                   |       |
| Unrealized gains  (losses) on securities available-for-sale, net of reclassification adjustment,  net of taxes |       | (9,285     | )             |       |       |        |       |         |        | (9,285                 | )          |
| Comprehensive  income                                                                                          |       | 61,474     |          |       |       |        |       |         |        |                   |       |
| Cash dividends  paid:                                                                                          |       |       |          |       |       |        |       |         |        |                   |       |
| Common stock  ($0.26 per share)                                                                                |       | (32,006    | )             |       |       |        |       | (32,006      | )           |                   |       |
| Issuance of  41,898 shares for dividend reinvestment and stock purchase plan                                   |       | 1,539      |          | 84         |       | 1,455       |       |         |        |                   |       |
| Issuance of  7,155 shares for employee stock purchase dividend reinvestment plan                               |       | 293        |          | 14         |       | 279         |       |         |        |                   |       |
| Issuance of  44,319 shares for employee stock option plan                                                      |       | 972        |          | 88         |       | 884         |       |         |        |                   |       |
| Directors’  deferred compensation plan:                                                                   |       |       |          |       |       |        |       |         |        |                   |       |
| Issuance of  3,924 shares                                                                                      |       | 137        |          | 8          |       | 129         |       |         |        |                   |       |
| Contribution                                                                                                   |       | 201        |          |       |       | 201         |       |         |        |                   |       |
| Dividend                                                                                                       |       |       |          |       |       | 76          |       | (76          | )           |                   |       |
| Nonvested stock  awards                                                                                        |       |       |          |       |       |        |       |         |        |                   |       |
| Issuance of  129,959 shares                                                                                    |       |       |          | 259        |       | (259        | )          |         |        |                   |       |
| Repurchase of  3,371 shares for tax settlement                                                                 |       | (129       | )             | (7         | )          | (122        | )          |         |        |                   |       |
| Expense                                                                                                        |       | 1,065      |          |       |       | 1,065       |       |         |        |                   |       |
| Vested stock  options                                                                                          |       | 817        |          |       |       | 817         |       |         |        |                   |       |
| Adjustment for  adoption of SFAS No. 123(R)                                                                    |       |       |          |       |       | (3,206      | )          | 3,206        |        |                   |       |
| Issuance of  41,084,826 shares for a 3 for 2 stock split                                                       |       | (166       | )             | 82,170     |       | (82,336     | )          | —       |        | —                 |       |
| **BALANCE,  MARCH 31, 2006**                                                                                   | ** ** | **$**      | **2,228,919** | ** ** | **$**      | **246,947** | ** ** | **$**        | **595,813** | ** **             | **$**      | **1,428,288** | ** ** | **$** | **(42,129** | **)** |

 

5

----

 

**MERCANTILEBANKSHARES CORPORATION**

#### **STATEMENTSOF CONSOLIDATED CASH FLOWS**

 
| **Increase (decrease) in cash and cash equivalents** | ** ** | **For the 3 months ended March 31,** | ** **  |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|-------------|
| **(Dollars in thousands)**                                               | ** ** | **2006**                                                           | ** **  | **2005** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                         |       |                                                               |        |   |   |
| Net income                                                                         | ** ** | **$**                                                              | **70,759**  | ** ** | $ | 62,627 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                               | ** **  |   |   |
| Provision for  credit losses                                                       | ** ** | **—**                                                         | ** **  | 756 |   |
| Depreciation                                                                       | ** ** | **3,860**                                                          | ** **  | 3,714 |   |
| Amortization of  other intangible assets                                           | ** ** | **2,325**                                                          | ** **  | 2,072 |   |
| Tax benefit from  the issuance of stock-based awards                               | ** ** | **91**                                                             | ** **  | — |   |
| Write-downs of  other real estate owned                                            | ** ** | **—**                                                         | ** **  | 1 |   |
| Gains on sales  of other real estate owned                                         | ** ** | **—**                                                         | ** **  | (125 | ) |
| (Gains) losses on  sales of investments securities                                 | ** ** | **13**                                                             | ** **  | (414 | ) |
| Gains on sales  of premises                                                        | ** ** | **(79**                                                            | **)**       | (1,147 | ) |
| Loans  held-for-sale                                                               | ** ** | **25,124**                                                         | ** **  | (13,341 | ) |
| Net (increase)  decrease in assets:                                                |       |                                                               | ** **  |   |   |
| Interest  receivable                                                               | ** ** | **(5,368**                                                         | **)**       | (5,796 | ) |
| Nonmarketable  investments                                                         | ** ** | **(5,654**                                                         | **)**       | (3,132 | ) |
| Other assets                                                                       | ** ** | **3,790**                                                          | ** **  | (6,252 | ) |
| Net increase  (decrease) in liabilities:                                           |       |                                                               | ** **  |   |   |
| Interest payable                                                                   | ** ** | **9,814**                                                          | ** **  | 8,268 |   |
| Other  liabilities                                                                 | ** ** | **13,781**                                                         | ** **  | 44,410 |   |
| Net cash provided  by operating activities                                         | ** ** | **118,456**                                                        | ** **  | 91,641 |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                         |       |                                                               | ** **  |   |   |
| Proceeds from  maturities of investment securities held-to-maturity                | ** ** | **211**                                                            | ** **  | 472 |   |
| Proceeds from  maturities of investment securities available-for-sale              | ** ** | **246,420**                                                        | ** **  | 219,959 |   |
| Proceeds from  sales of investment securities available-for-sale                   | ** ** | **599**                                                            | ** **  | 15,997 |   |
| Purchases of  investment securities available-for-sale                             | ** ** | **(291,786**                                                       | **)**       | (167,201 | ) |
| Purchases of  investment securities held-for-trading                               | ** ** | **(8,000**                                                         | **)**       | — |   |
| Net increase in  customer loans                                                    | ** ** | **(88,307**                                                        | **)**       | (185,665 | ) |
| Proceeds from  sales of other real estate owned                                    | ** ** | **—**                                                         | ** **  | 191 |   |
| Capital  expenditures                                                              | ** ** | **(4,448**                                                         | **)**       | (5,619 | ) |
| Proceeds from  sales of premises                                                   | ** ** | **321**                                                            | ** **  | 2,075 |   |
| Business  acquisition contingent consideration payment                             | ** ** | **(8,806**                                                         | **)**       | — |   |
| Purchase of  nonmarketable investments                                             | ** ** | **(3,873**                                                         | **)**       | (1,458 | ) |
| Net cash used in  investing activities                                             | ** ** | **(157,669**                                                       | **)**       | (121,249 | ) |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                         |       |                                                               | ** **  |   |   |
| Net increase in  noninterest-bearing deposits                                      | ** ** | **61,242**                                                         | ** **  | 49,635 |   |
| Net increase in  interest-bearing deposits                                         | ** ** | **435,203**                                                        | ** **  | 122,442 |   |
| Net decrease in  short-term borrowings                                             | ** ** | **(180,699**                                                       | **)**       | (30,894 | ) |
| Repayment of  long-term debt                                                       | ** ** | **(32,446**                                                        | **)**       | (1 | ) |
| Tax benefit from  the issuance of stock-based awards                               | ** ** | **765**                                                            | ** **  | — |   |
| Excess tax  benefit related to stock-based awards                                  | ** ** | **120**                                                            | ** **  | — |   |
| Proceeds from  issuance of shares                                                  | ** ** | **2,804**                                                          | ** **  | 3,070 |   |
| Repurchase of  common shares                                                       | ** ** | **(129**                                                           | **)**       | — |   |
| Dividends paid                                                                     | ** ** | **(32,006**                                                        | **)**       | (27,750 | ) |
| Net cash  provided by financing activities                                         | ** ** | **254,854**                                                        | ** **  | 116,502 |   |
| Net increase in  cash and cash equivalents                                         | ** ** | **215,641**                                                        | ** **  | 86,894 |   |
| Cash and cash  equivalents at beginning of period                                  | ** ** | **394,840**                                                        | ** **  | 245,134 |   |
| Cash and cash  equivalents at end of period                                        | ** ** | **$**                                                              | **610,481** | ** ** | $ | 332,028 |   |
| **SUPPLEMENTAL  INFORMATION**                                                      |       |                                                               | ** **  |   |   |
| Cash payments  for interest                                                        | ** ** | **$**                                                              | **59,786**  | ** ** | $ | 27,891 |   |
| Cash payments  for income taxes                                                    | ** ** | **200**                                                            | ** **  | 13,226 |   |

 

See notes to consolidatedfinancial statements

 

6

----

 

**MERCANTILEBANKSHARES CORPORATION**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

1. Basis of Presentation

 

The consolidatedfinancial statements, which include the accounts of Mercantile BanksharesCorporation (“Bankshares”) 

(Nasdaq: MRBK) and all ofits affiliates, are prepared in conformity with accounting principles generallyaccepted in the United 

States of America andfollow general practice within the banking industry. In the opinion ofmanagement, the consolidated financial statements include all adjustmentsnecessary for a fair presentation of the interim period. These adjustments areof a normal nature 

and include adjustmentsto eliminate all significant intercompany transactions. In view of the changingconditions in the national economy, the effect of actions taken by regulatoryauthorities and normal seasonal factors, the results for the interim period arenot necessarily indicative of annual performance. For purposes of comparability,certain prior period amounts have been reclassified to conform to currentperiod presentation.

 

The preparation offinancial statements in conformity with accounting principles generally acceptedin the United States of America requires management to make estimates andassumptions 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. Theseassumptions are based on information available as of the date of the financialstatements and could differ from actual results. See Annual Report on Form 10-Kfor more detail.

 

2. Business Combinations/ Restructuring

 

The following providesinformation concerning acquisitions and restructurings. Acquisitions wereaccounted for as purchases with the results of their operations subsequent tothe acquisition date to be included in Bankshares’ Statements of ConsolidatedIncome.

 

On March 27, 2006,Bankshares signed a definitive merger agreement with James Monroe Bancorp, Inc.(“James Monroe”). The acquisition of this Arlington, Virginia-based commercialbank is expected to be completed in the third quarter of 2006. Under the termsof the agreement, shareholders of James Monroe will be entitled to elect toreceive either cash in the amount of $23.50 for each share, or .6033 shares ofBankshares common stock for each share of James Monroe common stock they hold,so long as at least 50% but not more than 66% of the total consideration ispaid in Bankshares stock. Bankshares’ acquisition of James Monroe is estimatedto add $530 million in total assets, $378 million in gross loans, $471 millionin total deposits (based on December 31, 2005 financial information), and sixfull-service branches and a loan production office located in the affluent,fast-growing markets of Northern Virginia and suburban Washington, D.C. Themerger is subject to the approval of James Monroe shareholders and Federal and Statebanking authorities. For additional information, see the Form 8-K filed inconnection with the merger on March 27, 2006.

 

On May 18, 2005,Bankshares completed its acquisition of Community Bank of Northern Virginia (“CBNV”),a bank headquartered in Sterling, Virginia, which was merged intoMercantile-Safe Deposit & Trust Company. The total consideration paid toCBNV shareholders in connection with the acquisition was $82.9 million in cashand 3.7 million shares of Bankshares’ common stock. 

The transaction resultedin total assets acquired as of May 18, 2005 of $888.2 million, including $671.0million of loans and leases; liabilities assumed were $842.3 million, including$626.9 million of deposits. Additionally, Bankshares recorded $162.1 million ofgoodwill and $4.6 million of core deposit intangibles. Bankshares expensed no merger-relatedcosts for the three-month period ended March 31, 2006 and has expensed $1.3million since the inception of the merger.

 

7

----

 

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 thesame components as basic EPS with the denominator adjusted for the dilutiveeffect of stock options, restricted stock awards, restricted stock units andvested directors’ deferred compensation plan shares. The following tablesprovide reconciliation between the computation of basic EPS and diluted EPS forthe three months ended March 31, 2006 and 2005, respectively.

 
| ** **                                                                       | ** ** | **For the 3 months ended March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **Net**                                                            | ** ** | **Weighted Average** | ** ** | ** ** | ** ** |
| **2006**** (In thousands, except per share data)** | ** ** | **Income**                                                         | ** ** | **Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                                        | ** ** | **$**                                                              | **70,759** | ** ** | **123,043** | ** ** | **$** | **0.58** | ** ** |
| Dilutive effect  of:                                                             | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options  and restricted stock awards                                       | ** ** | ** **                                                         | ** ** | **962** | ** ** | ** ** | ** ** |
| Vested directors’  deferred compensation plan shares                        | ** ** | ** **                                                         | ** ** | **289** | ** ** | ** ** | ** ** |
| Diluted EPS                                                                      | ** ** | **$**                                                              | **70,759** | ** ** | **124,294** | ** ** | **$** | **0.57** | ** ** |

 
| ** **                                                             | ** ** | **For the 3 months ended March 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **Net**                                                            | ** ** | **Weighted Average** | ** ** | ** ** | ** ** |
| **2005(In thousands, except per share data)** | ** ** | **Income**                                                         | ** ** | **Common Shares** | ** ** | **EPS** | ** ** |
| Basic EPS                                                              |       | $                                                                  | 62,627     |   | 118,842 |   | $ | 0.53 |   |
| Dilutive effect  of:                                                   |       |                                                               |       |   |   |   |   |
| Stock options  and restricted stock awards                             |       |                                                               |       | 719 |   |   |   |
| Vested directors’  deferred compensation plan shares              |       |                                                               |       | 252 |   |   |   |
| Diluted EPS                                                            |       | $                                                                  | 62,627     |   | 119,813 |   | $ | 0.52 |   |

 

Antidilutive options andawards excluded from the computation of diluted earnings per share were 22,120and 174,848 for the three months ended March 31, 2006 and 2005, respectively.

 

# **4. Investment Securities**

 

At March 31, 2006 and December31, 2005, securities with an amortized cost of $1.4 billion and $1.3 billion, respectively,were pledged as collateral for certain deposits as required by regulatoryguidelines. The following table shows amortized cost and fair value ofinvestment securities at March 31, 2006 and December 31, 2005.

 
| ** **                                                                | ** ** | **March 31, 2006** | ** **    | **December 31, 2005** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------|---------------|---------------------------------|------------|
| ** **                                                                | ** ** | ** **                   | ** **    | **Gross**                       | ** ** | **Gross** | ** ** | ** ** | ** ** | ** ** | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                                                                | ** ** | **Amortized**                | ** **    | **Unrealized**                  | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **(Dollars in thousands)**                                      | ** ** | **Cost**                     | ** **    | **Gains**                       | ** ** | **Losses** | ** ** | **Value** | ** ** | **Cost** | ** ** | **Gains** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| Investment  securities held-to-maturity States and political subdivisions | ** ** | **$**                        | **16,448**    | ** **                      | **$**      | **432** | ** ** | **$** | **22** | ** ** | **$** | **16,858** |   | $ | 16,659 |   | $ | 541 |   | $ | 19 |   | $ | 17,181 |   |
|                                                                      |       |                         |          |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Investment  securities available-for-sale                                 |       |                         |          |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury                                                             | ** ** | **$**                        | **440,906**   | ** **                      | **$**      | **—** | ** ** | **$** | **4,181** | ** ** | **$** | **436,725** |   | $ | 434,893 |   | $ | 223 |   | $ | 3,080 |   | $ | 432,036 |   |
| U.S. Government  agencies                                                 | ** ** | **1,007,940**                | ** **    | **—**                      | ** ** | **13,736** | ** ** | **994,204** |   | 992,040 |   | 29 |   | 12,761 |   | 979,308 |   |
| States and  political subdivisions                                        | ** ** | **66,272**                   | ** **    | **118**                         | ** ** | **329** | ** ** | **66,061** |   | 70,017 |   | 306 |   | 188 |   | 70,135 |   |
| Mortgage-backed  securities                                               | ** ** | **1,607,610**                | ** **    | **409**                         | ** ** | **49,327** | ** ** | **1,558,692** |   | 1,581,845 |   | 685 |   | 38,269 |   | 1,544,261 |   |
| Other bonds,  notes and debentures                                        | ** ** | **19,899**                   | ** **    | **—**                      | ** ** | **209** | ** ** | **19,690** |   | 19,083 |   | — |   | 215 |   | 18,868 |   |
| Total bonds                                                               | ** ** | **3,142,627**                | ** **    | **527**                         | ** ** | **67,782** | ** ** | **3,075,372** |   | 3,097,878 |   | 1,243 |   | 54,513 |   | 3,044,608 |   |
| Other investments                                                         | ** ** | **43,983**                   | ** **    | **1,132**                       | ** ** | **925** | ** ** | **44,190** |   | 43,980 |   | 1,236 |   | 196 |   | 45,020 |   |
| Total                                                                     | ** ** | **$**                        | **3,186,610** | ** **                      | **$**      | **1,659** | ** ** | **$** | **68,707** | ** ** | **$** | **3,119,562** |   | $ | 3,141,858 |   | $ | 2,479 |   | $ | 54,709 |   | $ | 3,089,628 |   |

 

8

----

 

The following table showsthe unrealized gross losses and fair value of securities in the securitiesavailable-for-sale portfolio at March 31, 2006, by length of time thatindividual securities in each category have been in a continuous loss position.

 
| ** **                           | ** ** | **Less than 12 Months** | ** ** | **12 months or more** | ** ** | **Total**      | ** ** |
|--------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|----------------|------------|
| ** **                           | ** ** | **Gross**                              | ** ** | ** **                           | ** ** | **Gross**      | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **Unrealized**                         | ** ** | **Fair**                             | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| **(Dollars in thousands)** | ** ** | **Losses**                             | ** ** | **Value**                            | ** ** | **Losses**     | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** |
| ** **                           | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| U.S. Treasury                        | ** ** | **$**                                  | **2,046**  | ** **                           | **$**      | **321,680**    | ** ** | **$** | **2,135** | ** ** | **$** | **115,045** | ** ** | **$** | **4,181** | ** ** | **$** | **436,725** | ** ** |
| U.S. Government  agencies            | ** ** | **4,153**                              | ** ** | **458,127**                          | ** ** | **9,583**      | ** ** | **536,077** | ** ** | **13,736** | ** ** | **994,204** | ** ** |
| States and  political subdivisions   | ** ** | **281**                                | ** ** | **58,482**                           | ** ** | **48**         | ** ** | **7,579** | ** ** | **329** | ** ** | **66,061** | ** ** |
| Mortgage-backed  securities          | ** ** | **23,781**                             | ** ** | **643,646**                          | ** ** | **25,546**     | ** ** | **915,046** | ** ** | **49,327** | ** ** | **1,558,692** | ** ** |
| Other bonds,  notes and debentures   | ** ** | **16**                                 | ** ** | **3,962**                            | ** ** | **193**        | ** ** | **15,728** | ** ** | **209** | ** ** | **19,690** | ** ** |
| Total bonds                          | ** ** | **30,277**                             | ** ** | **1,485,897**                        | ** ** | **37,505**     | ** ** | **1,589,475** | ** ** | **67,782** | ** ** | **3,075,372** | ** ** |
| Other  investments                   | ** ** | **925**                                | ** ** | **44,190**                           | ** ** | **—**     | ** ** | **—** | ** ** | **925** | ** ** | **44,190** | ** ** |
|                                 | ** ** | ** **                             | ** ** | ** **                           | ** ** | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total                                | ** ** | **$**                                  | **31,202** | ** **                           | **$**      | **1,530,087**  | ** ** | **$** | **37,505** | ** ** | **$** | **1,589,475** | ** ** | **$** | **68,707** | ** ** | **$** | **3,119,562** | ** ** |

 

At March 31, 2006, therewere $1.6 billion of individual securities that had unrealized losses for aperiod greater than 12 months. At March 31, 2006, these securities had anunrealized loss of $37.5 million of which 68.1% were mortgage-backedsecurities. Management has assessed the impairment of these securities anddetermined that the impairment is temporary. All principal and interestpayments on available-for-sale debt securities in an unrealized loss positionfor greater than 12 months are expected to be collected given the high creditquality of the U.S. government agency debt securities and Bankshares’ abilityand intent to hold the securities until the value recovers or they mature.

 

# **5. Allowance for Loan Losses andReserve for Unfunded Commitments**

 

During the first quarterof 2006, Bankshares refined the model used for determining certain componentsof the allowance for loan losses. The model refinement did not have a materialimpact on Bankshares’ recorded allowance for loan losses. Additionally,Bankshares reclassified a portion of the allowance for loan losses to a reservefor unfunded lending commitments reflected in other liabilities in the consolidatedbalance sheet. As a result of the refinement of the modeling process for theallowance for loan losses, Bankshares was able specifically to identify riskinherent in unfunded commitments and make the reclassification noted above. Asno model data existed for previous years, prior period data has not beenreclassified for comparability.

 

# **The allowance for loan losses and reservefor unfunded commitments is presented below.**

 
| ** **                                    | ** ** | **For the 3 months ended March 31,** | ** **  |
|-----------------------------------------------|------------|----------------------------------------------------------|-------------|
| **(Dollars in thousands)**          | ** ** | **2006**                                                 | ** **  | **2005** | ** ** |
| **Allowance  for Loan Losses**                |       |                                                     |        |   |   |
| Balance,  beginning of period                 | ** ** | **$**                                                    | **156,673** | ** ** | $ | 149,002 |   |
| Provision for  credit losses                  | ** ** | **(990**                                                 | **)**       | 756 |   |
| Transfer to  reserve for unfunded commitments | ** ** | **(13,968**                                              | **)**       | — |   |
| Total                                         | ** ** | **141,715**                                              | ** **  | 149,758 |   |
| Charge-offs                                   | ** ** | **(1,378**                                               | **)**       | (1,942 | ) |
| Recoveries                                    | ** ** | **1,537**                                                | ** **  | 1,201 |   |
| Net recoveries  (charge-offs)                 | ** ** | **159**                                                  | ** **  | (741 | ) |
| Balance, end of  period                       | ** ** | **$**                                                    | **141,874** | ** ** | $ | 149,017 |   |
|                                          |       |                                                     | ** **  |   |   |
| **Reserve  for Unfunded Commitments**         |       |                                                     | ** **  |   |   |
| Balance,  beginning of period                 | ** ** | **$**                                                    | **—**  | ** ** | $ | — |   |
| Provision for  credit losses                  | ** ** | **990**                                                  | ** **  | — |   |
| Transfer from  allowance for loan losses      | ** ** | **13,968**                                               | ** **  | — |   |
| Balance, end of  period                       | ** ** | **$**                                                    | **14,958**  | ** ** | $ | — |   |
|                                               |            |                                                          |             |  |  |  |  |  |  |  |

 

9

----

 

# **6. 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 on atimely basis.

 

UnderStatements of Financial Accounting Standards (SFAS) Nos. 114 and 118, “Accountingby Creditors for Impairment of a Loan-an amendment of FASB Statements Nos. 5and 15,” a loan is considered impaired, based on current information andevents, if it is probable that Bankshares will not collect all principal andinterest payments according to the contractual terms of the loan agreement. Theimpairment of a loan is measured based on the present value of expected futurecash flows discounted at the loan’s effective interest rate, or the fair valueof the collateral if the repayment is expected to be provided predominantly bythe underlying collateral. Information with respect to impaired loansand the related valuation allowance (if the measure of the impaired loan isless than the recorded investment) at March 31, 2006, December 31, 2005 andMarch 31, 2005 is shown below. See Annual Report on Form 10-K for more detail.

 
| ** **                                                                       | ** ** | **March 31,** | ** **  | **December 31,** | ** ** | **March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------|-------------|-----------------------|------------|--------------------|------------|
| **(Dollars in thousands)**                                             | ** ** | **2006**           | ** **  | **2005**              | ** ** | **2005**           | ** ** |
| Impaired loans  with a specific valuation allowance                              | ** ** | **$**              | **3,680**   |                  | $          | 11,512             |       | $ | 17,188 |   |
| All other  impaired loans                                                        | ** ** | **17,082**         |        | 9,086                 |       | 11,592             |       |
| Total impaired  loans                                                            | ** ** | **$**              | **20,762**  |                  | $          | 20,598             |       | $ | 28,780 |   |
|                                                                             |       |               |        |                  |       |               |       |
| Specific  allowance for loan losses applicable to impaired loans                 | ** ** | **$**              | **2,108**   |                  | $          | 4,150              |       | $ | 10,437 |   |
| General  allowance for loan losses applicable to other than impaired loans       | ** ** | **139,766**        |        | 152,523               |       | 138,580            |       |
| Total allowance  for loan losses                                                 | ** ** | **$**              | **141,874** |                  | $          | 156,673            |       | $ | 149,017 |   |
|                                                                             |       |               |        |                  |       |               |       |
| Year-to-date  interest income on impaired loans recorded on the cash basis       | ** ** | **$**              | **35**      |                  | $          | 128                |       | $ | 23 |   |
| Year-to-date  average recorded investment in impaired loans during the period    | ** ** | **$**              | **20,762**  |                  | $          | 26,703             |       | $ | 28,780 |   |
| Quarter-to-date  interest income on impaired loans recorded on the cash basis    | ** ** | **$**              | **35**      |                  | $          | 14                 |       | $ | 23 |   |
| Quarter-to-date  average recorded investment in impaired loans during the period | ** ** | **$**              | **20,762**  |                  | $          | 20,598             |       | $ | 28,780 |   |

 

Note:  Impaired loans do not include large groups ofsmaller balance homogeneous loans that are evaluated collectively forimpairment (e.g., residential mortgages and consumer installment loans). Theallowance for loan losses related to these loans is included in the generalallowance for loan losses applicable to other than impaired loans.

 

On May 18, 2005,Bankshares acquired, as part of the CBNV acquisition, two commercial realestate loans totaling $4.9 million that were within the scope of AmericanInstitute of Certified Public Accountants issued Statement of Position (“SOP”)03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer.” One of the loans was subsequently paidin full and the remaining loan is deemed to be immaterial for purposes of the requireddisclosures.

 

7. Commitments andContingencies

 

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 $4.9 billion at March 31,2006, $4.8 billion at December 31, 2005, and $4.4 billion at March 31, 2005.

 

10

----

 

Letters of credit arecommitments issued to guarantee the performance of a customer to a third party.Outstanding letters of credit were $530.8 million at March 31, 2006, $540.6million at December 31, 2005 and $401.7 million at March 31, 2005. Feesreceived for issuing letters of credit are deferred and amortized over the lifeof the commitment. The unamortized fees on letters of credit at March 31, 2006,December 31, 2005, and March 31, 2005 had a carrying value of $1.7 million, $1.9million and $1.4 million, respectively.

 

One of Bankshares’mortgage banking subsidiaries is a Fannie Mae Delegated Underwriting andServicing lender, and has a loss sharing arrangement for loans originated onbehalf of and sold to Fannie Mae. The unamortized principal balance of theunderlying loans totaled $253.4 million, $249.8 million and $220.9 million atMarch 31, 2006, December 31, 2005 and March 31, 2005, respectively. The lossreserve for potential losses on loans originated and sold in the secondarymarket was $67.9 thousand at March 31, 2006 and $60.7 thousand at December 31,2005. The mortgage subsidiary also has originated and sold loans with recoursein the event of foreclosure on the underlying real estate. The unamortizedamount of principal balance of loans sold with recourse totaled $1.1 million atMarch 31, 2006, $1.3 million at December 31, 2005 and $1.6 million at March 31,2005. These mortgages are generally in good standing and are wellcollateralized; no loss has ensued and no future loss is expected.

 

Bankshares has committedto invest funds in third-party private equity investments. At March 31, 2006,December 31, 2005 and March 31, 2005, $27.0 million, $26.6 million and $32.5million, respectively, remained unfunded.

 

In the ordinary course ofbusiness, Bankshares and its subsidiaries are involved in a number of pendingand threatened legal actions and proceedings. In certain of these actions andproceedings, claims for substantial monetary damages are asserted againstBankshares and its subsidiaries. In view of the inherent difficulty ofpredicting the outcome of such matters, Bankshares cannot state what theeventual outcome of pending matters will be. However, based on currentknowledge, management does not believe that liabilities, if any, arising frompending litigation matters, will have a material adverse effect on theconsolidated financial position, earnings or liquidity of Bankshares. Ifpayment associated with a claim becomes probable and the cost can be reasonablyestimated, a contingent liability would be established based on informationcurrently available, advice of counsel and available insurance coverage.

 

8. Goodwill and OtherIntangible Assets

 

Goodwill totaled $678.9 millionat March 31, 2006 and $670.0 million at December 31, 2005. In 2005, Banksharesrecorded $162.1 million in goodwill in connection with the CBNV acquisitionthat increased the Banking segment’s goodwill to $630.2 million. The IWMsegment’s goodwill was $48.6 million at March 31, 2006 and $39.8 at December31, 2005. The increase in goodwill, during the quarter, is related to thepayment of $8.8 million in contingent consideration to the management of Boyd WattersonAsset Management as they met the performance conditions outlined in the mergeragreement.

 

The following tablediscloses the gross carrying amount and accumulated amortization of intangibleassets subject to amortization at March 31, 2006 and December 31, 2005.

 
| ** **                 | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|----------------------------|------------|------------------------------|------------|---------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Gross  carrying  amount**  | ** ** | **Accumulated  amortization**   | ** ** | **Net  amount** | ** ** | **Gross  carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net  amount** | ** ** |
| Core deposits              | ** ** | **$**                        | **54,509** | ** **                      | **$**      | **(22,277** | **)** | **$** | **32,232** |   | $ | 54,509 |   | $ | (20,790 | ) | $ | 33,719 |   |
| Mortgage  servicing        | ** ** | **2,967**                    | ** ** | **(1,166**                      | **)**      | **1,801** |   | 2,902 |   | (1,145 | ) | 1,757 |   |
| Customer lists  and other  | ** ** | **17,845**                   | ** ** | **(7,417**                      | **)**      | **10,428** |   | 17,845 |   | (6,668 | ) | 11,177 |   |
| Total                      | ** ** | **$**                        | **75,321** | ** **                      | **$**      | **(30,860** | **)** | **$** | **44,461** |   | $ | 75,256 |   | $ | (28,603 | ) | $ | 46,653 |   |

 

In connection with theCBNV acquisition, Bankshares recorded $4.6 million in core deposit intangibles.The core deposit intangible from CBNV is amortized over a weighted averageremaining useful life of nine years on a straight-line basis.

 

Identifiable intangibleassets are amortized based on estimated lives of up to 15 years. Managementreviews other intangible assets for impairment yearly or whenever events orchanges in circumstances indicate that their carrying amounts may not berecoverable. For those intangible assets subject to amortization, impairment isindicated if the sum of undiscounted estimated future net cash flows is lessthan the carrying amount of the asset. Impairment is recognized by writing downthe carrying value or adjusting the estimated life of the asset. Any impairmentrecognized in a valuation account is reflected in the income statement in thecorresponding period.

 

11

----

 

The following table showsthe current period and estimated future amortization expense for amortizedintangible assets. The projections of amortization expense shown for mortgageservicing rights are based on asset balances and the interest rate environmentas of March 31, 2006. Future amortization expense may be significantlydifferent depending upon changes in the mortgage-servicing portfolio, mortgageinterest rates and market conditions.

 
| ** **                                         | ** ** | ** ** | ** ** | ** **   | ** ** | ** **    | ** ** | **Customer**       | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|------------|------------|--------------|------------|---------------|------------|--------------------|------------|------------|------------|
| ** **                                         | ** ** | ** ** | ** ** | **Core**     | ** ** | **Mortgage**  | ** ** | **lists**          | ** ** | ** ** | ** ** |
| **(Dollars in thousands)**               | ** ** | ** ** | ** ** | **deposits** | ** ** | **servicing** | ** ** | **and other** | ** ** | **Total**  | ** ** |
| Three months  ended March 31, 2006 (actual)        | ** ** | ** ** | ** ** | **$**        | **1,487**  | ** **    | **$**      | **89**             | ** ** | **$**      | **749**    | ** ** | **$** | **2,325** | ** ** |
| Nine months  ended December 31, 2006 (estimated)   |       |       |       | 4,463        |       | 233           |       | 1,866              |       | 6,562      |       |
| Twelve months  ended December 31, 2006 (estimated) |       |       |       | $            | 5,950      |          | $          | 322                |       | $          | 2,615      |   | $ | 8,887 |   |
|                                               |       |       |       |         |       |          |       |               |       |       |       |
| Estimate for  year ended December 31,              |       | 2007       |       | $            | 5,747      |          | $          | 278                |       | $          | 2,533      |   | $ | 8,558 |   |
|                                               |       | 2008       |       | 4,653        |       | 261           |       | 1,637              |       | 6,551      |       |
|                                               |       | 2009       |       | 4,502        |       | 261           |       | 641                |       | 5,404      |       |
|                                               |       | 2010       |       | 4,502        |       | 241           |       | 505                |       | 5,248      |       |

 

9. Comprehensive Income

 

The following tablesummarizes the market value change and related tax effect of unrealized gains(losses) on securities available-for-sale for the quarters ended March 31, 2006and 2005, respectively. The total comprehensive income is included in theStatements of Changes in Consolidated Shareholders’ Equity.

 
| ** **                                                             | ** ** | **For the 3 months ended March 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                                           | ** ** | **2005** | ** ** |
| ** **                                                             | ** ** | **Pretax**                                                         | ** ** | **Tax** | ** ** | **Net** | ** ** | **Pretax** | ** ** | **Tax** | ** ** | **Net** | ** ** |
| **(Dollars in thousands)**                                   | ** ** | **Amount**                                                         | ** ** | **Benefit** | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Benefit** | ** ** | **Amount** | ** ** |
| Net Income                                                             | ** ** | ** **                                                         |       |   |   | **$** | **70,759** |   |   |   |   |   | $ | 62,627 |   |
| Other  comprehensive income                                            |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Unrealized  holding (losses) gains arising during the period           | ** ** | **(14,806**                                                        | **)**      | **5,529** | ** ** | **(9,277** | ) | (32,221 | ) | 12,031 |   | (20,190 | ) |
| Reclassification  adjustment for (gains) losses included in net income | ** ** | **(13**                                                            | **)**      | **5** | ** ** | **(8** | ) | (414 | ) | 164 |   | (250 | ) |
| Total other  comprehensive income                                      | ** ** | **(14,819**                                                        | **)**      | **5,534** | ** ** | **(9,285** | ) | (32,635 | ) | 12,195 |   | (20,440 | ) |
| Total  comprehensive income                                            | ** ** | ** **                                                         |       |   |   | **$** | **61,474** |   |   |   |   |   | $ | 42,187 |   |

 

12

----

 

10.Capital Adequacy

 

Bankshares and its bankaffiliates are subject to various regulatory capital adequacy requirementsadministered by federal and state banking agencies. These requirements includemaintaining certain capital ratios above minimum levels. These capital ratiosinclude Tier I Capital and Total Risk-Based Capital as percentages of netrisk-weighted assets and Tier I Capital as a percentage of adjusted averagetotal assets (leverage ratio). The minimum ratios for capital adequacy purposesare 4.00%, 8.00% and 4.00%, for the Tier I Capital, Total Capital and Leverage Ratios,respectively. To be categorized as *well capitalized,*a bank must maintain minimum ratios of 6.00%, 10.00% and 5.00%, for its Tier I Capital,Total Capital and Leverage Ratios, respectively. As of March 31, 2006,Bankshares and each of its bank affiliates exceeded all capital adequacyrequirements to be considered well capitalized.

 

Actual capital amountsand ratios are presented in the following table for Bankshares and itsaffiliates.

 
| **March 31, 2006 ****(Dollars in thousands)** | ** ** | **Tier I  Capital** | ** **    | **Total  Risk-Based  Capital** | ** ** | **Net  Risk-  Weighted  Assets** | ** ** | **Adjusted  Average  Total Assets** | ** **     | **Tier I  Capital  Ratio** | ** ** | **Total  Capital  Ratio** | ** ** | **Leverage  Ratio** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------|---------------|--------------------------------|------------|----------------------------------|------------|------------------------------------------|----------------|---------------------------------|------------|---------------------------|------------|---------------------|------------|
| **Bankshares**                                                         | ** ** | **$**                    | **1,554,465** | ** **                     | **$**      | **2,007,694**                    | ** ** | **$**                                    | **12,943,856** | ** **                      | **$**      | **15,638,122**            | ** ** | **12.01**           | **%**      | **15.51** | **%** | **9.94** | **%** |
| Annapolis Banking  & Trust                                         |       | 43,750                   |          | 50,986                         |       | 333,636                          |       | 480,975                                  |           | 13.11                           |       | 15.28                     |       | 9.10                |       |
| Citizens National  Bank                                                |       | 105,113                  |          | 153,331                        |       | 1,147,768                        |       | 1,295,059                                |           | 9.16                            |       | 13.36                     |       | 8.12                |       |
| Farmers &  Mechanics Bank                                          |       | 165,181                  |          | 226,141                        |       | 1,344,649                        |       | 1,694,947                                |           | 12.28                           |       | 16.82                     |       | 9.75                |       |
| Marshall National  Bank & Trust                                    |       | 13,066                   |          | 19,643                         |       | 135,944                          |       | 171,398                                  |           | 9.61                            |       | 14.45                     |       | 7.62                |       |
| Mercantile County  Bank                                                |       | 78,840                   |          | 117,345                        |       | 727,945                          |       | 938,636                                  |           | 10.83                           |       | 16.12                     |       | 8.40                |       |
| Mercantile  Eastern Shore Bank                                         |       | 52,596                   |          | 83,692                         |       | 453,498                          |       | 587,731                                  |           | 11.60                           |       | 18.45                     |       | 8.95                |       |
| Mercantile  Peninsula Bank                                             |       | 144,076                  |          | 217,188                        |       | 1,391,524                        |       | 1,708,838                                |           | 10.35                           |       | 15.61                     |       | 8.43                |       |
| Mercantile-Safe  Deposit & Trust Company                           |       | 523,168                  |          | 637,882                        |       | 5,788,861                        |       | 6,922,042                                |           | 9.04                            |       | 11.02                     |       | 7.56                |       |
| Mercantile  Southern Maryland Bank                                     |       | 94,802                   |          | 131,567                        |       | 652,702                          |       | 949,650                                  |           | 14.52                           |       | 20.16                     |       | 9.98                |       |
| National Bank of  Fredericksburg                                       |       | 37,762                   |          | 48,846                         |       | 370,932                          |       | 458,858                                  |           | 10.18                           |       | 13.17                     |       | 8.23                |       |
| Westminster Union  Bank                                                |       | 67,911                   |          | 99,024                         |       | 512,659                          |       | 813,006                                  |           | 13.25                           |       | 19.32                     |       | 8.35                |       |
|                                                                        |            |                          |               |                                |            |                                  |            |                                          |                |                                 |            |                           |            |                     |            |  |  |  |  |

 
| **December 31, 2005 (Dollars in thousands)** | ** ** | **Tier I  Capital** | ** ** | **Total  Risk-Based  Capital** | ** ** | **Net  Risk-  Weighted  Assets** | ** ** | **Adjusted  Average  Total Assets** | ** ** | **Tier I  Capital  Ratio** | ** ** | **Total  Capital  Ratio** | ** ** | **Leverage  Ratio** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------|------------|--------------------------------|------------|----------------------------------|------------|------------------------------------------|------------|---------------------------------|------------|---------------------------|------------|---------------------|------------|
| Bankshares                                                            |       | $                        | 1,518,454  |                           | $          | 1,975,313                        |       | $                                        | 12,848,926 |                            | $          | 15,471,385                |       | 11.82               | %          | 15.37 | % | 9.81 | % |
| Annapolis Banking  & Trust                                        |       | 43,148                   |       | 50,382                         |       | 331,167                          |       | 484,567                                  |       | 13.03                           |       | 15.21                     |       | 8.90                |       |
| Citizens National  Bank                                               |       | 103,600                  |       | 151,903                        |       | 1,139,217                        |       | 1,281,737                                |       | 9.09                            |       | 13.33                     |       | 8.08                |       |
| Farmers &  Mechanics Bank                                         |       | 164,489                  |       | 225,553                        |       | 1,341,615                        |       | 1,700,721                                |       | 12.26                           |       | 16.81                     |       | 9.67                |       |
| Marshall National  Bank & Trust                                   |       | 12,661                   |       | 19,235                         |       | 132,110                          |       | 164,212                                  |       | 9.58                            |       | 14.56                     |       | 7.71                |       |
| Mercantile County  Bank                                               |       | 77,489                   |       | 116,005                        |       | 728,884                          |       | 916,864                                  |       | 10.63                           |       | 15.92                     |       | 8.45                |       |
| Mercantile  Eastern Shore Bank                                        |       | 52,538                   |       | 83,614                         |       | 451,831                          |       | 575,426                                  |       | 11.63                           |       | 18.51                     |       | 9.13                |       |
| Mercantile  Peninsula Bank                                            |       | 141,149                  |       | 214,251                        |       | 1,336,315                        |       | 1,677,958                                |       | 10.56                           |       | 16.03                     |       | 8.41                |       |
| Mercantile-Safe  Deposit & Trust Company                          |       | 509,252                  |       | 624,036                        |       | 5,795,437                        |       | 6,721,535                                |       | 8.79                            |       | 10.77                     |       | 7.58                |       |
| Mercantile  Southern Maryland Bank                                    |       | 94,717                   |       | 131,461                        |       | 620,898                          |       | 954,636                                  |       | 15.25                           |       | 21.17                     |       | 9.92                |       |
| National Bank of  Fredericksburg                                      |       | 37,081                   |       | 48,169                         |       | 353,718                          |       | 455,590                                  |       | 10.48                           |       | 13.62                     |       | 8.14                |       |
| Westminster Union  Bank                                               |       | 66,961                   |       | 98,053                         |       | 509,424                          |       | 810,677                                  |       | 13.14                           |       | 19.25                     |       | 8.26                |       |
|                                                                       |            |                          |            |                                |            |                                  |            |                                          |            |                                 |            |                           |            |                     |            |  |  |  |  |

 

Bankshareshas an ongoing share repurchase program. Purchases may be made from time totime, subject to regulatory requirements, in open market or in privatelynegotiated transactions. Purchased shares are retired. During the quarter endedMarch 31, 2006, Bankshares purchased 3,371 shares in the net settlement of theminimum tax liability for vested restricted stock. At March 31, 2006, therewere 472,956 shares remaining available for repurchase under the program.

 

13

----

 

11. Segment Reporting

 

Operating segments asdefined by SFAS No. 131, “Disclosures about Segments of an Enterprise andRelated Information,” are components of an enterprise with separate financialinformation. The component engages in business activities from which it derivesrevenues and incurs expenses and the operating results of which managementrelies on for decision-making and performance assessment. Bankshares has tworeportable segments – Banking and Investment and Wealth Management (“IWM”). TheBanking segment is comprised of 11 affiliate banks. During 2005, the PrivateBank Group of Mercantile-Safe Deposit and Trust was consolidated into thePrivate Banking Group of IWM. The segment results have been reclassified toconform to current presentation for comparability. Additionally, as loans anddeposits are now being reflected in the IWM segment, a funds transfer-pricingmodel was utilized to match the duration of the funding and investment of theIWM segment assets and liabilities.

 

The tables below presentselected segment information for the three months ended March 31, 2006 and 2005.The components in the “Other” column consist of amounts for the nonbankaffiliates, unallocated corporate expenses including income taxes andintercompany eliminations. Certain expense amounts such as operations overhead werereclassified from internal financial reporting in order to provide for fullcost absorption. These reclassifications are shown in the “Adjustments” line.

 
| ** **                           | ** ** | **For the 3 months ended March 31, 2006** | ** **     |
|--------------------------------------|------------|------------------------------------------------------------------------------|----------------|
| **(Dollars in thousands)** | ** ** | **Banking**                                                                  | ** **     | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest  income                 | ** ** | **$**                                                                        | **155,894**    | ** ** | **$** | **2,572** | ** ** | **$** | **(153** | **)** | **$** | **158,313** | ** ** |
| Provision for  loan losses           | ** ** | **—**                                                                   | ** **     | **—** | ** ** | **—** | ** ** | **—** | ** ** |
| Noninterest  income                  | ** ** | **30,066**                                                                   | ** **     | **26,194** | ** ** | **4,346** | ** ** | **60,606** | ** ** |
| Noninterest  expenses                | ** ** | **(85,272**                                                                  | **)**          | **(21,519** | **)** | **76** | ** ** | **(106,715** | **)** |
| Adjustments                          | ** ** | **5,106**                                                                    | ** **     | **(257** | **)** | **(4,849** | **)** | **—** | ** ** |
| Income (loss)  before income taxes   | ** ** | **105,794**                                                                  | ** **     | **6,990** | ** ** | **(580** | **)** | **112,204** | ** ** |
| Income tax  (expense) benefit        | ** ** | **(37,115**                                                                  | **)**          | **(2,796** | **)** | **(1,534** | **)** | **(41,445** | **)** |
| Net income  (loss)                   | ** ** | **$**                                                                        | **68,679**     | ** ** | **$** | **4,194** | ** ** | **$** | **(2,114** | **)** | **$** | **70,759** | ** ** |
| Average loans                        | ** ** | **$**                                                                        | **11,470,757** | ** ** | **$** | **175,772** | ** ** | **$** | **375** | ** ** | **$** | **11,646,904** | ** ** |
| Average earning  assets              | ** ** | **14,748,209**                                                               | ** **     | **175,772** | ** ** | **(43,206** | **)** | **14,880,775** | ** ** |
| Average assets                       | ** ** | **16,172,368**                                                               | ** **     | **176,272** | ** ** | **87,324** | ** ** | **16,435,964** | ** ** |
| Average deposits                     | ** ** | **11,983,954**                                                               | ** **     | **270,132** | ** ** | **(313,130** | **)** | **11,940,956** | ** ** |
| Average equity                       | ** ** | **2,004,455**                                                                | ** **     | **36,758** | ** ** | **220,433** | ** ** | **2,261,646** | ** ** |

 
| ** **                           | ** ** | **For the 3 months ended March 31, 2005** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Banking**                                                                  | ** ** | **IWM** | ** ** | **Other** | ** ** | **Total** | ** ** |
| Net interest  income                 |       | $                                                                            | 141,108    |   | $ | 1,986 |   | $ | (11 | ) | $ | 143,083 |   |
| Provision for  loan losses           |       | (756                                                                         | )          | — |   | — |   | (756 | ) |
| Noninterest  income                  |       | 29,491                                                                       |       | 24,313 |   | 4,065 |   | 57,869 |   |
| Noninterest  expenses                |       | (80,451                                                                      | )          | (16,846 | ) | (2,856 | ) | (100,153 | ) |
| Adjustments                          |       | 3,536                                                                        |       | (1,669 | ) | (1,867 | ) | — |   |
| Income (loss)  before income taxes   |       | 92,928                                                                       |       | 7,784 |   | (669 | ) | 100,043 |   |
| Income tax (expense)  benefit        |       | (32,288                                                                      | )          | (3,113 | ) | (2,015 | ) | (37,416 | ) |
| Net income  (loss)                   |       | $                                                                            | 60,640     |   | $ | 4,671 |   | $ | (2,684 | ) | $ | 62,627 |   |
| Average loans                        |       | $                                                                            | 10,172,592 |   | $ | 141,345 |   | $ | 424 |   | $ | 10,314,361 |   |
| Average earning  assets              |       | 13,058,088                                                                   |       | 141,345 |   | 21,734 |   | 13,221,167 |   |
| Average assets                       |       | 14,206,965                                                                   |       | 141,634 |   | 159,745 |   | 14,508,344 |   |
| Average deposits                     |       | 10,711,996                                                                   |       | 191,322 |   | (184,584 | ) | 10,718,734 |   |
| Average equity                       |       | 1,772,458                                                                    |       | 33,130 |   | 144,688 |   | 1,950,276 |   |

 

14

----

 

12. Derivative Instrumentsand Hedging Activities

 

SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activitie*s*”,**SFAS No. 138, “Accounting for Certain DerivativeInstruments and Certain Hedging Activities – an amendment to FASB Statement No.133,”**and SFAS No. 149, “Amendment ofStatement No. 133 on Derivative Instruments and Hedging Activities”*(*collectively referred to as “derivatives”), establishaccounting and reporting standards for derivative instruments and for hedgingactivities. Bankshares maintains an overall interest rate risk managementstrategy that incorporates the use of derivative instruments to minimizesignificant unplanned fluctuations in earnings that are caused by interest ratevolatility. Currently, derivative instruments that are used as part of theinterest rate risk management strategy have been restricted to interest rateswaps. Interest rate swaps generally involve the exchange of fixed-rate andvariable-rate interest payments between two parties, based on a common notionalprincipal amount and maturity date. At March 31, 2006, Bankshares had interestrate swaps to convert a portion of its nonprepayable fixed-rate debt tofloating-rate debt. Bankshares also arranges interest rate swaps, caps andswaptions for commercial loan customers through its Capital Markets Group. Derivativetransactions executed with loan customers are hedged by means of an offsettingderivative trade with a third party. In this way, Bankshares manages the marketrisk arising from capital markets-related derivative activity.

 

The fair value ofderivative instruments is based on position and option valuations. The positionvaluation is estimated by using pricing models that incorporate quoted marketprices for swap rates and futures contracts, as well as market volatility, andassumes all counterparties have the same credit rating. The option valuation isestimated by using standard market models (such as the modified Black-Scholesmodel on interest rate options), incorporating quoted market prices andvolatilities. The fair value of derivative instruments relating to hedgingactivities recorded in other assets was $7.4 million (notional $397.1 million)and $5.3 million (notional $345.5 million) at March 31, 2006 and December 31,2005, respectively. The fair value of derivative instruments relating tohedging activities recorded in other liabilities was $21.5 million (notional $628.7million) and $12.3 million (notional $609.1 million) at March 31, 2006 andDecember 31, 2005, respectively.

 

Changes in the fair valueof a derivative that is designated and qualifies as a fair value hedge, alongwith the gain or loss on the hedged asset or liability that is attributable tothe hedged risk are recorded as other noninterest income in the results ofoperations. For all hedge relationships, ineffectiveness resulting fromdifferences between the changes in fair values or cash flows of the hedged itemand changes in fair value of the derivative are recognized as other noninterestincome in the results of operations. The net interest settlement on derivativesdesignated as fair value or cash flow hedges is treated as an adjustment of theinterest income or interest expense of the hedged assets or liabilities. Thefair-value hedges of nonprepayable fixed-rate debt were effective for thereported periods and qualified for short-cut hedge accounting treatment. Theimpact of the hedges increased interest expense $108 thousand in the firstthree months of 2006 as compared to a decrease of $1.6 million for the sameperiod in 2005.

 

The following tablessummarize the gross position of derivatives relating to hedging activities atMarch 31, 2006 and December 31, 2005.

 
| ** **                           | ** ** | **March 31, 2006** | ** **  | **December 31, 2005** | ** ** |
|--------------------------------------|------------|------------------------------|-------------|---------------------------------|------------|
| ** **                           | ** ** | **Notional or**         | ** **  | **Credit**                      | ** ** | **Estimated** | ** ** | **Notional or** | ** ** | **Credit** | ** ** | **Estimated** | ** ** |
| ** **                           | ** ** | **Contractual**              | ** **  | **Risk**                        | ** ** | **Net** | ** ** | **Contractual** | ** ** | **Risk** | ** ** | **Net** | ** ** |
| **(Dollars in thousands)** | ** ** | **Amount**                   | ** **  | **Amount (1)**             | ** ** | **Fair Value** | ** ** | **Amount** | ** ** | **Amount (1)** | ** ** | **Fair Value** | ** ** |
| *Asset/Liability  Management Hedges* |       |                         |        |                            |       |   |   |   |   |   |   |   |   |
| Interest Rate  Contracts:            |       |                         |        |                            |       |   |   |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                        | **350,000** | ** **                      | **$**      | **—** | ** ** | **$** | **(13,502** | ) | $ | 350,000 |   | $ | — |   | $ | (10,349 | ) |
|                                 |       |                         |        |                            |       |   |   |   |   |   |   |   |   |
| *Customer  Accommodations*           |       |                         |        |                            |       |   |   |   |   |   |   |   |   |
| Interest Rate  Contracts:            |       |                         |        |                            |       |   |   |   |   |   |   |   |   |
| Swaps                                | ** ** | **$**                        | **664,124** | ** **                      | **$**      | **7,377** | ** ** | **$** | **3,867** |   | $ | 592,934 |   | $ | 5,327 |   | $ | 3,462 |   |
| Swaptions/Caps  Purchased            | ** ** | **5,818**                    | ** **  | **57**                          | ** ** | **57** |   | 5,850 |   | 57 |   | 57 |   |
| Swaptions/Caps  Sold                 | ** ** | **5,818**                    | ** **  | **—**                      | ** ** | **(57** | ) | 5,850 |   | — |   | (57 | ) |

 

----

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

 

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 has forward commitments to sellindividual fixed-rate and variable-rate mortgage loans that are on its balancesheet at fair value or are approved, but not yet funded. The fair value of theforward contracts was $5.2 million at March 31, 2006 and $0.2 million atDecember 31, 2005.

 

15

----

 

13. Stock-basedCompensation Expense

 

Bankshares adopted SFASNo. 123(R), “Share-Based Payment,” effective January 1, 2006 under the modifiedversion of prospective application. The following disclosures are providedpursuant to the requirements of SFAS 123(R).

 

Under SFAS 123(R) awardsgranted to retirement eligible employees are expensed immediately. UnderBankshares’ Omnibus Stock Plan, retirement eligible is defined as employeesreaching normal retirement at age 65. As a practice, Bankshares has not grantedawards to retirement eligible employees. As of March 31, 2006, there were noretirement eligible employees with outstanding awards that had not been fullyexpensed. Prior to implementing SFAS 123(R), Bankshares accrued compensationcost for share-based compensation based on total awards granted, pursuant toSFAS 123. Any subsequent forfeitures were reversed from compensation expensewhen the grant was cancelled or expired. Upon implementation of SFAS 123(R), Banksharesis estimating forfeitures upon the grant of awards and reducing the amount tobe charged to expense by this estimate. The estimated forfeiture rate used tocalculate the current quarter’s compensation cost was 2%. Because of thehistorically low forfeiture rate, the impact to compensation expense wasimmaterial as compared to the first quarter of 2005.

 

We sponsor several share-basedplans, which are described below. The compensation cost that was expensed forthose plans was $1.7 million and $1.4 million for the quarters ended March31, 2006 and 2005, respectively. The total income tax benefit recognized in theincome statement for share-based compensation arrangements was immaterial forthe quarters ended March 31, 2006 and 2005. At March 31, 2006, unrecognizedcompensation cost related to nonvested stock options, restricted stock awardsand restricted stock units (“RSU”) totaled $25 million. The cost of thesenonvested awards is expected to be recognized over a weighted average period of2.52 years.

 

The 1999 Omnibus StockPlan permitted the grant of stock options and other stock incentives, includingrestricted stock awards, to key employees of Bankshares and its affiliates. The1999 Plan provided for the issuance of up to 4,500,000 shares (as adjusted forthe stock split) of Bankshares authorized but unissued common stock. Optionsoutstanding were granted at market value and included both performance-basedand nonperformance-based options. Options became exercisable ratably over threeor four years. If certain levels of earnings per share of Bankshares and netincome of affiliates were not achieved, all or a portion of theperformance-based options were forfeited and became available for future grants.All options terminate 10 years from date of grant if not exercised. Restrictedstock awards outstanding were granted at market value and vested ratably overthree years or in total at the end of a specified three-year period. The numberof shares of common stock that remained available for future grants under thePlan at March 31, 2006 was 329,815 shares.

 

The number of restrictedstock awards granted in the quarters ended March 31, 2006 and 2005 was 129,959and 55,446, respectively. Compensation expense is recognized on a straight-linebasis over the vesting period. Relative to awards granted in the quarter endedMarch 31, 2006, 85,309 shares are subject to a one-year vesting, and 44,650 vestover three years.

 

OnMarch 29, 2006, the Compensation Committee authorized the issuance of upto 317,802 performance based restricted stock units (“Performance RSUs”)pursuant to the 2006 Performance Stock Program. The vesting of the PerformanceRSUs willbe determinedbased upon the percentage improvement in Bankshares’ pre-tax operating income (“PTOI”)over a three-year performance period (the “Performance Period”) endingDecember 31, 2008 (with no adjustments for acquisitions or otherextraordinary events). In addition to the performance period, the awards earnedare subject to an additional one-year service requirement. Depending on actualperformance, the Performance RSUs will vest at levels from 0% to 100%. On thesame date, the Committee also awarded 104,630 RSUs to Bankshares’ chiefexecutive officer. The award will vest ratably over four years. The RSUsconverted into common stock will not be available for sale until the employmentof the chief executive officer terminates.

 

The table belowsummarizes activity related to stock options during the quarter ended March 31,2006.

 
| ** **                   | ** ** | **Options issued**  | ** ** | **Weighted average** | ** ** | **Options**     | ** **    | **Weighted average** | ** ** |
|------------------------------|------------|--------------------------|------------|---------------------------|------------|-----------------|---------------|---------------------------|------------|
| ** **                   | ** ** | **and outstanding** | ** ** | **exercise price**   | ** ** | **exercisable** | ** **    | **exercise price**   | ** ** |
| Balance,  December 31, 2005  |       | 2,659,240                |       | $                         | 25.01      |            | 1,489,397     |                      | $          | 20.80 |   |
| Granted                      |       | 454,000                  |       | 38.28                     |       |            |          |                      |       |
| Expired/Forfeited            |       | (5,519                   | )          | 13.45                     |       |            |          |                      |       |
| Exercised                    |       | (52,799                  | )          | 20.52                     |       |            |          |                      |       |
| **Balance,  March 31, 2006** | ** ** | **3,054,922**            | ** ** | **$**                     | **27.05**  | ** **      | **1,905,232** | ** **                | **$**      | **23.08** | ** ** |

 

16

----

 

The total intrinsic valueof stock options exercised during the quarters ended March 31, 2006 and 2005was $0.9 million and $4.3 million, respectively. Cash received from optionsexercised under all share-based payment arrangements for the quarters endedMarch 31, 2006 and 2005 was $0.9 million and $1.5 million, respectively. Theactual tax return benefit, associated with the tax deductions, recognized inthe income statement from the option exercise of the share-based paymentarrangements totaled $0.8 million for the quarter ended March 31, 2006 and nonefor the quarter ended March 31, 2005.

 

The following tableprovides selected information on nonvested stock options as of March 31, 2006,and changes during the quarter ended March 31, 2006.

 
| ** **                   | ** ** | ** **             | ** ** | **Weighted Average** | ** ** |
|------------------------------|------------|------------------------|------------|---------------------------|------------|
| ** **                   | ** ** | **Nonvested**          | ** ** | **Grant-Date**            | ** ** |
| ** **                   | ** ** | **Stock Options** | ** ** | **Fair Value**       | ** ** |
| Balance,  December 31, 2005  | ** ** | 1,164,825              |       | $                         | 30.36      |   |
| Granted                      |       | 454,000                |       | 38.28                     |       |
| Vested                       |       | (469,135               | )          | 30.04                     |       |
| Forfeited                    |       | —                 |       |                      |       |
| **Balance,  March 31, 2006** | ** ** | **1,149,690**          | ** ** | **$**                     | **33.62**  | ** ** |

 

 

The following tableprovides selected information on stock options outstanding and exercisable atMarch 31, 2006.

 
| ** **                                                                      | ** ** | **March 31, 2006** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------------|------------|
| **(Dollars in thousands, except per share data)** | ** ** | **Outstanding**              | ** ** | **Exercisable** | ** ** |
| Number of  Options                                                              |       | 3,054,922                    |       | 1,905,232 |   |
| Weighted-average  exercise price                                                |       | $                            | 27.05      |   | $ | 23.08 |   |
| Aggregate  Intrinsic Value                                                      |       | $                            | 34,846     |   | $ | 29,276 |   |
| Weighted-average  remaining contractual term, in years                          |       | 7.49                         |       | 6.63 |   |

 

The weighted averagegrant-date fair value of options granted during the quarters ended March 31,2006 and 2005 was $7.06 and $6.36, respectively. The total fair value of sharesvested during the quarters ended March 31, 2006 and 2005 was $18.0 million and$10.3 million, respectively.

 

The weighted average fairvalue of options granted is estimated as of the grant date using theBlack-Scholes option-pricing model. The following weighted average assumptionswere used as inputs to the Black-Scholes model for grants in the quarters endedMarch 31, 2006 and 2005, respectively:

 

•                  Dividend yields of 2.72% and 2.69%

•                  Volatilities of 20.28% and 21.85%

•                  Risk-free interest rates of 4.67% and4.12%

•                  Expected terms of 4.6 years for bothperiods

 

The expected terms ofoptions were determined by reviewing historically the time within which aminimum of 50% of shares granted to an employee were exercised over the past 6years. The expected volatility assumptions were derived by analyzing thehistorical price volatility of our stock over the past 5 years.

 

17

----

 

The following tableprovides selected information related to restricted stock awards and restrictedstock units as of March 31, 2006, and changes during the quarter ended March31, 2006.

 
| ** **                         | ** ** | **Restricted  Stock Awards** | ** ** | **Restricted  Stock Units** | ** ** |
|------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| Outstanding at  December 31, 2005  |       | 249,090                           |       | —                           |       |
| Granted                            |       | 129,959                           |       | 422,432                          |       |
| Vested                             |       | (48,901                           | )          | —                           |       |
| **Outstanding  at March 31, 2006** | ** ** | **330,148**                       | ** ** | **422,432**                      | ** ** |

 

Another form ofstock-based compensation is phantom stock, which is used for a portion ofBankshares’ directors’ deferred compensation plan. This plan provides for theissuance of up to 667,500 shares of Bankshares’ authorized but unissued commonstock. The Plan requires all deferred fees to be settled in Bankshares’ stock.

 

14. Pension & OtherPost-retirement Benefit Plans

 

Bankshares sponsorsqualified and nonqualified pension plans and other postretirement benefit plansfor its employees. The following table summarizes the components of the netperiodic benefit cost for the pension plans for the three months ended March 31,2006 and 2005, respectively.

 
| ** **                           | ** ** | **For the 3 months ended March 31, 2006** | ** ** | **For the 3 months ended March 31, 2005** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **Qualified**                                                                | ** ** | **Nonqualified**                                                             | ** ** | **Total** | ** ** | **Qualified** | ** ** | **Nonqualified** | ** ** | **Total** | ** ** |
| Service cost                         | ** ** | **$**                                                                        | **1,895**  | ** **                                                                   | **$**      | **173** | ** ** | **$** | **2,068** |   | $ | 1,778 |   | $ | 165 |   | $ | 1,943 |   |
| Interest cost                        | ** ** | **2,908**                                                                    | ** ** | **43**                                                                       | ** ** | **2,951** |   | 2,813 |   | 35 |   | 2,848 |   |
| Expected return on plan assets       | ** ** | **(4,489**                                                                   | **)**      | **—**                                                                   | ** ** | **(4,489** | ) | (4,138 | ) | — |   | (4,138 | ) |
| Amortization of prior service cost   | ** ** | **300**                                                                      | ** ** | **—**                                                                   | ** ** | **300** |   | 300 |   | — |   | 300 |   |
| Recognized net actuarial (gain) loss | ** ** | **374**                                                                      | ** ** | **(46**                                                                      | **)**      | **328** |   | 350 |   | — |   | 350 |   |
| Amortization of transition asset     | ** ** | **—**                                                                   | ** ** | **—**                                                                   | ** ** | **—** |   | — |   | — |   | — |   |
| Net periodic benefit cost            | ** ** | **$**                                                                        | **988**    | ** **                                                                   | **$**      | **170** | ** ** | **$** | **1,158** |   | $ | 1,103 |   | $ | 200 |   | $ | 1,303 |   |

 

The following tablesummarizes the components of the net periodic benefit cost for the otherpostretirement benefit plans for the three months ended March 31, 2006 and 2005,respectively.

 
| ** **                           | ** ** | **For the 3 months ended March 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------------------------------|------------|
| **(Dollars in thousands)** | ** ** | **2006**                                                           | ** ** | **2005** | ** ** |
| Service cost                         | ** ** | **$**                                                              | **107**    |   | $ | 133 |   |
| Interest cost                        | ** ** | **248**                                                            |       | 249 |   |
| Expected return on plan assets       | ** ** | **—**                                                         |       | — |   |
| Amortization of prior service cost   | ** ** | **—**                                                         |       | — |   |
| Recognized net actuarial (gain) loss | ** ** | **76**                                                             |       | 88 |   |
| Amortization of transition asset     | ** ** | **—**                                                         |       | — |   |
| Net periodic benefit cost            | ** ** | **$**                                                              | **431**    |   | $ | 470 |   |

 

As previously disclosedin its financial statements for the year ended December 31, 2005, Banksharesgenerally makes cash contributions to the pension plan in amounts up to thatpermitted by guidelines established under employee benefit and tax laws. Banksharesestimates that it could be able to contribute up to approximately $19 millionto the pension plan for 2006. Cash contributions are normally made aftervaluations have been finalized for the plan year and prior to the tax returnfiling date. As of March 31, 2006, total contributions of $15 million had beenmade in 2006. No further contributions are expected to be made in the currentyear.

 

18

----

 

15. Recent AccountingStandards

 

On December 19, 2005, the Financial Accounting Standards Board (“FASB”)issued Staff Position (“FSP”) No. SOP 94-6-1, “Terms of Loan Products ThatMay Give Rise to a Concentration of Credit Risk.”  This FSP clarifies that loan products whosecontractual features may expose an originator, holder, investor, guarantor, orservicer to an increased risk of nonpayment or not realizing the full value of theloan (i.e., nontraditional loan products) may result in a concentration ofcredit risk, as defined in FASB Statement No. 107, “Disclosures about Fair Value of Financial Instruments.”  The FSP emphasizes the requirement to assessthe reporting adequacy of disclosures for all lending products. This FSP waseffective December 19, 2005. Adoption of this SOP did not have a materialeffect on Bankshares’ results of operations or financial condition.

 

On February 16, 2006, theFASB issued Statement No. 155, “Accountingfor Certain Hybrid Instruments.”  Thisstandard amends the guidance in FASB Statements (“SFAS”) No. 133, “Accounting for Derivative Instruments andHedging Activities”, and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities.”  SFASNo. 155 allows financial instruments that have embedded derivatives to beaccounted for as a whole (eliminating the need to bifurcate the derivative fromits host) if the holder elects to account for the whole instrument on a fairvalue basis. SFAS No. 155 is effective for all financial instruments acquiredor issued after the beginning of an entity’s first fiscal year that beginsafter September 15, 2006. Bankshares does not anticipate this statement willhave a material effect on its results of operations or financial condition.

 

In March 2006, the FASBissued SFAS No. 156, “Accounting forServicing of Financial Assets-An Amendment of FASB Statement No. 140.”  This standard amends the guidance in SFASNo.140, “Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities.”  Among other requirements, SFAS No. 156requires an entity to recognize a servicing asset or servicing liability eachtime it undertakes an obligation to service a financial asset by entering intoa servicing contract. The standardrequires initial measurement of all newly-purchased or issued separatelyrecognized servicing assets and servicing liabilities at fair value, ifpracticable. Subsequent measurements may be made using either the fair value oramortization method. Statement No. 156 is effective as ofthe beginning of an entity’s first fiscal year that begins after September 15,2006 with early adoption permitted in the quarter-ended March 31, 2006. Banksharesdoes not anticipate this statement will have a material effect on its resultsof operations or financial condition.

 

19

----

# ** **

# **Item2. Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

#### **MERCANTILEBANKSHARES CORPORATION**

#### ** **

HIGHLIGHTS

 

**Consolidated Financial Results**

 

Net income for thequarter ended March 31, 2006 was $70.8 million, a 13.0% increase from netincome of $62.6 million for the same period in 2005 and a 5.5% decrease fromthe $74.9 million reported for the fourth quarter of 2005. For the quarterended March 31, 2006, diluted net income per share was $0.57, an increase of 9.6%from the $0.52 reported for the same period last year and a decrease of 5.0%from the $0.60 reported for the fourth quarter of last year. Adjusted weightedaverage shares outstanding increased from 119.8 million for the quarter endedMarch 31, 2005 to 124.3 million for the quarter ended March 31, 2006.

 

Net interest income forthe quarter ended March 31, 2006 increased 10.6% to $158.3 million from $143.1million for the first quarter of last year.

 

At March 31, 2006,nonperforming assets amounted to $23.6 million or 0.20% of period-end loans andother real estate owned, a decline from $31.4 million at March 31, 2005. Nonperformingassets were $23.2 million at December 31, 2005. The comparable nonperformingasset ratios were 0.30% and 0.20% at March 31, 2005 and December 31, 2005,respectively. The level of “monitored” loans, or loans with characteristicssuggesting that they could be classified as nonperforming in the near future,amounted to $13.9 million at March 31, 2006. Monitored loans were $2.2 millionat March 31, 2005 and December 31, 2005. Nonperforming loans as a percentage oftotal loans remained at historically low levels.

 

Noninterest income, whichincludes investment and wealth management fees, service charges on depositaccounts, mortgage banking-related fees, securities gains and losses,nonmarketable investments income and other income, increased 4.7% to $60.6million for the first quarter of 2006 from $57.9 million for the first quarterof 2005.

 

Noninterest expenses,which include salaries, employee benefits, net occupancy expense of bankpremises, furniture and equipment expenses, communications and supplies andother expenses, increased by 6.6% for the quarter ended March 31, 2006 to $106.7million from $100.2 million for the first quarter of 2005.

 

Banksharesalso reports cash operating earnings, defined as “GAAP”(Generally Accepted Accounting Principles) earnings excluding the amortizationof intangible assets associated with purchase accounting for businesscombinations; securities gains and losses; and other significant gains, lossesor expenses (such as those associated with integrating acquired entities’operations into Bankshares) unrelated toBankshares’ core operations. Webelieve these non-GAAP measures provide information useful to investors inunderstanding our ongoing core business and operational performance trends. Thesemeasures should not be viewed as a substitute for GAAP. Management believespresentations of financial measures excluding the impact of certain itemsprovide useful supplemental information and better reflect its core operatingactivities. In order to arrive at core business operating results, the effectsof certain non-core business transactions such as gains and losses on the saleof securities, amortization of intangibles, restructuring charges andmerger-related expenses, have been excluded. Management reviews these samemeasures internally. For instance, the cash operating efficiency ratio, ratherthan the GAAP basis efficiency ratio, is used to measure management’s successat controlling ongoing, core operating expenses. We believe these measures areconsistent with how investors and analysts typically evaluate our industry, andby providing these measures, we facilitate their analysis. Cash operating earnings totaled $72.1 million forthe first quarter of 2006, an increase of 14.3% over $63.1 million for thesame period in 2005.

 

Additionally, managementbelieves that reporting several key measures based on tangible assets (totalassets less intangible assets) and tangible equity (total equity lessintangible assets) is important, as this more closely approximates the basisfor measuring the adequacy of capital for regulatory purposes. The ratio ofaverage tangible equity to average tangible assets was 9.81% for the quarterending March 31, 2006 compared with 10.00% for the same period in 2005. See “Reconciliationof Non-GAAP Measures” for the reconciliation of GAAP measures to non-GAAPmeasures found elsewhere this document.

 

20

----

 

CRITICAL ACCOUNTINGPOLICIES AND RELATED ESTIMATES

 

In order to understandBankshares financial position and results of operations, it is important tounderstand Bankshares’ significant accounting policies and the extent to whichjudgment and estimates are used in applying those policies. Bankshares’accounting and reporting policies are in accordance with accounting principlesgenerally accepted in the United States (GAAP), and they conform to generalpractices within the applicable industries. Management uses a significantamount of judgment and estimates based on assumptions for which the actualresults are uncertain when the estimate is made. Bankshares has identified fivepolicies as being particularly sensitive in terms of judgments and the extentto which estimates are used: allowance for loan losses and the reserve forunfunded commitments, loans in nonaccrual status or deemed to be impaired,investment securities, income taxes, and valuation of goodwill and intangibleassets. An update of our accounting policy for the allowance for loan lossesand the reserve for unfunded commitments is provided below. For moreinformation on our critical accounting policies, please refer to our 2005Annual Report on Form 10-K.

 

**Allowance for Loan Losses andReserve for Unfunded Commitments**

 

Arriving at anappropriate level of allowance for loan losses involves a high degree ofjudgment. Bankshares’ allowance for loan losses provides for probable lossesbased on evaluations of known and inherent risks in the loan portfolio. Theallowance for loan losses is maintained at a level considered by management tobe adequate to absorb losses inherent in the loan portfolio as of the date ofthe consolidated financial statements. We have developed appropriate policiesand procedures for assessing the adequacy of the allowance for loan losses thatreflect management’s careful evaluation of credit risk considering allavailable information. Management uses historical quantitative information toassess the adequacy of the allowance for loan losses as well as qualitativeinformation about the prevailing economic and business environment, among otherthings. In developing this assessment, management must rely on estimates andexercise judgment in assigning credit risk. Depending on changingcircumstances, future assessments of credit risk may yield materially differentresults from the estimates, which may require an increase or decrease in theallowance for loan losses.

 

We employ a variety ofmodeling and estimation tools in developing the appropriate allowance. Bankshares’allowance consists of formula-based components for business and retail loans, anallowance for impaired loans and an unallocated component. The followingprovides a description of each of these components of the allowance, thetechniques used and the estimates and judgments inherent in each. In the firstquarter of 2006, management refined the methodologies for the formula-basedcomponents to align more appropriately the allowance methodology with our currentframework for analyzing credit losses. Formula-based allowance calculations forbusiness and retail components permit us to address specifically the currenttrends and events affecting the credit risk in the loan portfolio.

 

Business loans arecomprised of commercial, commercial real estate and construction loans, whichare evaluated separately for impairment. For business loans, the formula-basedcomponent of the allowance for loan losses is based on statistical migrationestimates of the average losses observed for business loans classified bycredit grade. Average losses for each credit grade are computed using theannualized historical rate at which loans in each credit grade have defaulted (probabilityof default rates or “PD”) and the historical average losses realized fordefaulted loans (loss-given-default or “LGD”). We have developed default ratesby analyzing four years of our default experience and more than 14 years ofcomparable external data. Default rates, which are validated annually, are estimatesderived from long-term averages and are not based on short-term economic orenvironmental factors. LGD rates have been developed using industry benchmarks.

 

Retail loans arecomprised of consumer installment and residential mortgage loans. For retail loans,the formula-based component of the allowance for loan losses is primarily basedon the probability of default rates and LGD rates for specific groups ofsimilar loans by product category. The probability of default rates are basedon four years of our default experience and between 14 and 19 years ofcomparable industry data. LGD rates were developed using industry benchmarks.

 

For both business and retailloans, the formula-based components include additional qualitative amounts toestablish reasonable ranges that consider observed historical variability inlosses. Factors we may consider in setting these amounts include, but are notlimited to, industry-specific data, portfolio specific risks or concentrations,and macroeconomic conditions. Including these variability components in themodel enables us to capture probable incurred losses that are not yet evidentin current default grades, delinquencies and other credit-risk measurementtools.

 

The specific allowanceallocation is based on an analysis of the loan portfolio. Each loan with anoutstanding balance in excess of a specified threshold that is either innonaccrual status or on the “Watchlist” is evaluated. The Watchlist includesloans identified and closely followed by management. These loans possesscertain qualities or characteristics that may lead to collection and lossissues. The identified loans are evaluated for potential loss by analyzingcurrent collateral values or present value of cash flows, as well as thecapacity of the guarantor, as applicable. This is in accordance with SFASNo. 114, “Accounting for Creditors for Impairment of a Loan,” and SFAS No.118, “Accounting for Creditors for Impairment of a Loan – Income Recognitionand Disclosure.”

 

21

----

 

The allowance for loanlosses also contains an unallocated component. The unallocated allowancerecognizes the imprecision inherent in estimating and measuring inherent losswhen allocating the allowance to individual, or pools of, loans. It also takesinto consideration the allowance level deemed appropriate by each affiliatebased on its local knowledge and input from bank regulators and their view fromthe standpoint of safety and soundness, among other factors. The amount of thiscomponent and its relationship to the total allowance for loan losses maychange from one period to another.

 

In first quarter of 2006,we reclassified a portion of the allowance for loan losses to a reserve forunfunded commitments, which is included in the other liabilities section of theconsolidated balance sheet. The modeling process used in the first quarter of2006 for the determination of the reserve for unfunded lending commitments isconsistent with the process described above for the formula-based component ofthe allowance for loan losses, also including as a key factor a benchmarkaverage rate at which unfunded exposures have been funded at the time ofdefault. The development of this modeling in 2006 enabled Bankshares toevaluate specifically the risk inherent in unfunded commitments and make thereclassification discussed above. As no model data existed in previous years,prior period data has not been reclassified for comparability.

 

SEGMENT REPORTING

 

As noted in Note No. 11 “SegmentReporting”, Bankshares reports two business segments – (1) Banking and (2) Investmentand Wealth Management (“IWM”) - for which financial information is segregatedfor use in assessing performance and allocating resources when reporting to theBoard of Directors. Segment financial information is subjective and, unlikefinancial accounting, is not necessarily based on GAAP. As a result, thefinancial information of the reporting segments is not necessarily comparablewith similar information reported by others and may not be comparable withBankshares’ consolidated results. Certain expense amounts, such as operationsoverhead, have been reclassified from internal financial reporting in order toprovide for proper allocation of costs in the reported data.

 

A schedule disclosing thedetails of these operating segments can be found in Note No. 11 "SegmentReporting."

 

**Banking**

 

The Banking segmentconsists of 11 affiliate banks. Mortgage banking activities are not viewed as aseparate business line due to their insignificant impact on the core businessof Bankshares and, accordingly, are included in the Banking segment.

 

For the first quarter of 2006compared with the first quarter of 2005 net income for Banking increased 13.3%to $68.7 million, from $60.6 million. Net interest income for Banking increased10.5% to $155.9 million for the three months ended March 31, 2006. The growthin net interest income in 2006 reflected a 12.9% increase in average earningassets, offset by an 8 basis point decline in the net interest margin from 4.44%at March 31, 2005 to 4.36% at March 31, 2006. The increase in average loanbalances of 12.8% for the first quarter of 2006 was due largely to the CBNVacquisition. Commercial real estate loan balances increased 21.1%, residentialreal estate loan balances increased 8.7% and construction loan balancesincreased 26.5%. Average deposits included growth in money market accounts,time deposits greater than $100,000 and noninterest-bearing checking, offset bya reduction in balances associated with savings accounts and checking plusinterest accounts in the first quarter of 2006, compared with the first quarterof 2005. The decline in the net interest margin was primarily attributable to theimpact of growth in premium money market accounts and certificates of depositsas customers shifted to these higher rate products, and yields on loans andinvestments lagging the increase in funding costs.

 

As a reflection of theoverall improvement in the Banking credit quality trends, Banking recorded noprovision for credit losses for the first quarter of 2006 compared with $0.8million for the same period of 2005. During the first quarter of 2006, Bankingestablished a reserve for unfunded commitments of $15 million by a reclassificationof $14 million from the allowance for loan losses and the recording of a $1.0million provision related to increased unfunded commitments during the quarter.The allowance for loan losses as a percent of loans was 1.21% at March 31, 2006compared with 1.35% at December 31, 2005 and 1.43% at March 31, 2005.

 

Noninterest expenses were$85.3 million for the first quarter of 2006, compared with $80.5 million forthe same period of 2005, an increase of $4.8 million or 6.0%. Noninterestexpenses net of adjustments were $80.2 million for the first quarter of 2006, a$3.3 million increase, or 4.2%, over $76.9 million for the same period of 2005.The increase in noninterest expenses was primarily related to the CBNVacquisition as well as normal merit and salary increases, higher incentive compensationand benefits costs and the addition of new branches.

 

22

----

 

**Investment & WealthManagement**

 

Investment andWealth Management (“IWM”) includes Asset Management, Private Banking, TrustServices, Retail Brokerage Services and Custody Services. IWM provides a fullline of investment products and retirement, tax and estate planning services.IWM products include:

 

•                  Retail Brokerage Services:  Stocks, bonds, proprietary and nonproprietarymutual funds, fixed and variable annuities.

•                  Asset Management Services:  Proprietary and nonproprietary mutual funds,proprietary and nonproprietary separate account management, customized wealthadvisory services, defined benefit and defined contribution retirement services,family office services, individual and institutional trust services and custodyservices.

•                  Private Banking Services:  Deposits, loans, and mortgages.

 

First quarter 2006net income in IWM decreased 10.2% or $0.5 million to $4.2 million, from $4.7 millionin the first quarter of 2005. Pretax profit margins were 24.3% and 29.6% forthe first quarters of 2006 and 2005, respectively. As noted later in thissection, the quarter included non-recurring after-tax expenses of $1.1 million.Excluding these expenses, net income increased $0.6 million, or 13.6%, to $5.3 million,and the pre-tax margin was 30.7%. For more information on corporate overheadsee “Other” in “Segment Reporting” below.

 

The increase in the equitymarkets in 2005 continued into the first quarter of 2006. The S&P 500 indexended March 31, 2006 at 1,295, up 9.7% from 1,180 at the end of March 2005. Othermajor indices had positive results. Between March 31, 2005 and March 31, 2006,the Dow Jones Industrial Average increased 5.8% to 11,109 and the Nasdaq rose17 % to 2,340. The fixed income markets, as measured by the Lehman Brothers USAggregate Bond Index, were down 2.7% for the twelve month period ending March31, 2006. Given the relatively balanced weighting of equities and fixed income withinBankshares’ investment asset base, the markets overall had a positive impact onthe first quarter of 2006. At March 31, 2006, 44% of IWM managed assets wereinvested in equities, including real estate. Approximately 37% of managedassets were invested in fixed income securities and 19% were invested in cashand other.

 
| ** **                               | ** ** | **As of March 31,** | ** ** |
|------------------------------------------|------------|------------------------------------|------------|
| **Market Indices**                  | ** ** | **2006**                           | ** ** | **2005** | ** ** |
| Dow Jones  Industrial Average            | ** ** | **11,109**                         | ** ** | 10,504 |   |
| Year-over-Year %  Change                 | ** ** | **5.8**                            | **%**      | 1.4 | % |
| S&P 500  Index-period-end            | ** ** | **1,295**                          | ** ** | 1,180 |   |
| Year-over-Year %  Change                 | ** ** | **9.7**                            | **%**      | 4.7 | % |
| Nasdaq                                   | ** ** | **2,340**                          | ** ** | 1,999 |   |
| Year-over-Year %  Change                 | ** ** | **17**                             | **%**      | 0.3 | % |
| Lehman Brothers  US Aggregate Bond Index | ** ** | **99.9**                           | ** ** | 102.7 |   |
| Year-over-Year %  Change                 | ** ** | **-2.7**                           | **%**      | -4.3 | % |

 

Revenues in thefirst quarter of 2006 increased $2.5 million, or 9.4%, to $28.8 million from $26.3million in the same period last year. Significant revenue growth was realizedin Mercantile Funds, Brokerage and Private Banking. Solid growth was realizedin Private Wealth Management and a modest decline occurred in InstitutionalManagement.

 

Private Wealth Managementbenefited from the increase in equity markets during the past year, growth innew assets, and a fee increase on some accounts as of the beginning of 2006.Personal Assets under Administration increased $0.8 billion, or 6.8%, to $12.9billion year-over-year. Personal Assets with Investment Responsibility increased$0.5 billion, or 5.5%, to $8.9 billion and Assets with No InvestmentResponsibility increased $0.4 billion, or 9.8%, to $4.0 billion year-over-year.

 

Institutional InvestmentManagement overall suffered from a decline in assets year-over-year. Anincrease in real estate fees was partially offset by lower revenues in our BoydWatterson Asset Management subsidiary primarily attributable to a decline inequity assets under management. In addition, higher terminations in ourinstitutional custody business last year continued to affect negatively institutionalrevenues in the first quarter of 2006. Total Institutional Assets under Administration,including Boyd Watterson, declined $1.1 billion, or 3.0%, to $34.7 billion. InstitutionalAssets with Investment Responsibility declined $0.6 billion, or 4.9%, to $11.6billion. Assets under Administration with No Investment Responsibility declined$0.4 billion, or 1.9%, to $23.1 billion. During the second half of 2006, oneclient with significant Assets under Administration with No InvestmentResponsibility will terminate its account. No material revenue impact willresult in 2006.

 

23

----

 

The Mercantile Fundsbenefited from higher assets flows into the funds, improved equity markets, andstrong performance in the hedge funds of funds. Mercantile Fund assetsincreased $208 million or 5.4 % to $4 billion, driven by a 15% increase inpersonal trust assets, on a year-over-year basis.

 

Brokerage commissions andincome benefited from growth in the number of accounts and assets held inaccounts. Brokerage assets increased $160 million, or 18%, to $1 billionyear-over-year.

 

Private Banking revenuesbenefited from significant loan and deposit growth.

 
| **IWM ASSET DATA (Dollars in billions)** | ** ** | **For the 3 months ended March 31,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                                           | ** ** | **2005** | ** ** |
| *Personal*                                                        |       |                                                               |       |   |   |
| Assets with  Investment Responsibility                            | ** ** | **$**                                                              | **8.9**    |   | $ | 8.5 |   |
| Assets with no  Investment Responsibility                         | ** ** | **4.0**                                                            |       | 3.6 |   |
| Total Personal                                                    | ** ** | **12.9**                                                           |       | 12.1 |   |
|                                                              |       |                                                               |       |   |   |
| *Institutional*                                                   |       |                                                               |       |   |   |
| Assets with  Investment Responsibility                            | ** ** | **11.6**                                                           |       | 12.1 |   |
| Assets with no  Investment Responsibility                         | ** ** | **23.1**                                                           |       | 23.6 |   |
| Total  Institutional                                              | ** ** | **34.7**                                                           |       | 35.7 |   |
|                                                              |       |                                                               |       |   |   |
| *Mutual  Funds Not Included Above*                                | ** ** | **0.3**                                                            |       | 0.2 |   |
|                                                              |       |                                                               |       |   |   |
| *Total*                                                           |       |                                                               |       |   |   |
| Assets with  Investment Responsibility                            | ** ** | **20.8**                                                           |       | 20.8 |   |
| Assets with no  Investment Responsibility                         | ** ** | **27.1**                                                           |       | 27.2 |   |
| Total Assets  Under Administration                                | ** ** | **$**                                                              | **47.9**   |   | $ | 48.0 |   |
|                                                                   |            |                                                                    |            |  |  |  |  |  |  |  |

 

At March 31, 2006, assetsunder administration by IWM were $47.9 billion, a decrease of $0.1 billion, or0.2%, from the prior year. Bankshares had investment responsibility for $20.8billion, unchanged compared with the prior year.

 

Additional revenue growthwill depend on continued new sales and increased distribution, equity and bondmarket conditions and acquisitions, if any.

 

In the first quarter of2006, expenses increased 27.7%, or $4.7 million, to $21.5 million, compared with$16.8 million in the first quarter of last year. Approximately $1.8 million ofthis increase consisted of severance and other expenses related to formeremployees. Increases also occurred in employee-related, technology,professional services, operations and occupancy expenses which were onlypartially offset by a modest decrease in marketing expenses.

 

24

----

 

**BANKSHARES EARNINGS PERFORMANCE**

 

**Analysis of Interest Rates andInterest Differentials**

 

The following tablepresents the distribution of the average consolidated balance sheet, interestincome/expense and annualized yields earned and rates paid through the threemonths ended March 31, 2006 and 2005.

 
| ** **                                         | ** ** | **2006**                            | ** **     | **2005**                                  | ** **  |
|----------------------------------------------------|------------|-------------------------------------|----------------|-------------------------------------------|-------------|
| **(Dollars in thousands)**                         | ** ** | **Average   Balance (2)** | ** **     | **Income (1)   / Expense** | ** **  | **Yield (1)   / Rate** | ** ** | **Average   Balance (2)** | ** ** | **Income (1)   / Expense** | ** ** | **Yield (1)   / Rate** | ** ** |
| Earning assets                                     |       |                                |           |                                      |        |   |   |   |   |   |   |   |   |
| Loans:                                             |       |                                |           |                                      |        |   |   |   |   |   |   |   |   |
| Commercial                                         | ** ** | **$**                               | **2,933,214**  | ** **                                | **$**       | **51,076** | ** ** | **7.06** | **%** | $ | 2,848,452 |   | $ | 41,467 |   | 5.90 | % |
| Commercial real  estate                            | ** ** | **3,673,385**                       | ** **     | **62,420**                                | ** **  | **6.89** | ** ** | 3,133,446 |   | 48,534 |   | 6.28 |   |
| Construction                                       | ** ** | **1,681,253**                       | ** **     | **32,584**                                | ** **  | **7.86** | ** ** | 1,328,633 |   | 20,451 |   | 6.24 |   |
| Residential real  estate                           | ** ** | **1,831,603**                       | ** **     | **27,837**                                | ** **  | **6.16** | ** ** | 1,710,003 |   | 24,955 |   | 5.92 |   |
| Home equity lines                                  | ** ** | **496,526**                         | ** **     | **8,879**                                 | ** **  | **7.25** | ** ** | 495,935 |   | 6,557 |   | 5.36 |   |
| Consumer                                           | ** ** | **1,030,923**                       | ** **     | **14,577**                                | ** **  | **5.73** | ** ** | 797,892 |   | 11,681 |   | 5.94 |   |
| Total loans                                        | ** ** | **11,646,904**                      | ** **     | **197,373**                               | ** **  | **6.87** | ** ** | 10,314,361 |   | 153,645 |   | 6.04 |   |
| Federal funds  sold, et al                         | ** ** | **57,318**                          | ** **     | **657**                                   | ** **  | **4.65** | ** ** | 31,854 |   | 343 |   | 4.37 |   |
| Securities:                                        |       |                                |           |                                      |        |   | ** ** |   |   |   |   |   |   |
| Taxable  securities                                |       |                                |           |                                      |        |   | ** ** |   |   |   |   |   |   |
| U.S. Treasury and  government agencies securities  | ** ** | **1,440,180**                       | ** **     | **12,935**                                | ** **  | **3.64** | ** ** | 1,426,230 |   | 12,069 |   | 3.43 |   |
| Mortgage-backed  securities                        | ** ** | **1,589,017**                       | ** **     | **16,860**                                | ** **  | **4.30** | ** ** | 1,303,700 |   | 12,923 |   | 4.02 |   |
| Other investments                                  | ** ** | **63,199**                          | ** **     | **633**                                   | ** **  | **4.06** | ** ** | 63,943 |   | 649 |   | 4.12 |   |
| Tax-exempt  securities                             |       |                                |           |                                      |        |   | ** ** |   |   |   |   |   |   |
| States and  political subdivisions                 | ** ** | **83,957**                          | ** **     | **1,287**                                 | ** **  | **6.22** | ** ** | 80,921 |   | 1,192 |   | 5.97 |   |
| Total securities                                   | ** ** | **3,176,353**                       | ** **     | **31,715**                                | ** **  | **4.05** | ** ** | 2,874,794 |   | 26,833 |   | 3.79 |   |
| Interest-bearing  deposits in other banks          | ** ** | **200**                             | ** **     | **1**                                     | ** **  | **1.36** | ** ** | 158 |   | 1 |   | 1.47 |   |
| Total earning  assets                              | ** ** | **14,880,775**                      | ** **     | **229,746**                               | ** **  | **6.26** | ** ** | 13,221,167 |   | 180,822 |   | 5.55 |   |
| Cash and due from  banks                           | ** ** | **301,305**                         | ** **     | ** **                                | ** **  | ** ** | ** ** | 290,911 |   |   |   |   |   |
| Bank premises and  equipment, net                  | ** ** | **138,237**                         | ** **     | ** **                                | ** **  | ** ** | ** ** | 141,426 |   |   |   |   |   |
| Other assets                                       | ** ** | **1,272,673**                       | ** **     | ** **                                | ** **  | ** ** | ** ** | 1,004,526 |   |   |   |   |   |
| Less: allowance  for loan losses                   | ** ** | **(157,026**                        | **)**          | ** **                                | ** **  | ** ** | ** ** | (149,686 | ) |   |   |   |   |
| Total assets                                       | ** ** | **$**                               | **16,435,964** | ** **                                | ** **  | ** ** | ** ** | ** ** | $ | 14,508,344 |   |   |   |   |   |
| Interest-bearing  liabilities                      | ** ** | ** **                          | ** **     | ** **                                |        |   | ** ** |   |   |   |   |   |   |
| Deposits:                                          | ** ** | ** **                          | ** **     | ** **                                |        |   | ** ** |   |   |   |   |   |   |
| Savings                                            | ** ** | **$**                               | **1,321,364**  | ** **                                | **1,470**   | ** ** | **0.45** | ** ** | $ | 1,459,580 |   | 1,151 |   | 0.32 |   |
| Checking plus  interest accounts                   | ** ** | **1,341,714**                       | ** **     | **628**                                   | ** **  | **0.19** | ** ** | 1,350,521 |   | 515 |   | 0.15 |   |
| Money market                                       | ** ** | **1,848,724**                       | ** **     | **9,935**                                 | ** **  | **2.18** | ** ** | 1,550,919 |   | 3,589 |   | 0.94 |   |
| Time deposits  $100,000 and over                   | ** ** | **1,904,098**                       | ** **     | **18,764**                                | ** **  | **4.00** | ** ** | 1,427,571 |   | 9,347 |   | 2.66 |   |
| Other time  deposits                               | ** ** | **2,318,985**                       | ** **     | **18,446**                                | ** **  | **3.23** | ** ** | 1,905,548 |   | 10,703 |   | 2.28 |   |
| Total  interest-bearing deposits                   | ** ** | **8,734,885**                       | ** **     | **49,243**                                | ** **  | **2.29** | ** ** | 7,694,139 |   | 25,305 |   | 1.33 |   |
| Short-term  borrowings                             | ** ** | **1,320,595**                       | ** **     | **11,023**                                | ** **  | **3.39** | ** ** | 1,000,929 |   | 4,042 |   | 1.64 |   |
| Long-term debt                                     | ** ** | **730,236**                         | ** **     | **9,334**                                 | ** **  | **5.18** | ** ** | 689,372 |   | 6,815 |   | 4.01 |   |
| Total  interest-bearing funds                      | ** ** | **10,785,716**                      | ** **     | **69,600**                                | ** **  | **2.62** | ** ** | 9,384,440 |   | 36,162 |   | 1.56 |   |
| Noninterest-bearing  deposits                      | ** ** | **3,206,071**                       | ** **     | ** **                                | ** **  | ** ** | ** ** | 3,024,595 |   |   |   |   |   |
| Other liabilities  and accrued expenses            | ** ** | **182,531**                         | ** **     | ** **                                | ** **  | ** ** | ** ** | 149,033 |   |   |   |   |   |
| Total liabilities                                  | ** ** | **14,174,318**                      | ** **     | ** **                                | ** **  | ** ** | ** ** | 12,558,068 |   |   |   |   |   |
| Shareholders’  equity                         | ** ** | **2,261,646**                       | ** **     | ** **                                | ** **  | ** ** | ** ** | 1,950,276 |   |   |   |   |   |
| Total liabilities  & shareholders’ equity | ** ** | **$**                               | **16,435,964** | ** **                                | ** **  | ** ** | ** ** | ** ** | $ | 14,508,344 |   |   |   |   |   |
| Net interest rate  spread                          |       |                                | ** **     | **$**                                     | **160,146** | ** ** | **3.64** | **%** |   |   | $ | 144,660 |   | 3.99 | % |
| Effect of  noninterest-bearing funds               |       |                                |           |                                      | ** **  | **0.72** | ** ** |   |   |   |   | 0.45 |   |
| Net interest  margin on earning assets             |       |                                |           |                                      | ** **  | **4.36** | **%** |   |   |   |   | 4.44 | % |
| Tax-equivalent  adjustment included in:            |       |                                |           |                                      | ** **  | ** ** | ** ** |   |   |   |   |   |   |
| Loan income                                        |       |                                | ** **     | **$**                                     | **1,318**   | ** ** | ** ** | ** ** |   |   | $ | 1,101 |   |   |   |
| Investment  securities income                      |       |                                | ** **     | **515**                                   | ** **  | ** ** | ** ** |   |   | 476 |   |   |   |
| Total                                              |       |                                | ** **     | **$**                                     | **1,833**   |   |   | ** ** |   |   | $ | 1,577 |   |   |   |

 

----

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

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

 

25

----

 

**Rate / Volume Analysis**

 

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

 
| ** **                                 | ** ** | **For the 3 months ended March 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2006 vs. 2005**                                        | ** ** |
| ** **                                 | ** ** | **Due to variances in**                             | ** ** |
| **(Dollars in thousands)**       | ** ** | **Total**                                                          | ** ** | **Rates (6)** | ** ** | **Volumes (5), (6)** | ** ** |
| Interest earned  on:                       |       |                                                               |       |   |   |   |   |
| Loans:                                     |       |                                                               |       |   |   |   |   |
| Commercial (1)                             |       | $                                                                  | 9,609      |   | $ | 8,133 |   | $ | 1,476 |   |
| Commercial real  estate (2)                |       | 13,886                                                             |       | 4,711 |   | 9,175 |   |
| Construction (3)                           |       | 12,133                                                             |       | 5,299 |   | 6,834 |   |
| Residential real  estate                   |       | 2,882                                                              |       | 1,034 |   | 1,848 |   |
| Home equity  lines                         |       | 2,322                                                              |       | 2,311 |   | 11 |   |
| Consumer                                   |       | 2,896                                                              |       | (399 | ) | 3,295 |   |
| Taxable  securities                        |       | 4,787                                                              |       | 1,850 |   | 2,937 |   |
| Tax-exempt  securities (4)                 |       | 95                                                                 |       | 48 |   | 47 |   |
| Federal funds  sold, et al                 |       | 314                                                                |       | 22 |   | 292 |   |
| Interest-bearing  deposits in other banks  |       | —                                                             |       | — |   | — |   |
| Total interest  income                     |       | 48,924                                                             |       | 23,301 |   | 25,623 |   |
|                                       |       |                                                               |       |   |   |   |   |
| Interest paid  on:                         |       |                                                               |       |   |   |   |   |
| Savings deposits                           |       | 319                                                                |       | 473 |   | (154 | ) |
| Checking plus  interest deposits           |       | 113                                                                |       | 117 |   | (4 | ) |
| Money market  accounts                     |       | 6,346                                                              |       | 4,746 |   | 1,600 |   |
| Certificates of  deposit $100,000 and over |       | 9,417                                                              |       | 4,721 |   | 4,696 |   |
| Other time  deposits                       |       | 7,743                                                              |       | 4,454 |   | 3,289 |   |
| Short-term  borrowings                     |       | 6,981                                                              |       | 4,313 |   | 2,668 |   |
| Long-term debt                             |       | 2,519                                                              |       | 1,997 |   | 522 |   |
| Total interest  expense                    |       | 33,438                                                             |       | 24,396 |   | 9,042 |   |
| Net interest  earned                       |       | $                                                                  | 15,486     |   | $ | (1,094 | ) | $ | 16,580 |   |

 

----

(1)          Interest quarter-to-date tax-equivalent adjustment of $0.8 million for 2006and 2005 is included in the commercial loan rate variances.

(2)          Interest quarter-to-date tax-equivalent adjustment of $0.1 million for 2005is included in the commercial real estate loan rate variances.

(3)          Interest quarter-to-date tax-equivalent adjustment of $0.3 million for2006 and $0.2 million for 2005, respectively, are included in the constructionloan rate variances.

(4)          Interest quarter-to-date tax-equivalent adjustment of $0.5 million for 2006and 2005 is included in the tax-exempt securities rate variances.

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

(6)          Categories do not adddue to the effect of changes in product mix.

 

26

----

 

**Net Interest Income and NetInterest Margin**

 

In the first quarter of 2006net interest income, on a tax-equivalent basis, was $160.1 million, comparedwith $144.7 million for the first quarter of 2005, which represented a $15.5million, or 10.7%, increase from 2005. The increase was primarily due to balancesheet growth reflecting the CBNV merger as well as organic loan growth.

 

The net interest margin declinedfrom 4.44% in the first quarter of 2005 to 4.36% in the first quarter of 2006. Thedecline was due primarily to growth in premium money market accounts andcertificates of deposit as customers shifted to these higher rate products; increasedcompetition affecting yields on new loans and the overall yield on theinvestment portfolio lagging the increase in funding costs. Bankshares paid anaverage rate of 2.29% on interest-bearing deposits during the first quarter of 2006,an increase of 95 basis points over the first quarter of 2005. By contrast ,the yield on average loans and investments increased by 83 basis points and 26basis points, respectively, from the first quarter of 2005. The amortization ofdeferred loan origination costs during the first quarter of 2006 reduced themargin by two basis points compared with the first quarter of last year. It isanticipated that increased amortization of deferred loan origination costs willcontinue to affect the margin by an additional one to two basis points perquarter for the next two to three years as the amount amortized builds over theaverage life of the originated loans.

 

On a linked quarterbasis, net interest income declined by 2.5% from $162.4 million. The decline inthe linked-quarter net interest income was attributable to both the decline inthe net interest margin and two fewer days in the quarter. The seven basispoint decline in the net interest margin was primarily attributable to arefinement in prepayment speed calculations in the mortgage-backed securitiesportfolio, which benefited net interest margin by four basis points in thefourth quarter of 2005 and reduced net interest margin by one basis point inthe first quarter of 2006.

 

Average earning assets inthe first quarter of 2006 increased $1.7 billion, or 12.6%, over the sameperiod in 2005. Loans averaged $11.6 billion in the first quarter of 2006,compared with $10.3 billion in the first quarter of 2005, an increase of 12.9%due largely to the CBNV acquisition. During the first quarter of 2006 totalaverage loan growth was driven by growth in commercial real estate of $539.9million, or 17.2%, construction loan growth of $352.6 million, or 26.5%, consumerloan growth of $233.0 million , or 29.2%, and residential mortgage loan growthof $121.6 million or 12.9%.

 

Average investmentsecurities for the first quarter of 2006 increased by $301.6 million, or 10.5%,compared with the same period of 2005.

 

Average core deposits(total deposits less certificates of deposit of $100,000 and over) are animportant contributor to growth in net interest income and the net interestmargin. Average core deposits were $10.0 billion and $9.3 billion and funded 61%and 64% of average total assets in the first quarters of 2006 and 2005,respectively. Average noninterest-bearing checking accounts for the firstquarter of 2006 were higher by $181.5 million, or 6.0%, compared with the sameperiod in 2005. Total average interest-bearing deposits increased by $1.0 billion,or 13.5%, for the first quarter of 2006, compared with the same period of 2005.The year-over-year increase in average interest-bearing deposits during thefirst quarter of 2006 included an increase in time deposits and money marketaccounts partially offset by a decline in checking plus interest and savingsaccounts.

 

Based on current marketconditions, management anticipates a moderate increase in short-term interestrates in the near-term. Given the current rate environment, the flatness of theyield curve and competitive pressure on both loan and deposit pricing, weanticipate that the net interest margin will remain under some pressurethroughout the year.

 

27

----

 

# **NoninterestIncome**

# ** **

Noninterest income forthe quarter ended March 31, 2006 increased by $2.7 million, or 4.7%, to $60.6million compared with $57.9 million for the same period in 2005. Noninterestincome declined 2.4% compared to the fourth quarter of 2005. The table belowshows the major components of noninterest income.

 
| ** **                                  | ** ** | **For the 3 months ended** | ** ** | ** **        |
|---------------------------------------------|------------|------------------------------------------------|------------|-------------------|
| ** **                                  | ** ** | **March 31,**                             | ** ** | **% Change** | ** ** |
| **(Dollars in thousands)**        | ** ** | **2006**                                       | ** ** | **2005**          | ** ** | **2006/2005** | ** ** |
| Investment and  wealth management           | ** ** | **$**                                          | **26,121** |              | $ | 24,057 |   | 8.6 | % |
| Service charges  on deposit accounts        | ** ** | **10,292**                                     | ** ** | 10,426            |   | (1.3 | ) |
| Mortgage banking-related  fees:             |       |                                           | ** ** |              |   |   |   |
| Commercial                                  | ** ** | **1,879**                                      | ** ** | 1,837             |   | 2.3 |   |
| Residential                                 | ** ** | **331**                                        | ** ** | 446               |   | (25.8 | ) |
| Total mortgage  banking-related fees        | ** ** | **2,210**                                      | ** ** | 2,283             |   | (3.2 | ) |
| Net investment  securities gains / (losses) | ** ** | **(13**                                        | **)**      | 414               |   | (103.1 | ) |
| Nonmarketable  investments:                 |       |                                           | ** ** |              |   |   |   |
| Private equity  and other investments       | ** ** | **1,324**                                      | ** ** | 2,461             |   | (46.2 | ) |
| Hedge funds                                 | ** ** | **3,395**                                      | ** ** | 1,964             |   | 72.9 |   |
| Bank-owned life  insurance                  | ** ** | **1,550**                                      | ** ** | 846               |   | 83.2 |   |
| Total  nonmarketable investments            | ** ** | **6,269**                                      | ** ** | 5,271             |   | 18.9 |   |
| Other income:                               |       |                                           | ** ** |              |   |   |   |
| Electronic banking  fees                    | ** ** | **5,636**                                      | ** ** | 5,173             |   | 9.0 |   |
| Charges and fees  on loans                  | ** ** | **2,765**                                      | ** ** | 2,795             |   | (1.1 | ) |
| Insurance                                   | ** ** | **5,101**                                      | ** ** | 4,540             |   | 12.4 |   |
| All other income                            | ** ** | **2,225**                                      | ** ** | 2,910             |   | (23.5 | ) |
| Total other  income                         | ** ** | **15,727**                                     | ** ** | 15,418            |   | 2.0 |   |
| Total                                       | ** ** | **$**                                          | **60,606** | ** **        | $ | 57,869 |   | 4.7 |   |
|                                             |            |                                                |            |                   |  |  |  |  |  |  |

 

IWM represents thelargest source of noninterest income at 43.1% and increased 8.6%, or $2.1million, over the first quarter of 2005. The growth of IWM revenue was dueprincipally to stronger equity markets during 2006 compared with 2005,increased new sales in Private Wealth Management, increased brokerage activityand stronger performance in the hedge funds of funds. IWM revenue increased7.7%, or $1.9 million, over the fourth quarter of 2005. This increase was dueprimarily to stronger equity markets during 2006 and increased brokerageactivity.

 

Service charges ondeposits decreased slightly from the prior year. The decrease related primarilyto our business customers. For the first quarter of 2006 compared with thefirst quarter of 2005, service charges decreased by $0.1 million, or 1.3%.

 

Mortgage banking-relatedfees were slightly lower than the first quarter of 2005, primarily due to lowerresidential fees resulting from lower profit margins. Mortgage-banking fees decreased$2.5 million compared with the fourth quarter of 2005 due to lower volumes incommercial business and lower residential fees due to lower profit margins.

 

Nonmarketable investmentsincome increased nearly $1.0 million over 2005 due to increases in hedge fundincome and higher income from bank-owned life insurance due to betterperformance and the investment of an additional $50.0 million in the thirdquarter of 2005. These increases were partially offset by a decline in privateequity investment performance. Nonmarketable investments income was nearly flatcompared with the fourth quarter of 2005. Hedge fund income was higher due tobetter performance offset partially by a decline in private equity performance.

 

Other income was slightlyhigher than the first quarter of 2005, primarily due to the CBNV acquisitionand higher insurance revenues, which are derived from fee income related to thesale and servicing of insurance products. Other income was $0.4 million lessthan the fourth quarter of 2005. This decrease was due primarily to $1.4million in lower capital markets-related revenue.

 

28

----

 

**Noninterest Expenses**

 

Noninterest expenses forthe three months ended March 31, 2006 increased by $6.6 million, or 6.6%, to$106.7 million compared with $100.2 million for the three months ended March31, 2005. Noninterest expenses decreased 1.5% from the fourth quarter of 2005. Thetable below shows the major components of noninterest expenses.

 
| ** **                              | ** ** | **For the 3 months ended** | ** **  | ** **        |
|-----------------------------------------|------------|------------------------------------------------|-------------|-------------------|
| ** **                              | ** ** | **March 31,**                             | ** **  | **% Change** | ** ** |
| **(Dollars in thousands)**    | ** ** | **2006**                                       | ** **  | **2005**          | ** ** | **2006/2005** | ** ** |
| Salaries                                | ** ** | **$**                                          | **49,099**  |              | $ | 46,554 |   | 5.5 | % |
| Employee  benefits                      | ** ** | **14,735**                                     |        | 11,897            |   | 23.9 |   |
| Net occupancy  expense of bank premises | ** ** | **7,771**                                      |        | 6,922             |   | 12.3 |   |
| Furniture and  equipment expenses       | ** ** | **8,305**                                      |        | 7,279             |   | 14.1 |   |
| Communications  and supplies            | ** ** | **3,818**                                      |        | 4,040             |   | (5.5 | ) |
| Other expenses:                         |       |                                           |        |              |   |   |   |
| Professional  services                  | ** ** | **5,170**                                      |        | 5,125             |   | 0.9 |   |
| Advertising and  promotional expenses   | ** ** | **1,498**                                      |        | 1,711             |   | (12.4 | ) |
| Electronic  banking expense             | ** ** | **3,127**                                      |        | 3,241             |   | (3.5 | ) |
| Amortization of  intangible assets      | ** ** | **2,325**                                      |        | 2,072             |   | 12.2 |   |
| Outsourcing  expense                    | ** ** | **2,823**                                      |        | 2,690             |   | 4.9 |   |
| All other  expenses                     | ** ** | **8,044**                                      |        | 8,622             |   | (6.7 | ) |
| Total other  expenses                   | ** ** | **22,987**                                     |        | 23,461            |   | (2.0 | ) |
| Total                                   | ** ** | **$**                                          | **106,715** |              | $ | 100,153 |   | 6.6 |   |
|                                         |            |                                                |             |                   |  |  |  |  |  |  |

 

The efficiency ratio, akey measure of expense management, improved in the first quarter of 2006compared with the same quarter of 2005. The efficiency ratio is computed bydividing noninterest expenses by the sum of net interest income on atax-equivalent basis and noninterest income. Bankshares’ efficiency ratio was48.34% for the three months ended March 31, 2006 compared with 49.45% for thethree months ended March 31, 2005. On a non-GAAP basis, the cash operatingefficiency ratio excludes the amortization of intangible assets associated withpurchase accounting for business combinations; securities gains and losses; andother significant gains, losses or expenses (such as those associated withintegrating acquired entities’ operations into Bankshares) unrelated toBankshares’ core operations. Bankshares’ cash operating efficiency ratio was 47.30%and 48.68% for the three months ended March 31, 2006 and 2005, respectively. Thereconciliation of GAAP to non-GAAP measures is found elsewhere in this filing.

 

Salaries, which includebase compensation, commissions, incentive compensation and stock-basedcompensation, are the largest component of noninterest expense at 46.0%. Salaryexpense increased $2.5 million, or 5.5%, compared with the first quarter of 2005.The acquisition of CBNV added $1.6 million to this expense category. Alsocontributing to the increase was $2.4 million in merit and staffing increases,$1.2 million in higher commissions and incentive compensation related toimproved operating performance and $1.6 million in severance costs. Theseincreases were partially offset by a reduction of $4.7 million in salariesexpense due to an increase in the amount of deferred loan origination costs. Employeebenefits increased $2.8 million due to increases in payroll taxes, retirement-relatedcosts and medical premiums.

 

Net occupancy expense, whichincludes premises depreciation, rents, maintenance and utilities increased $0.8million, or 12.3%, over the prior year. This increase was due to theacquisition of CBNV and the addition of new branches. Furniture and equipmentexpenses increased by nearly $1.0 million over the same period last year. Theincrease in this category was due primarily to increases in software-relatedcosts and the acquisition of CBNV.

 

Other expenses consist ofprofessional services, marketing, electronic banking and several othercategories such as travel and membership, amortization, licensing, insuranceand sundry expenses. For the three months ended March 31, 2006 compared withthe three months ended March 31, 2005, other expenses decreased $0.5 million, or2.0%. The decrease in other expenses was primarily due to $2.1 million ofexpense in 2005 related to a litigation matter.

 

29

----

 

ANALYSIS OF FINANCIALCONDITION

 

At March 31, 2006compared with March 31, 2005, total assets increased 14.7% or $2.2 billion. AtMarch 31, 2006 compared with December 31, 2005, total assets increased 2.2% or$361.5 million.

 

A comparative schedule ofaverage balances is included in the table found elsewhere in this document.

 

**Securities Available-for-Sale**

 

The securitiesavailable-for-sale portfolio includes both debt and marketable equitysecurities. Bankshares’ holds debt securities available-for-sale primarily forliquidity, interest rate risk-management and yield enhancement purposes. Accordingly,this portfolio primarily includes very liquid, high quality federalagency-backed debt securities. At March 31, 2006, the portfolio totaled $3.1 billionof debt securities available-for-sale, compared with $3.0 billion at December31, 2005. One hundred eighty-four securities were in a continuous loss positionfor 12 months or more at March 31, 2006, which consisted primarily ofmortgage-backed securities. Because the declines in fair value were due tochanges in market interest rates, not in estimated cash flows, noother-than-temporary impairment was recorded at March 31, 2006. There was a netunrealized loss on these debt securities available-for-sale of $37.5 millionand $32.8 million at March 31, 2006 and December 31, 2005, respectively.

 

The weighted-averageexpected maturity of debt securities available-for-sale was 2.3 years at March31, 2006. Since approximately 51% of this portfolio was mortgage-backedsecurities, the expected remaining maturity may differ from contractualmaturity because borrowers may have the right to prepay obligations before theunderlying mortgages mature. See Note No. 4 “Investment Securities” to theFinancial Statements for securities available-for-sale by security type.

 

**Loan Portfolio**

 

Total loans at March 31,2006 were $11.7 billion, compared with $11.6 billion at December 31, 2005. Theincrease in total loans was primarily driven by growth in construction lendingand residential mortgages. Construction loans totaled $1.7 billion at March 31,2006, compared with $1.6 billion at December 31, 2005, an increase of $133million or 8.3%. Residential real estate loans increased $53.9 million, or 3.0%,from December 31, 2005. Total loans at March 31, 2006 increased $1.3 billion,or 12.3%, over March 31, 2005.

 

**Deposits**

 

Total deposits at March31, 2006, were $12.6 billion, an increase of $496.2 million, or 4.1%, overDecember 31, 2005. Noninterest-bearing deposits were $3.4 billion at March 31,2006, compared with $3.3 billion at December 31, 2005, an increase of $61.2million or 1.8%. Interest-bearing deposits totaled $9.2 billion at March 31,2006, compared with $8.8 billion at December 31, 2005, an increase of $435.0 million,or 5.0%. The increase in interest-bearing deposits included increases in moneymarket accounts of $212.9 million, or 10.9%, and time deposit accounts of $41.6million, or 1.8%. These increases were partially offset by a decrease in interestbearing checking accounts of $21.7 million, or 1.5%, and savings accounts of $21.8million or 1.6%.

 

At March 31, 2006, totaldeposits increased 14.6% or $1.6 billion compared with the year-earlier period.Growth in deposits was due in part from the CBNV acquisition as well as organicdeposit growth. The affiliate-banking model positions Bankshares to compete notonly with the large national and regional banking companies in the gathering ofthese funds, but also with local community banks. Based on historicalexperience, Bankshares expects to retain these deposits in a rising interestrate environment although pricing pressure is expected to intensify.

 

**Borrowings**

 

Bankshares utilizes bothshort-term and long-term borrowings to fund growth of earning assets in excessof deposit growth. Short-term borrowings, which include federal funds purchased,securities sold under agreements to repurchase and other short-term borrowings,were $1.1 billion at March 31, 2006, compared with $1.2 billion at December 31,2005. Short-term funding is managed to levels deemed appropriate givenalternative funding sources. Long-term debt was $701.7 million at March 31, 2006,a decrease of $40.5 million, or 5.5%, compared with the $742.2 million atDecember 31, 2005.

 

30

----

 

**Capital**

 

Shareholders’ equity atMarch 31, 2006 was $2.2 billion. Bankshares has authorization to repurchase upto approximately 0.5 million additional shares. During the quarter, Banksharesrepurchased 3,371 shares in the net settlement of minimum tax liability for vestedrestricted stock awards.

 

On January 10, 2006,Bankshares announced a three-for-two stock split on its common stock payable inthe form of a stock dividend on January 27, 2006 to stockholders of record asof the close of business on January 20, 2006. For comparative purposes, certainshares, average shares and per share amounts have been restated. At March 31,2006 and December 31, 2005, the cash-dividend payout ratio was 44.83% and 43.42%,respectively. For more details, see the Statements of Changes in ConsolidatedShareholders’ Equity.

 

RISK MANAGEMENT

 

**Credit Risk Analysis**

 

Bankshares’ loans andcommitments are substantially to borrowers located in its immediate region. Bankshareshas limited its participation in multibank credits where Bankshares is not themanaging or agent bank. Central to the operation of a sound and successfulfinancial institution is the balanced management of asset growth and creditquality. Responsibility for loan underwriting and monitoring is clearly fixedon key management personnel in each of our affiliates and, ultimately, on theboards of directors of each affiliate. These responsibilities are supported atthe holding company level by appropriate underwriting guidelines and ongoingloan review. In addition, Bankshares has set an internal limit for eachaffiliate bank that is well below the regulatory limit on the maximum amount ofcredit that may be extended to a single borrower.

 

For more information oncredit risk see “Risk Management – Credit Risk Analysis” in the MercantileBankshares Corporation’s 2005 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). Withrespect to nonaccrual loans, Bankshares’ policy is that, regardless of thevalue of the underlying collateral and/or guarantees, no interest is accrued onthe entire balance once either principal or interest payments on any loanbecome 90 days past due at the end of a calendar quarter. All accrued anduncollected interest on such loans is eliminated from the income statement andis recognized only as collected. If a loan is impaired and has a specific lossallocation based on an analysis under SFAS No. 114, “**Accountingby Creditors for Impairment of a Loan—an amendment of FASB Statements No. 5 and15,**” all payments are then applied against the loan’s principal.A loan may be placed on nonaccrual status sooner than this standard if, inmanagement’s judgment, such action is warranted.

 

During the three monthsended March 31, 2006, nonperforming assets increased slightly to $23.6 millionfrom $23.2 million at December 31, 2005. Nonperforming assets as a percent ofperiod-end loans and other real estate owned was 0.20% at March 31, 2006 and atDecember 31, 2005.

 

At March 31, 2006 andDecember 31, 2005, monitored loans, or loans with characteristics suggestingthat they could be classified as nonperforming in the near future, were $13.9 millionand $2.2 million, respectively. The increase in monitored loans relates to onerelationship at Mercantile-Safe Deposit and Trust that is well secured, but hashad consistently late payments.

 

31

----

 

The table below presentsa comparison of nonperforming assets at March 31, 2006, December 31, 2005 andMarch 31, 2005.

 
| ** **                                                                         | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|--------------------|------------|
| **(Dollars in thousands)**                                               | ** ** | **2006**           | ** ** | **2005**              | ** ** | **2005**           | ** ** |
| Nonaccrual loans (1)                                                               |       |               |       |                  |       |               |       |
| Commercial and  leasing                                                            | ** ** | **$**              | **15,748** | ** **            | $          | 15,771             |       | $ | 25,999 |   |
| Commercial real  estate                                                            | ** ** | **4,600**          | ** ** | 4,451                 |       | 2,775              |       |
| Construction                                                                       | ** ** | **414**            | ** ** | 376                   |       | 6                  |       |
| Residential real  estate                                                           | ** ** | **1,577**          | ** ** | 1,505                 |       | 1,642              |       |
| Home equity  lines                                                                 | ** ** | **148**            | ** ** | 88                    |       | 370                |       |
| Consumer                                                                           | ** ** | **403**            | ** ** | 374                   |       | 442                |       |
| Total                                                                              | ** ** | **22,890**         | ** ** | 22,565                |       | 31,234             |       |
| Renegotiated  loans (1)                                                            | ** ** | **—**         | ** ** | —                |       | —             |       |
| Loans contractually  past due 90 days or more and still accruing interest          | ** ** | **—**         | ** ** | —                |       | —             |       |
| Total  nonperforming loans                                                         | ** ** | **22,890**         | ** ** | 22,565                |       | 31,234             |       |
| Other real  estate owned                                                           | ** ** | **713**            | ** ** | 667                   |       | 145                |       |
| Total  nonperforming assets                                                        | ** ** | **$**              | **23,603** | ** **            | $          | 23,232             |       | $ | 31,379 |   |
| Nonperforming  loans as a percent of period-end loans                              | ** ** | **0.20**           | **%**      | 0.19                  | %          | 0.30               | %          |
| Nonperforming  assets as a percent of period-end loans and other real estate owned | ** ** | **0.20**           | **%**      | 0.20                  | %          | 0.30               | %          |

 

----

(1)          Aggregate gross interestincome of $0.5 million, $2.1 million and $0.7 million for the first threemonths of 2006, the year 2005 and the first three months of 2005, respectively,on nonaccrual and renegotiated loans, would have been recorded if these loanshad been accruing on their original terms throughout the period or sinceorigination if held for part of the period. The amount of interest income onthe nonaccrual and renegotiated loans that was recorded totaled $0.3 million, $0.5million and $0.2 million for the first three months of 2006, the year 2005 andthe first three months of 2005, respectively.

 

**Note:  **Bankshares was monitoringloans $13.9 million at March 31, 2006, and $2.2 million at each of December 31,2005 and March 31, 2005, not classified as nonaccrual or renegotiated loans. Theseloans had characteristics that indicated they might result in suchclassification in the future.

 

**Net Recoveries/Charge-offs**

 

Net recoveries for thethree months ended March 31, 2006 were $159 thousand compared to netcharge-offs of $503 thousand and $741 thousand for the three months endedDecember 31, 2005 and March 31, 2005, respectively. Net recoveries as a percentof period end loans of .01% in the three months ended March 31, 2006 showed a fourbasis points improvement from the same period last year.

 

**Provision for Credit Losses**

 

The provision for creditlosses to zero during the quarter as compared to $756 thousand for the threemonths ended March 31, 2005, reflecting improved loan quality and continuedfavorable economic conditions. No provision for credit losses was recorded forthe quarter ended December 31, 2005.

 

32

----

 

**Allowance for Loan Losses andReserve for Unfunded Commitments**

 

The allowance for loanlosses declined $14.8 million to $141.9 million at March 31, 2006, or 1.21% ofperiod-end loans, compared with $156.7 million, or 1.35% of period end loans,at year-end 2005 and $149.0 million, or 1.43% of period end loans, at March 31,2005. The decline from year-end 2005 was primarily related to the reclassificationof $14.0 million out of the reserve for loan losses to establish the reservefor unfunded commitments in other liabilities.

 

The reserve for unfundedcommitments increased $15.0 million from December 31, 2005 due to a reclassificationof $14.0 million from the allowance for loan losses at December 31, 2005 toestablish the reserve and a provision of $1.0 million related to increasedunfunded commitments during the first quarter of 2006. The reserve for unfundedcommitments is included in other liabilities in the consolidated balance sheet.

 

The following tablepresents a summary of the activity in the Allowance for Loan Losses and theReserve for Unfunded Commitments.

 
| ** **                                                               | ** ** | **For the 3 months ended March 31,** | ** **     |
|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------|----------------|
| **(Dollars in thousands)**                                     | ** ** | **2006**                                                           | ** **     | **2005** | ** ** |
| Allowance for  loan losses, beginning of period                          | ** ** | **$**                                                              | **156,673**    | ** ** | $ | 149,002 |   |
| Charge-offs:                                                             |       |                                                               | ** **     |   |   |
| Commercial and  leasing                                                  | ** ** | **(401**                                                           | **)**          | (1,299 | ) |
| Commercial real  estate                                                  | ** ** | **(209**                                                           | **)**          | (32 | ) |
| Construction                                                             | ** ** | **—**                                                         | ** **     | — |   |
| Residential real  estate                                                 | ** ** | **(2**                                                             | **)**          | (11 | ) |
| Home equity  lines                                                       | ** ** | **—**                                                         | ** **     | — |   |
| Consumer                                                                 | ** ** | **(766**                                                           | **)**          | (600 | ) |
| Total                                                                    | ** ** | **(1,378**                                                         | **)**          | (1,942 | ) |
| Recoveries:                                                              |       |                                                               | ** **     |   |   |
| Commercial and  leasing                                                  | ** ** | **908**                                                            | ** **     | 595 |   |
| Commercial real  estate                                                  | ** ** | **33**                                                             | ** **     | 6 |   |
| Construction                                                             | ** ** | **1**                                                              | ** **     | — |   |
| Residential real  estate                                                 | ** ** | **25**                                                             | ** **     | 35 |   |
| Home equity  lines                                                       | ** ** | **2**                                                              | ** **     | — |   |
| Consumer                                                                 | ** ** | **568**                                                            | ** **     | 565 |   |
| Total                                                                    | ** ** | **1,537**                                                          | ** **     | 1,201 |   |
| Net  (charge-offs) recoveries                                            | ** ** | **159**                                                            | ** **     | (741 | ) |
| Provision for  credit losses                                             | ** ** | **(990**                                                           | **)**          | 756 |   |
| Transfer to  reserve for unfunded commitments                            | ** ** | **(13,968**                                                        | **)**          | — |   |
| Allowance for  loan losses, end of period                                | ** ** | **$**                                                              | **141,874**    | ** ** | $ | 149,017 |   |
|                                                                     |       |                                                               | ** **     |   |   |
| Reserve for  unfunded lending commitments, beginning of period           | ** ** | **$**                                                              | **—**     | ** ** | $ | — |   |
| Provision for  credit losses                                             | ** ** | **990**                                                            | ** **     | — |   |
| Transfer from  allowance for loan losses                                 | ** ** | **13,968**                                                         | ** **     | — |   |
| Reserve for  unfunded lending commitments, end of period                 | ** ** | **$**                                                              | **14,958**     | ** ** | **$** | **—** | ** ** |
|                                                                     |       |                                                               | ** **     |   |   |
| Average loans                                                            | ** ** | **$**                                                              | **11,646,904** | ** ** | $ | 10,314,361 |   |
| Period-end loans                                                         | ** ** | **$**                                                              | **11,696,168** | ** ** | $ | 10,413,222 |   |
|                                                                     |       |                                                               | ** **     |   |   |
| **Allowance  for loan losses**                                           |       |                                                               | ** **     |   |   |
| Percent of net  charge-offs (recoveries), (annualized), to average loans | ** ** | **(0.01**                                                          | **)%**         | 0.03 | % |
| Percent of  allowance for loan losses to period-end loans                | ** ** | **1.21**                                                           | **%**          | (1.43 | )% |

 

33

----

** **

**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 2005 Annual Report on Form 10-K.

 

EARNINGS SIMULATION MODELPROJECTIONS

 

Bankshares assessesinterest rate risk by comparing projected net interest income in the currentrate environment with various interest rate scenarios that differ in thedirection of interest rate changes, the degree of change over time, the speedof the change and the projected shape of the yield curve. This analysisincorporates substantially all of Bankshares’ assets and liabilities andoff-balance sheet instruments. Through these simulations, management estimatesthe impact on net interest income of a 200 basis point upward and downwardchange in interest rates. The following table summarizes the effect that a +/-200 basis point change in interest rates would have on Bankshares’ net interestincome over the next 12 months.

 
| ** **                                  | ** ** | **Calculated increase / (decrease) in** | ** ** |
|---------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                  | ** ** | **projected net interest income**            | ** ** |
| **Change in interest rates** | ** ** | **As of March 31,**                          | ** ** |
| **(basis points)**                          | ** ** | **2006**                                                    | ** ** | **2005** | ** ** |
| +200                                        | ** ** | **2.44**                                                    | **%**      | 4.89 | % |
| +100                                        | ** ** | **1.29**                                                    | **%**      | 2.44 | % |
| -100                                        | ** ** | **-1.79**                                                   | **%**      | -1.48 | % |
| -200                                        | ** ** | **-4.46**                                                   | **%**      | N/A | % |

 

At March 31, 2006,Bankshares’ interest sensitivity position was slightly asset sensitive than itwas at March 31, 2005. Based on its most recent simulation model, Bankshares’net interest income would increase by $8.7 million, or 1.29%, and $16.3 million,or 2.44%, if interest rates were to move up gradually over the next six monthsby 100 basis points or 200 basis points, respectively. A downward movement of 100basis points would reduce net interest income by $12.0 million or 1.79%. Adownward movement of 200 basis points would reduce net interest income by $29.9million or 4.46%. Bankshares manages the interest rate risk profile withinpolicy limits. At March 31, 2006, and December 31, 2005 Bankshares was withinits policy guidelines. In response to action by the Federal Reserve to increaseshort-term interest rates, Bankshares’ prime interest rate continues to rise. AtMarch 31, 2006, Bankshares had approximately $4.6 billion in loans that willreprice daily or monthly as market rates change. The effects of a rising rateenvironment on interest expense are less predictable due to customer behaviorthat can result in changes in the mix of deposit products. Current trends have generatedgrowth in higher-rate premium money market and certificate of deposit accounts.Given the current rate environment, the flatness of the yield curve and competitivepressure on both loan and deposit pricing, we anticipate that the net interestmargin will remain under some pressure throughout the year.

 

Bankshares also utilizesinterest rate derivatives to hedge interest rate risk exposures. The creditrisk amount and estimated net fair values of these derivatives as of March 31,2006 and December 31, 2005 are presented in Note No. 12 "Derivative Instrumentsand Hedging Activities". Derivatives are used for asset/liabilitymanagement in three ways:

 

•                  Toconvert long-term fixed-rate debt to floating-rate payments by entering into receive-fixedswaps at issuance;

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

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

 

34

----

 

MARKET VALUE OF EQUITYMODELING

 

Bankshares also utilizesthe market value of equity as a measurement tool in managing interest ratesensitivity. The market value of equity measures the degree to which the marketvalues of Bankshares’ assets and liabilities and off-balance sheet instrumentswill change given a change in interest rates. ALCO guidelines limit the changein market value of equity in a 200 basis point parallel rate shock to 25% ofthe market value of equity assuming interest rates at March 31, 2006. The up200 basis point scenario resulted in a 2.9% decrease at March 31, 2006 and a 2.3%increase at December 31, 2005. The down 200 basis point scenario resulted in a 3.1%decrease at March 31, 2006 and a 4.6% decrease at December 31, 2005. At March31, 2006 and December 31, 2005, Bankshares was within its policy guidelines.

 

The valuation analysis isdependent upon certain key assumptions about the nature of indeterminate maturitiesof assets and liabilities. Management estimates the average life and ratecharacteristics of asset and liability accounts based on historical analysisand management’s expectation of rate behavior. These assumptions areperiodically validated and updated.

 

**Market Risk**

 

Market risk is defined asthe constraint imposed by lower market values of assets and liabilities asinterest rates and equity markets fluctuate. Changes in market values alsoaffect the fee income earned by IWM, where a significant portion of the feeschedule is tied to current asset values under management or administration. Bankshareshas designated substantially all of its investment portfolio asavailable-for-sale, and in accordance with financial reporting standards, thisportfolio is reported at fair value. Changes in fair value, net of tax, arereflected as a component of shareholders’ equity.

 

*Trading Activities*

 

Bankshares provides capitalmarket products to its customers. From a market risk perspective, Bankshares’net income is exposed to changes in interest rates, credit spreads, and equitiesand their implied volatilities. The primary purpose of Bankshares’ capitalmarkets business is to accommodate customers in the management of their marketprice risks. Derivative transactions executed with customers are simultaneouslyhedged in the capital markets. All derivatives transacted with customers usedto hedge capital market transactions with customers are carried at fair value. TheAsset/Liability Management Committee establishes and monitors counterparty risklimits. The notional amount, exposure amount and estimated net fair value ofall customer accommodation derivatives at March 31, 2006 are included in NoteNo. 12 "Derivative Instruments and Hedging Activities".

 

*Equity Markets*

 

Bankshares is directlyand indirectly affected by changes in the equity markets. Bankshares has madeinvestments in private equities. These investments are made within capitalallocations approved by management. Management reviews these investments atleast quarterly and assesses them for possible other-than-temporary impairment.Private equity investments totaled $20.9 million at March 31, 2006 and $18.4million at March 31, 2005.

 

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

 

**Liquidity Risk**

 

Liquidity risk is thepossibility that Bankshares will not be able to fund present and futurefinancial obligations. The objective of liquidity management is to maintain theability to meet commitments to fund loans, purchase securities and repaydeposits and other liabilities in accordance with their terms. To achieve thisobjective, the Asset/Liability Management Committee establishes and monitorsliquidity guidelines that require sufficient asset-based liquidity to coverpotential funding requirements and to avoid over-reliance on volatile, lessreliable funding markets. Debt securities in the available-for-sale portfolioprovide liquidity, in addition to the immediately liquid resources of cash anddue from banks and federal funds sold and securities purchased under resaleagreements. By limiting the maturity of securities and maintaining aconservative investment posture, management can rely on the investment portfolioto help meet any short-term funding needs. U.S. Treasury and agency securities,which provide the greatest liquidity, averaged $1.4 billion in each of thefirst quarter of 2006, fourth quarter of 2005 and first quarter of 2005.

 

Core customer deposits havehistorically provided a substantial source of relatively stable and low-costfunds. For the three months ended March 31, 2006, core deposits (total depositsless certificates of deposit of $100,000 and over), averaged $10.0 billioncompared with $10.1 billion for the fourth quarter of 2005 and $9.3 billion forthe first quarter of 2005. Although not viewed as core deposits, a substantialportion of short-term borrowings, comprised of securities sold under agreementsto repurchase and commercial paper, originate from core deposit relationshipstied to the overnight cash management program offered to customers. Long-termdebt and short-term borrowings funded the remaining assets.

 

35

----

 

In addition to these sources,Bankshares has access to national markets for certificates of deposit,commercial paper and debt financing. Should it need to further supplement itsliquidity, Bankshares has $2.1 billion in lines with the Federal Home Loan Bankof Atlanta (FHLB) and back-up commercial paper lines of $40 million withcommercial banks. Bankshares is required to obtain approval from holders ofBankshares’ 6.72% and 6.80% unsecured senior notes if it incrementally borrowsin excess of $150 million under these FHLB lines.

 

Liquidity is alsoavailable through Bankshares’ ability to raise funds in the capital markets. Banksharesaccesses capital markets for long-term funding by issuing registered debt andprivate placements. In September 2005, Moody’s Investors Service affirmedBankshares’ commercial paper rating of “P-1” and Bankshares’ subordinated debtrating of “A2.”  Also in September 2005,Standard & Poor’s Ratings Service affirmed Bankshares’ rating of “A+/Stable/A-1”,and counterparty rating of “A+/Stable/A-1.”  Rating agencies base their ratings on manyquantitative and qualitative factors, including capital adequacy, liquidity,asset quality, quality of the management team, business mix and level andquality of earnings.

 

For additionalinformation see “Risk Management – Liquidity Risk” in Mercantile BanksharesCorporation’s 2005 Annual Report on Form 10-K.

 

**Contractual Obligations andCommitments**

 

In the normal course ofbusiness, 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 financialservices provider, Bankshares routinely enters into commitments to extendcredit, including loan commitments, standby letters of credit and financialguarantees. For a discussion of these commitments, see Note No. 7 “Commitmentsand Contingencies” above. For a discussion of contractual commitments see “Off-BalanceSheet Arrangements and Contractual Obligations” in Mercantile BanksharesCorporation’s 2005 Annual Report on Form 10-K. Items disclosed in the AnnualReport on Form 10-K have not changed materially since the report was filed.

 

**Cautionary Statement**

 

This report containsfinancial information determined by methods other than in accordance withGenerally Accepted Accounting Principles (“GAAP”). Bankshares’ management usesthese non-GAAP measures in their analysis of the Company’s performance. Inparticular, net interest income, net interest margin and the cash operating efficiencyratio are calculated on a fully tax-equivalent basis (“FTE”). The FTE basis isdetermined by adjusting net interest income to reflect tax-exempt interestincome on a before-tax equivalent basis. These measures typically adjust GAAPperformance measures to exclude intangible assets and the amortization ofintangible assets related to the consummation of mergers. These operatingearnings measures may also exclude other significant gains, losses or expensesthat are not considered components of core earnings. Since these items andtheir impact on Bankshares’ performance are difficult to predict, managementbelieves presentations of financial measures excluding the impact of theseitems provide useful supplemental information that is essential to a properunderstanding of the operating results and financial position of Bankshares’core businesses. These disclosures should not be viewed as a substitute forresults determined in accordance with GAAP, nor are they necessarily comparableto operating earnings performance measures that may be presented by othercompanies.

 

This report containsforward-looking statements within the meaning of and pursuant to the safeharbor provisions of the Private Securities Litigation Reform Act of 1995. Aforward-looking statement encompasses any estimate, prediction, opinion orstatement of belief contained in this report and the underlying managementassumptions. Such statements in this report include:  identification of trends; loan growth;deposit retention; comments on adequacy of the allowance for loan losses;credit quality; in effects of asset sensitivity and interest rate changes; and informationconcerning market risk referenced in Item 3. Forward-looking statements arebased on current expectations and assessments of potential developmentsaffecting market conditions, interest rates and other economic conditions, andresults may ultimately vary from the statements made in this report. Inaddition, the following factors, among others, could cause actual results to differmaterially from the anticipated results or expectations expressed in theforward-looking statements: administrative and operational efficiencies may notimprove to the degree projected; and competitive pressures and regulatorycomplexities that affect our banks may be more severe than expected.

 

36

----

 

 **Supplemental Informationby Quarter**

 Select Financial Data

(Dollars in thousands, except per share data)

 
| ** **                                                                            | ** ** | **1Q 06** | ** **     | **4Q 05** | ** ** | **3Q 05** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|----------------|----------------|------------|----------------|------------|
| **OPERATING  RESULTS**                                                                |       |           |           |           |       |           |       |
| Net interest  income (1)                                                              | ** ** | **$**          | **158,313**    | ** **     | $          | 162,434        |       | $ | 159,242 |   |
| Net interest  income - taxable equivalent (1)                                         | ** ** | **160,146**    | ** **     | 164,267        |       | 161,023        |       |
| Provision for  credit losses                                                          | ** ** | **—**     | ** **     | —         |       | 820            |       |
| Net income                                                                            | ** ** | **70,759**     | ** **     | 74,863         |       | 70,956         |       |
| **PER  COMMON SHARE DATA***                                                           |       |           | ** **     |           |       |           |       |
| Basic net income                                                                      | ** ** | **$**          | **0.58**       | ** **     | $          | 0.61           |       | $ | 0.58 |   |
| Diluted net  income                                                                   | ** ** | **0.57**       | ** **     | 0.60           |       | 0.57           |       |
| Dividends paid                                                                        | ** ** | **0.26**       | ** **     | 0.25           |       | 0.25           |       |
| Book value at  period end                                                             | ** ** | **18.05**      | ** **     | 17.81          |       | 17.47          |       |
| Market value at  period end                                                           | ** ** | **38.45**      | ** **     | 37.63          |       | 35.92          |       |
| Market range:                                                                         |       |           | ** **     |           |       |           |       |
| High                                                                                  | ** ** | **39.82**      | ** **     | 40.09          |       | 37.46          |       |
| Low                                                                                   | ** ** | **36.88**      | ** **     | 34.11          |       | 34.13          |       |
|                                                                                  | ** ** | ** **     | ** **     |           |       |           |       |
| **AVERAGE  BALANCE SHEET DATA**                                                       |       |           | ** **     |           |       |           |       |
| Total loans                                                                           | ** ** | **$**          | **11,646,904** | ** **     | $          | 11,497,885     |       | $ | 11,389,731 |   |
| Total earning  assets                                                                 | ** ** | **14,880,775** | ** **     | 14,698,731     |       | 14,490,736     |       |
| Total assets                                                                          | ** ** | **16,435,964** | ** **     | 16,258,275     |       | 16,065,168     |       |
| Total deposits                                                                        | ** ** | **11,940,956** | ** **     | 11,894,394     |       | 11,751,990     |       |
| Shareholders’  equity                                                            | ** ** | **2,261,646**  | ** **     | 2,210,050      |       | 2,179,415      |       |
|                                                                                  | ** ** | ** **     | ** **     |           |       |           |       |
| **STATISTICS  AND RATIOS (Net income annualized)**                                    |       |           | ** **     |           |       |           |       |
| Return on  average assets                                                             | ** ** | **1.75**       | **%**          | 1.83           | %          | 1.75           | %          |
| Return on  average equity (2)                                                         | ** ** | **12.69**      | ** **     | 13.44          |       | 12.92          |       |
| Return on  average tangible equity (2)                                                | ** ** | **18.97**      | ** **     | 20.26          |       | 19.62          |       |
| Average equity  to average assets (2)                                                 | ** ** | **13.76**      | ** **     | 13.59          |       | 13.57          |       |
| Average tangible  equity to average tangible assets (2)                               | ** ** | **9.81**       | ** **     | 9.61           |       | 9.53           |       |
| Net interest  rate spread - taxable equivalent                                        | ** ** | **3.64**       | ** **     | 3.78           |       | 3.83           |       |
| Net interest  margin on earning assets - taxable equivalent                           | ** ** | **4.36**       | ** **     | 4.43           |       | 4.41           |       |
| Efficiency ratio  (1),(3)                                                             | ** ** | **48.34**      | ** **     | 47.87          |       | 48.36          |       |
| Cash operating  efficiency ratio (1),(3)                                              | ** ** | **47.30**      | ** **     | 46.69          |       | 46.99          |       |
| Dividend payout  ratio*                                                               | ** ** | **44.83**      | ** **     | 40.98          |       | 43.10          |       |
|                                                                                  | ** ** | ** **     | ** **     |           |       |           |       |
| Bank offices                                                                          | ** ** | **238**        | ** **     | 240            |       | 238            |       |
| Employees                                                                             | ** ** | **3,658**      | ** **     | 3,606          |       | 3,607          |       |
|                                                                                  | ** ** | ** **     | ** **     |           |       |           |       |
| **CREDIT  QUALITY DATA AT PERIOD END**                                                |       |           | ** **     |           |       |           |       |
| Net charge-offs  / (recoveries)                                                       | ** ** | **$**          | **(159**       | **)**          | $          | 503            |       | $ | 745 |   |
| Nonaccrual loans                                                                      | ** ** | **22,890**     | ** **     | 22,565         |       | 27,022         |       |
| Restructured  loans                                                                   | ** ** | **—**     | ** **     | —         |       | —         |       |
| Total  nonperforming loans                                                            | ** ** | **22,890**     | ** **     | 22,565         |       | 27,022         |       |
| Other real  estate owned, net                                                         | ** ** | **713**        | ** **     | 667            |       | 777            |       |
| Total  nonperforming assets                                                           | ** ** | **23,603**     | ** **     | 23,232         |       | 27,799         |       |
|                                                                                  | ** ** | ** **     | ** **     |           |       |           |       |
| **CREDIT  QUALITY RATIOS**                                                            |       |           | ** **     |           |       |           |       |
| Net charge-offs  / (recoveries) – annualized - as a percent of period-end loans  | ** ** | **(0.01**      | **)**          | 0.02           |       | 0.03           |       |
| Nonperforming  loans as a percent of period-end loans                                 | ** ** | **0.20**       | ** **     | 0.19           |       | 0.24           |       |
| Allowance for  loan losses as a percent of period-end loans**                         | ** ** | **1.21**       | ** **     | 1.35           |       | 1.37           |       |
| Allowance for  loan losses as a percent of nonperforming loans                        | ** ** | **619.81**     | ** **     | 694.32         |       | 581.66         |       |
| Other real  estate owned as a percent of period-end loans and other real estate owned | ** ** | **0.01**       | ** **     | 0.01           |       | 0.01           |       |
| Nonperforming  assets as a percent of period-end loans and other real estate owned    | ** ** | **0.20**       | ** **     | 0.20           |       | 0.24           |       |
| Nonperforming  assets as a percent of total assets                                    | ** ** | **0.14**       | ** **     | 0.14           |       | 0.17           |       |

 

37

----

 
| ** **                                                                            | ** ** | ** **     | ** ** | ** **     | ** ** | **1Q 06 ** | ** ** | **1Q 06** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------|------------|----------------|------------|----------------------|------------|----------------|------------|
| ** **                                                                            | ** ** | ** **     | ** ** | ** **     | ** ** | **vs **         | ** ** | **vs**         | ** ** |
| ** **                                                                            | ** ** | **2Q 05** | ** ** | **1Q 05** | ** ** | **4Q 05**       | ** ** | **1Q 05** | ** ** |
| **OPERATING  RESULTS**                                                                |       |           |       |           |       |                 |       |           |       |
| Net interest  income (1)                                                              |       | $              | 152,367    |           | $          | 143,083              |       | (2.5           | )%         | 10.6 | % |
| Net interest  income - taxable equivalent (1)                                         |       | 154,023        |       | 144,660        |       | (2.5                 | )          | 10.7           |       |
| Provision for  credit losses                                                          |       | —         |       | 756            |       | —               |       | (100.0         | )          |
| Net income                                                                            |       | 67,873         |       | 62,627         |       | (5.5                 | )          | 13.0           |       |
| **PER  COMMON SHARE DATA***                                                           |       |           |       |           |       |                 |       |           |       |
| Basic net income                                                                      |       | $              | 0.56       |           | $          | 0.53                 |       | (4.9           | )%         | 9.4 | % |
| Diluted net  income                                                                   |       | 0.56           |       | 0.52           |       | (5.0                 | )          | 9.6            |       |
| Dividends paid                                                                        |       | 0.25           |       | 0.23           |       | 4.0                  |       | 13.0           |       |
| Book value at  period end                                                             |       | 17.25          |       | 16.26          |       | 1.3                  |       | 11.0           |       |
| Market value at  period end                                                           |       | 34.35          |       | 33.91          |       | 2.2                  |       | 13.4           |       |
| Market range:                                                                         |       |           |       |           |       |                 |       |           |       |
| High                                                                                  |       | 35.20          |       | 34.90          |       | (0.7                 | )          | 14.1           |       |
| Low                                                                                   |       | 32.39          |       | 32.27          |       | 8.1                  |       | 14.3           |       |
| **AVERAGE  BALANCE SHEET DATA**                                                       |       |           |       |           |       |                 |       |           |       |
| Total loans                                                                           |       | $              | 10,899,263 |           | $          | 10,314,361           |       | 1.3            | %          | 12.9 | % |
| Total earning  assets                                                                 |       | 13,840,991     |       | 13,221,167     |       | 1.2                  |       | 12.6           |       |
| Total assets                                                                          |       | 15,233,571     |       | 14,508,344     |       | 1.1                  |       | 13.3           |       |
| Total deposits                                                                        |       | 11,273,220     |       | 10,718,734     |       | 0.4                  |       | 11.4           |       |
| Shareholders’  equity                                                            |       | 2,042,104      |       | 1,950,276      |       | 2.3                  |       | 16.0           |       |
| **STATISTICS  AND RATIOS (Net income annualized)**                                    | ** ** | ** **     | ** ** | ** **     | ** ** | ** **           | ** ** | ** **     | ** ** |
| Return on  average assets                                                             |       | 1.79           | %          | 1.75           | %          |                 |       |           |       |
| Return on  average equity (2)                                                         |       | 13.33          |       | 13.02          |       |                 |       |           |       |
| Return on  average tangible equity (2)                                                |       | 19.64          |       | 18.57          |       |                 |       |           |       |
| Average equity  to average assets (2)                                                 |       | 13.41          |       | 13.44          |       |                 |       |           |       |
| Average tangible  equity to average tangible assets (2)                               |       | 9.67           |       | 10.00          |       |                 |       |           |       |
| Net interest  rate spread - taxable equivalent                                        |       | 3.95           |       | 3.99           |       |                 |       |           |       |
| Net interest  margin on earning assets - taxable equivalent                           |       | 4.46           |       | 4.44           |       |                 |       |           |       |
| Efficiency ratio  (1),(3)                                                             |       | 48.54          |       | 49.45          |       |                 |       |           |       |
| Cash operating  efficiency ratio (1),(3)                                              |       | 48.26          |       | 48.68          |       |                 |       |           |       |
| Dividend payout  ratio*                                                               |       | 44.64          |       | 43.40          |       |                 |       |           |       |
| Bank offices                                                                          |       | 239            |       | 225            |       | (2                   | )          | 13             |       |
| Employees                                                                             |       | 3,630          |       | 3,423          |       | 52                   |       | 235            |       |
| **CREDIT  QUALITY DATA AT PERIOD END**                                                |       |           |       |           |       |                 |       |           |       |
| Net charge-offs  / (recoveries)                                                       |       | $              | (998       | )              | $          | 741                  |       | (131.6         | )%         | (121.5 | ) |
| Nonaccrual loans                                                                      |       | 26,909         |       | 31,234         |       | 1.4                  |       | (26.7          | )          |
| Restructured  loans                                                                   |       | —         |       | —         |       | —               |       | —         |       |
| Total  nonperforming loans                                                            |       | 26,909         |       | 31,234         |       | 1.4                  |       | (26.7          | )          |
| Other real estate  owned, net                                                         |       | 777            |       | 145            |       | 6.9                  |       | 391.7          |       |
| Total  nonperforming assets                                                           |       | 27,686         |       | 31,379         |       | 1.6                  |       | (24.8          | )          |
| **CREDIT  QUALITY RATIOS**                                                            |       |           |       |           |       |                 |       |           |       |
| Net charge-offs  /(recoveries) — annualized - as a percent of period-end loans   |       | (0.04          | )          | 0.03           |       |                 |       |           |       |
| Nonperforming  loans as a percent of period-end loans                                 |       | 0.24           |       | 0.30           |       |                 |       |           |       |
| Allowance for  loan losses as a percent of period-end loans**                         |       | 1.38           |       | 1.43           |       |                 |       |           |       |
| Allowance for  loan losses as a percent of nonperforming loans                        |       | 583.82         |       | 477.10         |       |                 |       |           |       |
| Other real  estate owned as a percent of period-end loans and other real estate owned |       | 0.01           |       | —         |       |                 |       |           |       |
| Nonperforming  assets as a percent of period-end loans and other real estate owned    |       | 0.24           |       | 0.30           |       |                 |       |           |       |
| Nonperforming  assets as a percent of total assets                                    |       | 0.17           |       | 0.21           |       |                 |       |           |       |

 

----

*In January 2006, Bankshares announced a three-for-twostock split on its common stock. Per share amounts and other applicableinformation have been adjusted to give effect to the split.

 

**The decline in the allowance for loan losses was due primarily to thereclassification of $14.0 million out of the allowance for loan losses to a separatereserve for unfunded commitments, which is recorded in other liabilities in theconsolidated balance sheet.

 

(1),(2), (3) See “Reconciliation of Non-GAAP Measures”

 

38

----

 

**Statements of Consolidated Income**

(Dollars in thousands, except per share data)

 
| ** **                                               | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **1Q 06** | ** ** | **1Q 06** | ** ** |
|----------------------------------------------------------|------------|----------------|-------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                                               | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **vs**         | ** ** | **vs**         | ** ** |
| ** **                                               | ** ** | **1Q 06** | ** **  | **4Q 05** | ** ** | **3Q 05** | ** ** | **2Q 05** | ** ** | **1Q 05** | ** ** | **4Q 05** | ** ** | **1Q 05** | ** ** |
| **INTEREST  INCOME**                                     |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| Interest and fees  on loans                              | ** ** | **$**          | **196,055** | ** **     | $          | 192,697        |       | $              | 185,714    |           | $          | 169,877        |       | $              | 152,544    |   | 1.7 | % | 28.5 | % |
| Interest and  dividends on investment securities:        |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| Taxable interest  income                                 | ** ** | **29,795**     | ** **  | 30,081         |       | 26,686         |       | 25,374         |       | 24,992         |       | (1.0           | )          | 19.2           |       |
| Tax-exempt  interest income                              | ** ** | **778**        | ** **  | 813            |       | 839            |       | 788            |       | 721            |       | (4.3           | )          | 7.9            |       |
| Other investment  income                                 | ** ** | **627**        | ** **  | 722            |       | 526            |       | 583            |       | 644            |       | (13.2          | )          | (2.6           | )          |
| ** **                                               |       | **31,200**     | ** **  | 31,616         |       | 28,051         |       | 26,745         |       | 26,357         |       | (1.3           | )          | 18.4           |       |
| Other interest  income                                   | ** ** | **658**        | ** **  | 890            |       | 760            |       | 442            |       | 344            |       | (26.1          | )          | 91.3           |       |
| Total interest  income                                   | ** ** | **227,913**    | ** **  | 225,203        |       | 214,525        |       | 197,064        |       | 179,245        |       | 1.2            |       | 27.2           |       |
|                                                     |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| **INTEREST  EXPENSE**                                    |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| Interest on  deposits                                    | ** ** | **49,243**     | ** **  | 44,637         |       | 38,591         |       | 31,384         |       | 25,305         |       | 10.3           |       | 94.6           |       |
| Interest on  short-term borrowings                       | ** ** | **11,023**     | ** **  | 9,038          |       | 7,702          |       | 5,484          |       | 4,042          |       | 22.0           |       | 172.7          |       |
| Interest on  long-term debt                              | ** ** | **9,334**      | ** **  | 9,094          |       | 8,990          |       | 7,829          |       | 6,815          |       | 2.6            |       | 37.0           |       |
| Total interest  expense                                  | ** ** | **69,600**     | ** **  | 62,769         |       | 55,283         |       | 44,697         |       | 36,162         |       | 10.9           |       | 92.5           |       |
|                                                     |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| **NET  INTEREST INCOME**                                 | ** ** | **158,313**    | ** **  | 162,434        |       | 159,242        |       | 152,367        |       | 143,083        |       | (2.5           | )          | 10.6           |       |
| Provision for  credit losses                             | ** ** | **—**     | ** **  | —         |       | 820            |       | —         |       | 756            |       | —         |       | (100.0         | )          |
|                                                     |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| **NET  INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES** | ** ** | **158,313**    | ** **  | 162,434        |       | 158,422        |       | 152,367        |       | 142,327        |       | (2.5           | )          | 11.2           |       |
|                                                     |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| **NONINTEREST  INCOME**                                  |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| Investment and  wealth management                        | ** ** | **26,121**     | ** **  | 24,251         |       | 23,668         |       | 23,780         |       | 24,057         |       | 7.7            |       | 8.6            |       |
| Service charges  on deposit accounts                     | ** ** | **10,292**     | ** **  | 10,893         |       | 11,478         |       | 11,088         |       | 10,426         |       | (5.5           | )          | (1.3           | )          |
| Mortgage  banking-related fees                           | ** ** | **2,210**      | ** **  | 4,690          |       | 5,151          |       | 2,895          |       | 2,283          |       | (52.9          | )          | (3.2           | )          |
| Investment  securities gains and (losses)                | ** ** | **(13**        | **)**       | (53            | )          | (32            | )          | 76             |       | 414            |       | 75.5           |       | (103.1         | )          |
| Nonmarketable  investments                               | ** ** | **6,269**      | ** **  | 6,199          |       | 4,190          |       | 4,222          |       | 5,271          |       | 1.1            |       | 18.9           |       |
| Other income                                             | ** ** | **15,727**     | ** **  | 16,131         |       | 18,619         |       | 18,005         |       | 15,418         |       | (2.5           | )          | 2.0            |       |
| Total noninterest  income                                | ** ** | **60,606**     | ** **  | 62,111         |       | 63,074         |       | 60,066         |       | 57,869         |       | (2.4           | )          | 4.7            |       |
|                                                     |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| **NONINTEREST  EXPENSES**                                |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| Salaries                                                 | ** ** | **49,099**     | ** **  | 51,740         |       | 51,748         |       | 50,180         |       | 46,554         |       | (5.1           | )          | 5.5            |       |
| Employee benefits                                        | ** ** | **14,735**     | ** **  | 10,685         |       | 11,637         |       | 11,956         |       | 11,897         |       | 37.9           |       | 23.9           |       |
| Net occupancy  expense of bank premises                  | ** ** | **7,771**      | ** **  | 7,678          |       | 7,139          |       | 6,857          |       | 6,922          |       | 1.2            |       | 12.3           |       |
| Furniture and  equipment expenses                        | ** ** | **8,305**      | ** **  | 8,491          |       | 7,965          |       | 7,924          |       | 7,279          |       | (2.2           | )          | 14.1           |       |
| Communications  and supplies                             | ** ** | **3,818**      | ** **  | 4,414          |       | 3,933          |       | 4,019          |       | 4,040          |       | (13.5          | )          | (5.5           | )          |
| Other expenses                                           | ** ** | **22,987**     | ** **  | 25,365         |       | 25,960         |       | 22,977         |       | 23,461         |       | (9.4           | )          | (2.0           | )          |
| Total noninterest  expenses                              | ** ** | **106,715**    | ** **  | 108,373        |       | 108,382        |       | 103,913        |       | 100,153        |       | (1.5           | )          | 6.6            |       |
|                                                     |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| Income before  income taxes                              | ** ** | **112,204**    | ** **  | 116,172        |       | 113,114        |       | 108,520        |       | 100,043        |       | (3.4           | )          | 12.2           |       |
| Applicable income  taxes                                 | ** ** | **41,445**     | ** **  | 41,309         |       | 42,158         |       | 40,647         |       | 37,416         |       | 0.3            |       | 10.8           |       |
|                                                     |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| **NET  INCOME**                                          | ** ** | **$**          | **70,759**  | ** **     | $          | 74,863         |       | $              | 70,956     |           | $          | 67,873         |       | $              | 62,627     |   | (5.5 | ) | 13.0 |   |
|                                                     |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| Weighted average  shares outstanding*                    | ** ** | **123,043**    | ** **  | 122,923        |       | 122,797        |       | 120,772        |       | 118,842        |       | 0.1            |       | 3.5            |       |
| Adjusted weighted  average shares outstanding*           | ** ** | **124,294**    | ** **  | 124,134        |       | 123,953        |       | 121,741        |       | 119,813        |       | 0.1            |       | 3.7            |       |
|                                                     |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| **NET  INCOME PER COMMON SHARE:***                       |       |           | ** **  |           |       |           |       |           |       |           |       |           |       |           |       |
| Basic                                                    | ** ** | **$**          | **0.58**    | ** **     | $          | 0.61           |       | $              | 0.58       |           | $          | 0.56           |       | $              | 0.53       |   | (4.9 | ) | 9.4 |   |
| Diluted                                                  | ** ** | **$**          | **0.57**    | ** **     | $          | 0.60           |       | $              | 0.57       |           | $          | 0.56           |       | $              | 0.52       |   | (5.0 | ) | 9.6 |   |

 

----

*In January 2006, Bankshares announced a three-for-two stock split on its commonstock. Average share and per share amounts have been adjusted to give effect tothe split.

 

39

----

 

**Statements of ConsolidatedNoninterest Income and Noninterest Expenses**

(Dollars in thousands)

 
| ** **                                | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **1Q 06** | ** ** | **1Q 06** | ** ** |
|-------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                                | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **vs**         | ** ** | **vs**         | ** ** |
| **Noninterest Income**               | ** ** | **1Q 06** | ** ** | **4Q 05** | ** ** | **3Q 05** | ** ** | **2Q 05** | ** ** | **1Q 05** | ** ** | **4Q 05** | ** ** | **1Q 05** | ** ** |
| Investment and  wealth management         | ** ** | **$**          | **26,121** | ** **     | $          | 24,251         |       | $              | 23,668     |           | $          | 23,780         |       | $              | 24,057     |   | 7.7 | % | 8.6 | % |
| Service charges  on deposit accounts      | ** ** | **10,292**     | ** ** | 10,893         |       | 11,478         |       | 11,088         |       | 10,426         |       | (5.5           | )          | (1.3           | )          |
| Mortgage  banking-related fees:           |       |           | ** ** |           |       |           |       |           |       |           |       |           |       |           |       |
| Commercial                                | ** ** | **1,879**      | ** ** | 4,000          |       | 4,086          |       | 2,092          |       | 1,837          |       | (53.0          | )          | 2.3            |       |
| Residential                               | ** ** | **331**        | ** ** | 690            |       | 1,065          |       | 803            |       | 446            |       | (52.0          | )          | (25.8          | )          |
| Total mortgage  banking-related fees      | ** ** | **2,210**      | ** ** | 4,690          |       | 5,151          |       | 2,895          |       | 2,283          |       | (52.9          | )          | (3.2           | )          |
| Investment  securities gains and (losses) | ** ** | **(13**        | **)**      | (53            | )          | (32            | )          | 76             |       | 414            |       | 75.5           |       | (103.1         | )          |
| Nonmarketable  investments:               |       |           | ** ** |           |       |           |       |           |       |           |       |           |       |           |       |
| Private equity  and other investments     | ** ** | **1,324**      | ** ** | 3,310          |       | 39             |       | 4,569          |       | 2,461          |       | (60.0          | )          | (46.2          | )          |
| Hedge funds                               | ** ** | **3,395**      | ** ** | 1,104          |       | 2,897          |       | (1,245         | )          | 1,964          |       | 207.5          |       | 72.9           |       |
| Bank-owned life  insurance                | ** ** | **1,550**      | ** ** | 1,785          |       | 1,254          |       | 898            |       | 846            |       | (13.2          | )          | 83.2           |       |
| Total  nonmarketable investments          | ** ** | **6,269**      | ** ** | 6,199          |       | 4,190          |       | 4,222          |       | 5,271          |       | 1.1            |       | 18.9           |       |
| Other income:                             |       |           | ** ** |           |       |           |       |           |       |           |       |           |       |           |       |
| Electronic banking  fees                  | ** ** | **5,636**      | ** ** | 5,832          |       | 7,010          |       | 5,954          |       | 5,173          |       | (3.4           | )          | 9.0            |       |
| Charges and fees  on loans                | ** ** | **2,765**      | ** ** | 3,063          |       | 3,786          |       | 3,020          |       | 2,795          |       | (9.7           | )          | (1.1           | )          |
| Insurance                                 | ** ** | **5,101**      | ** ** | 3,439          |       | 3,480          |       | 3,558          |       | 4,540          |       | 48.3           |       | 12.4           |       |
| All other income                          | ** ** | **2,225**      | ** ** | 3,797          |       | 4,343          |       | 5,473          |       | 2,910          |       | (41.4          | )          | (23.5          | )          |
| Total other  income                       | ** ** | **15,727**     | ** ** | 16,131         |       | 18,619         |       | 18,005         |       | 15,418         |       | (2.5           | )          | 2.0            |       |
| Total                                     | ** ** | **$**          | **60,606** | ** **     | $          | 62,111         |       | $              | 63,074     |           | $          | 60,066         |       | $              | 57,869     |   | (2.4 | ) | 4.7 |   |

 
| ** **                              | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **1Q 06** | ** ** | **1Q 06** | ** ** |
|-----------------------------------------|------------|----------------|-------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                              | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | **vs**         | ** ** | **vs**         | ** ** |
| **Noninterest Expenses**           | ** ** | **1Q 06** | ** **  | **4Q 05** | ** ** | **3Q 05** | ** ** | **2Q 05** | ** ** | **1Q 05** | ** ** | **4Q 05** | ** ** | **1Q 05** | ** ** |
| Salaries                                | ** ** | **$**          | **49,099**  |           | $          | 51,740         |       | $              | 51,748     |           | $          | 50,180         |       | $              | 46,554     |   | (5.1 | )% | 5.5 | % |
| Employee  benefits                      | ** ** | **14,735**     |        | 10,685         |       | 11,637         |       | 11,956         |       | 11,897         |       | 37.9           |       | 23.9           |       |
| Net occupancy  expense of bank premises | ** ** | **7,771**      |        | 7,678          |       | 7,139          |       | 6,857          |       | 6,922          |       | 1.2            |       | 12.3           |       |
| Furniture and  equipment expenses       | ** ** | **8,305**      |        | 8,491          |       | 7,965          |       | 7,924          |       | 7,279          |       | (2.2           | )          | 14.1           |       |
| Communications  and supplies            | ** ** | **3,818**      |        | 4,414          |       | 3,933          |       | 4,019          |       | 4,040          |       | (13.5          | )          | (5.5           | )          |
| Other expenses:                         |       |           |        |           |       |           |       |           |       |           |       |           |       |           |       |
| Professional  services                  | ** ** | **5,170**      |        | 5,867          |       | 6,040          |       | 4,882          |       | 5,125          |       | (11.9          | )          | 0.9            |       |
| Advertising and  promotional expenses   | ** ** | **1,498**      |        | 2,553          |       | 2,162          |       | 2,677          |       | 1,711          |       | (41.3          | )          | (12.4          | )          |
| Electronic  banking expenses            | ** ** | **3,127**      |        | 3,503          |       | 4,025          |       | 3,177          |       | 3,241          |       | (10.7          | )          | (3.5           | )          |
| Amortization of  intangible assets      | ** ** | **2,325**      |        | 2,291          |       | 2,231          |       | 2,179          |       | 2,072          |       | 1.5            |       | 12.2           |       |
| Outsourcing  expenses                   | ** ** | **2,823**      |        | 3,065          |       | 3,093          |       | 2,383          |       | 2,690          |       | (7.9           | )          | 4.9            |       |
| All other  expenses                     | ** ** | **8,044**      |        | 8,086          |       | 8,409          |       | 7,679          |       | 8,622          |       | (0.5           | )          | (6.7           | )          |
| Total other  expenses                   | ** ** | **22,987**     |        | 25,365         |       | 25,960         |       | 22,977         |       | 23,461         |       | (9.4           | )          | (2.0           | )          |
| Total                                   | ** ** | **$**          | **106,715** |           | $          | 108,373        |       | $              | 108,382    |           | $          | 103,913        |       | $              | 100,153    |   | (1.5 | ) | 6.6 |   |

 

40

----

 

**Consolidated Average BalanceSheets**

*(Dollars in thousands)*

 
| ** **                                         | ** ** | **1Q 06** | ** **     | **4Q 05**  | ** ** | **3Q 05** | ** ** |
|----------------------------------------------------|------------|----------------|----------------|-----------------|------------|----------------|------------|
| ** **                                         | ** ** | **Average**    | ** **     | **Yield(1)**    | ** ** | **Average**    | ** ** | **Yield(1)** | ** ** | **Average** | ** ** | **Yield(1)** | ** ** |
| ** **                                         | ** ** | **Balance**    | ** **     | **/ Rate** | ** ** | **Balance**    | ** ** | **/ Rate** | ** ** | **Balance** | ** ** | **/ Rate** | ** ** |
| **Earning assets Loans:**                     | ** ** | ** **     | ** **     | ** **      | ** ** |           |       |   |   |   |   |   |   |   |   |   |
| Commercial and  leasing                            | ** ** | **$**          | **2,933,214**  | ** **      | **7.06**   | %              | $          | 2,912,089 |   | 6.86 | % | $ | 2,914,761 |   | 6.62 | % |
| Commercial real  estate                            | ** ** | **3,673,385**  | ** **     | **6.89**        |       | 3,664,491      |       | 6.79 |   | 3,610,170 |   | 6.65 |   |
| Construction                                       | ** ** | **1,681,253**  | ** **     | **7.86**        |       | 1,574,597      |       | 7.56 |   | 1,544,082 |   | 7.21 |   |
| Residential real  estate                           | ** ** | **1,831,603**  | ** **     | **6.16**        |       | 1,798,686      |       | 6.05 |   | 1,775,023 |   | 5.98 |   |
| Home equity lines                                  | ** ** | **496,526**    | ** **     | **7.25**        |       | 511,673        |       | 6.73 |   | 517,798 |   | 6.23 |   |
| Consumer                                           | ** ** | **1,030,923**  | ** **     | **5.73**        |       | 1,036,349      |       | 5.68 |   | 1,027,897 |   | 5.71 |   |
| Total loans                                        | ** ** | **11,646,904** | ** **     | **6.87**        |       | 11,497,885     |       | 6.69 |   | 11,389,731 |   | 6.51 |   |
|                                               |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Federal funds  sold, et al                         | ** ** | **57,318**     | ** **     | **4.65**        |       | 76,062         |       | 4.64 |   | 57,932 |   | 5.20 |   |
|                                               |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Securities: (2)                                    |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Taxable  securities                                |       |           |           |            |       |           |       |   |   |   |   |   |   |
| U.S. Treasury and  government agencies             | ** ** | **1,440,180**  | ** **     | **3.64**        |       | 1,429,583      |       | 3.41 |   | 1,431,397 |   | 3.35 |   |
| Mortgage-backed                                    | ** ** | **1,589,017**  | ** **     | **4.30**        |       | 1,545,324      |       | 4.56 |   | 1,455,475 |   | 3.98 |   |
| Other investments                                  | ** ** | **63,199**     | ** **     | **4.06**        |       | 60,998         |       | 4.77 |   | 62,318 |   | 3.35 |   |
| Tax-exempt  securities                             |       |           |           |            |       |           |       |   |   |   |   |   |   |
| States and  political subdivisions                 | ** ** | **83,957**     | ** **     | **6.22**        |       | 88,679         |       | 6.01 |   | 93,683 |   | 5.89 |   |
| Total securities                                   | ** ** | **3,176,353**  | ** **     | **4.05**        |       | 3,124,584      |       | 4.08 |   | 3,042,873 |   | 3.73 |   |
|                                               |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Interest-bearing  deposits in other banks          | ** ** | **200**        | ** **     | **1.36**        |       | 200            |       | 1.35 |   | 200 |   | 1.02 |   |
| Total earning  assets                              | ** ** | **14,880,775** | ** **     | **6.26**        |       | 14,698,731     |       | 6.13 |   | 14,490,736 |   | 5.92 |   |
|                                               |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Cash and due from  banks                           | ** ** | **301,305**    | ** **     | ** **      |       | 319,176        |       |   |   | 326,515 |   |   |   |
| Bank premises and  equipment, net                  | ** ** | **138,237**    |           |            |       | 139,662        |       |   |   | 147,248 |   |   |   |
| Other assets                                       | ** ** | **1,272,673**  | ** **     | ** **      |       | 1,258,868      |       |   |   | 1,257,846 |   |   |   |
| Less: allowance  for loan losses                   | ** ** | **(157,026**   | )              |            |       | (158,162       | )          |   |   | (157,177 | ) |   |   |
| Total assets                                       | ** ** | **$**          | **16,435,964** | ** **      | ** ** |           | $          | 16,258,275 |   |   |   | $ | 16,065,168 |   |   |   |
|                                               |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Interest-bearing liabilities                       |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Deposits:                                          |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Savings                                            | ** ** | **$**          | **1,321,364**  | ** **      | **0.45**   |           | $          | 1,371,020 |   | 0.45 |   | $ | 1,420,283 |   | 0.42 |   |
| Checking plus  interest                            | ** ** | **1,341,714**  | ** **     | **0.19**        |       | 1,398,809      |       | 0.18 |   | 1,428,344 |   | 0.17 |   |
| Money market                                       | ** ** | **1,848,724**  | ** **     | **2.18**        |       | 1,785,001      |       | 1.86 |   | 1,692,684 |   | 1.54 |   |
| Time deposits  $100,000 and over                   | ** ** | **1,904,098**  | ** **     | **4.00**        |       | 1,784,340      |       | 3.66 |   | 1,674,265 |   | 3.30 |   |
| Other time  deposits                               | ** ** | **2,318,985**  | ** **     | **3.23**        |       | 2,300,075      |       | 3.03 |   | 2,295,608 |   | 2.76 |   |
| Total  interest-bearing deposits                   | ** ** | **8,734,885**  | ** **     | **2.29**        |       | 8,639,245      |       | 2.05 |   | 8,511,184 |   | 1.80 |   |
|                                               |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Short-term  borrowings                             | ** ** | **1,320,595**  | ** **     | **3.39**        |       | 1,213,396      |       | 2.96 |   | 1,185,142 |   | 2.58 |   |
| Long-term debt                                     | ** ** | **730,236**    | ** **     | **5.18**        |       | 766,451        |       | 4.71 |   | 797,527 |   | 4.47 |   |
| Total  interest-bearing funds                      | ** ** | **10,785,716** | ** **     | **2.62**        |       | 10,619,092     |       | 2.35 |   | 10,493,853 |   | 2.09 |   |
|                                               |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Noninterest-bearing  deposits                      | ** ** | **3,206,071**  |           |            |       | 3,255,149      |       |   |   | 3,240,806 |   |   |   |
| Other liabilities  and accrued expenses            | ** ** | **182,531**    |           |            |       | 173,984        |       |   |   | 151,094 |   |   |   |
| Total liabilities                                  | ** ** | **14,174,318** |           |            |       | 14,048,225     |       |   |   | 13,885,753 |   |   |   |
| Shareholders’  equity                         | ** ** | **2,261,646**  |           |            |       | 2,210,050      |       |   |   | 2,179,415 |   |   |   |
| Total liabilities  & shareholders’ equity | ** ** | **$**          | **16,435,964** |            |       |           | $          | 16,258,275 |   |   |   | $ | 16,065,168 |   |   |   |
|                                               |       |           |           |            |       |           |       |   |   |   |   |   |   |
| Net interest rate  spread                          | ** ** | ** **     |           | **3.64**        | %          |           |       | 3.78 | % |   |   | 3.83 | % |
| Effect of  noninterest-bearing funds               |       |           | ** **     | **0.72**        |       |           |       | 0.65 |   |   |   | 0.58 |   |
| Net interest  margin on earning assets             | ** ** | ** **     |           | **4.36**        | %          |           |       | 4.43 | % |   |   | 4.41 | % |

 

41

----

 

**Consolidated Average BalanceSheets *(continued)***

*(Dollars in thousands)*

* *
| ** **                                         | ** ** | ** **     | ** ** | ** **      | ** ** | ** **     | ** ** | ** **      | ** ** | **Average Balance** | ** ** |
|----------------------------------------------------|------------|----------------|------------|-----------------|------------|----------------|------------|-----------------|------------|--------------------------|------------|
| ** **                                         | ** ** | **2Q 05** | ** ** | **1Q 05**  | ** ** | **1Q 06** | ** ** | **1Q 06**  | ** ** |
| ** **                                         | ** ** | **Average**    | ** ** | **Yield(1)**    | ** ** | **Average**    | ** ** | **Yield(1)**    | ** ** | **vs**                   | ** ** | **vs** | ** ** |
| ** **                                         | ** ** | **Balance**    | ** ** | **/ Rate** | ** ** | **Balance**    | ** ** | **/ Rate** | ** ** | **4Q 05**           | ** ** | **1Q 05** | ** ** |
| **Earning assets Loans:**                     |       |           |       |            |       |           |       |            |       |                     |       |   |   |   |   |
| Commercial and  leasing                            |       | $              | 2,926,234  |            | 6.31       | %              | $          | 2,848,452       |       | 5.90                     | %          | 0.7 | % | 3.0 | % |
| Commercial real  estate                            |       | 3,363,924      |       | 6.51            |       | 3,133,446      |       | 6.28            |       | 0.2                      |       | 17.2 |   |
| Construction                                       |       | 1,442,621      |       | 6.66            |       | 1,328,633      |       | 6.24            |       | 6.8                      |       | 26.5 |   |
| Residential real  estate                           |       | 1,762,991      |       | 5.95            |       | 1,710,003      |       | 5.92            |       | 1.8                      |       | 7.1 |   |
| Home equity lines                                  |       | 502,917        |       | 5.85            |       | 495,935        |       | 5.36            |       | (3.0                     | )          | 0.1 |   |
| Consumer                                           |       | 900,576        |       | 5.77            |       | 797,892        |       | 5.94            |       | (0.5                     | )          | 29.2 |   |
| Total loans                                        |       | 10,899,263     |       | 6.29            |       | 10,314,361     |       | 6.04            |       | 1.3                      |       | 12.9 |   |
|                                               |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Federal funds  sold, et al                         |       | 40,904         |       | 4.33            |       | 31,854         |       | 4.37            |       | (24.6                    | )          | 79.9 |   |
|                                               |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Securities: (2)                                    |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Taxable  securities                                |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| U.S. Treasury and  government agencies             |       | 1,382,037      |       | 3.37            |       | 1,426,230      |       | 3.43            |       | 0.7                      |       | 1.0 |   |
| Mortgage-backed                                    |       | 1,365,012      |       | 4.05            |       | 1,303,700      |       | 4.02            |       | 2.8                      |       | 21.9 |   |
| Other investments                                  |       | 65,051         |       | 3.63            |       | 63,943         |       | 4.12            |       | 3.6                      |       | (1.2 | ) |
| Tax-exempt  securities                             |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| States and  political subdivisions                 |       | 88,537         |       | 5.90            |       | 80,921         |       | 5.97            |       | (5.3                     | )          | 3.8 |   |
| Total securities                                   |       | 2,900,637      |       | 3.77            |       | 2,874,794      |       | 3.79            |       | 1.7                      |       | 10.5 |   |
|                                               |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Interest-bearing  deposits in other banks          |       | 187            |       | 1.31            |       | 158            |       | 1.47            |       | —                   |       | 26.6 |   |
| Total earning  assets                              |       | 13,840,991     |       | 5.76            |       | 13,221,167     |       | 5.55            |       | 1.2                      |       | 12.6 |   |
|                                               |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Cash and due from  banks                           |       | 301,484        |       |            |       | 290,911        |       |            |       | (5.6                     | )          | 3.6 |   |
| Bank premises and  equipment, net                  |       | 144,347        |       |            |       | 141,426        |       |            |       | (1.0                     | )          | (2.3 | ) |
| Other assets                                       |       | 1,099,607      |       |            |       | 1,004,526      |       |            |       | 1.1                      |       | 26.7 |   |
| Less: allowance  for loan losses                   |       | (152,858       | )          |            |       | (149,686       | )          |            |       | (0.7                     | )          | 4.9 |   |
| Total assets                                       |       | $              | 15,233,571 |            |       |           | $          | 14,508,344      |       |                     |       | 1.1 |   | 13.3 |   |
|                                               |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Interest-bearing liabilities                       |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Deposits:                                          |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Savings                                            |       | $              | 1,463,960  |            | 0.36       |           | $          | 1,459,580       |       | 0.32                     |       | (3.6 | ) | (9.5 | ) |
| Checking plus  interest                            |       | 1,418,337      |       | 0.16            |       | 1,350,521      |       | 0.15            |       | (4.1                     | )          | (0.7 | ) |
| Money market                                       |       | 1,574,422      |       | 1.15            |       | 1,550,919      |       | 0.94            |       | 3.6                      |       | 19.2 |   |
| Time deposits  $100,000 and over                   |       | 1,618,161      |       | 2.97            |       | 1,427,571      |       | 2.66            |       | 6.7                      |       | 33.4 |   |
| Other time  deposits                               |       | 2,060,974      |       | 2.54            |       | 1,905,548      |       | 2.28            |       | 0.8                      |       | 21.7 |   |
| Total  interest-bearing deposits                   |       | 8,135,854      |       | 1.55            |       | 7,694,139      |       | 1.33            |       | 1.1                      |       | 13.5 |   |
|                                               |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Short-term  borrowings                             |       | 1,021,281      |       | 2.15            |       | 1,000,929      |       | 1.64            |       | 8.8                      |       | 31.9 |   |
| Long-term debt                                     |       | 742,056        |       | 4.23            |       | 689,372        |       | 4.01            |       | (4.7                     | )          | 5.9 |   |
| Total  interest-bearing funds                      |       | 9,899,191      |       | 1.81            |       | 9,384,440      |       | 1.56            |       | 1.6                      |       | 14.9 |   |
|                                               |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Noninterest-bearing  deposits                      |       | 3,137,366      |       |            |       | 3,024,595      |       |            |       | (1.5                     | )          | 6.0 |   |
| Other liabilities  and accrued expenses            |       | 154,910        |       |            |       | 149,033        |       |            |       | 4.9                      |       | 22.5 |   |
| Total liabilities                                  |       | 13,191,467     |       |            |       | 12,558,068     |       |            |       | 0.9                      |       | 12.9 |   |
| Shareholders’  equity                         |       | 2,042,104      |       |            |       | 1,950,276      |       |            |       | 2.3                      |       | 16.0 |   |
| Total liabilities  & shareholders’ equity |       | $              | 15,233,571 |            |       |           | $          | 14,508,344      |       |                     |       | 1.1 |   | 13.3 |   |
|                                               |       |           |       |            |       |           |       |            |       |                     |       |   |   |
| Net interest rate  spread                          |       |           |       | 3.95            | %          |           |       | 3.99            | %          |                     |       |   |   |
| Effect of  noninterest-bearing funds               |       |           |       | 0.51            |       |           |       | 0.45            |       |                     |       |   |   |
| Net interest  margin on earning assets             |       |           |       | 4.46            | %          |           |       | 4.44            | %          |                     |       |   |   |

 

----

(1)Presented on a tax-equivalent basis using the statutory federal corporateincome tax rate of 35%; see “Reconciliation of Non-GAAP Measures.”

(2) Nonaccrual loans areincluded in average loans.

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

 

42

----

 

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

 

Webelieve the non-GAAP measures we use provide information useful to investors inunderstanding our ongoing core business and operational performance trends.These measures should not be viewed as a substitute for GAAP. Managementbelieves presentations of financial measures excluding the impact of certainitems provide useful supplemental information and better reflect its coreoperating activities. In order to arrive at core business operations results,the effects of certain non-core business transactions such as gains and losseson the sales of securities, amortization of intangibles, restructuring chargesand merger-related expenses, have been excluded. Management reviews these samemeasures internally. For instance, the cash operating efficiency ratio, ratherthan the GAAP basis efficiency ratio, is used to measure management’s successat controlling ongoing, core operating expenses. Additionally, managementbelieves that reporting several key measures based on tangible assets (totalassets less intangible assets) and tangible equity (total equity lessintangible assets) is important as this more closely approximates the basis formeasuring the adequacy of capital for regulatory purposes.

 
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** ** | **1Q 06** | ** **  | **4Q 05** | ** ** | **3Q 05** | ** ** | **2Q 05** | ** ** | **1Q 05** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------|-------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                | ** ** | ** **     | ** **  | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** | ** **     | ** ** |
| (1) The net interest margin and efficiency ratios are presented on a  fully taxable-equivalent (FTE) and annualized basis. The FTE basis adjusts  for the tax-favored status of income from certain loans and investments.  Management believes this measure to be the preferred industry measurement of  net interest income and provides a relevant comparison between taxable and  nontaxable investments.                                                                                                                                                                             |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       |
| Net interest  income (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         | ** ** | **$**          | **158,313** |           | $          | 162,434        |       | $              | 159,242    |           | $          | 152,367 |   | $ | 143,083 |   |
| Taxable-equivalent  adjustment                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **1,833**      |        | 1,833          |       | 1,781          |       | 1,656          |       | 1,577          |       |
| Net interest  income - taxable equivalent                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **$**          | **160,146** |           | $          | 164,267        |       | $              | 161,023    |           | $          | 154,023 |   | $ | 144,660 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (2) Management excludes the  balance of intangible assets and their related amortization expense from its  calculation of return on average tangible equity and average tangible equity  to average tangible assets. This adjustment allows management to review the  core operating results and core capital position of Bankshares. This is  consistent with the treatment by the bank and regulatory agencies that excludes  goodwill and other intangible assets from their calculation of risk-based  capital ratios.                                                                |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       |
| Return on  average equity (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | ** ** | **12.69**      | %           | 13.44          | %          | 12.92          | %          | 13.33          | %          | 13.02          | %          |
| Impact of  excluding average intangible assets and amortization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | ** ** | **6.28**       |        | 6.82           |       | 6.70           |       | 6.31           |       | 5.55           |       |
| Return on  average tangible equity                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **18.97**      | %           | 20.26          | %          | 19.62          | %          | 19.64          | %          | 18.57          | %          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |       |           |        |           |       |           |       |           |       |           |       |
| Average equity  to average assets (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **13.76**      | %           | 13.59          | %          | 13.57          | %          | 13.41          | %          | 13.44          | %          |
| Impact of  excluding average intangible assets and amortization                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           | ** ** | **(3.95**      | )           | (3.98          | )          | (4.04          | )          | (3.74          | )          | (3.44          | )          |
| Average tangible  equity to average tangible assets                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **9.81**       | %           | 9.61           | %          | 9.53           | %          | 9.67           | %          | 10.00          | %          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (3) The efficiency ratio is  measured by dividing noninterest expenses by the sum of net interest income  on an FTE basis and noninterest income. When computing the cash operating  efficiency ratio and cash operating earnings, management excludes the  amortization of intangible assets, restructuring charges, merger-related  expenses, and gains and losses on sales of premises and from sales of  investment securities in order to assess the core operating results of  Bankshares and because of the uncertainty as to timing and amount of gain or  loss to be recognized. |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| Efficiency ratio  (GAAP basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **48.34**      | %           | 47.87          | %          | 48.36          | %          | 48.54          | %          | 49.45          | %          |
| Impact of  excluding: Securities gains and (losses)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **—**     |        | (0.01          | )          | —         |       | 0.02           |       | 0.10           |       |
| Gains/(losses)  on sales of premises                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** ** | **0.02**       |        | —         |       | (0.05          | )          | 0.78           |       | 0.27           |       |
| Amortization of  deposit intangibles                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** ** | **(0.68**      | )           | (0.66          | )          | (0.65          | )          | (0.69          | )          | (0.67          | )          |
| Amortization of  other intangibles                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **(0.38**      | )           | (0.35          | )          | (0.34          | )          | (0.34          | )          | (0.35          | )          |
| Restructuring  charges                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | ** ** | **—**     |        | —         |       | —         |       | —         |       | -              |       |
| Merger-related  expenses                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **—**     |        | (0.16          | )          | (0.33          | )          | (0.05          | )          | (0.12          | )          |
| Cash operating  efficiency ratio                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** ** | **47.30**      | %           | 46.69          | %          | 46.99          | %          | 48.26          | %          | 48.68          | %          |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (4) Bankshares presents  cash operating earnings in order to assess its core operating results.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
| Net income (GAAP  basis)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **$**          | **70,759**  |           | $          | 74,863         |       | $              | 70,956     |           | $          | 67,873 |   | $ | 62,627 |   |
| Less: Securities  (gains) and losses, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** ** | **8**          |        | 32             |       | 19             |       | (46            | )          | (250           | )          |
| (Gains)/losses  on sales of premises, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | ** ** | **(48**        | )           | —         |       | 117            |       | (2,048         | )          | (693           | )          |
| Plus:  Amortization of deposit intangibles, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | ** ** | **899**        |        | 899            |       | 892            |       | 875            |       | 826            |       |
| Amortization of  other intangibles, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            | ** ** | **507**        |        | 486            |       | 458            |       | 442            |       | 426            |       |
| Restructuring  charges, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **—**     |        | —         |       | —         |       | —         |       | —         |       |
| Merger-related  expenses, net of tax                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      | ** ** | **—**     |        | 216            |       | 449            |       | 56             |       | 156            |       |
| Cash operating  earnings                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **$**          | **72,125**  |           | $          | 76,496         |       | $              | 72,891     |           | $          | 67,152 |   | $ | 63,092 |   |

 

43

----

 

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

# ** **

Information responsive tothis item as of December 31, 2005 appears under the captions “Risk Management”,“Interest Rate Sensitivity Analysis (Static Gap)” and “Earnings SimulationModel Projections” of the registrant’s Form 10-K for the year ended December31, 2005. There was no material change in such information as of March 31,2006.

 

# **Item4. Controls and Procedures**

 

As of March 31, 2006,Bankshares’ management, under the supervision and with the participation ofBankshares’ principal executive officer and principal financial officer,evaluated the effectiveness of the design and operation of our disclosurecontrols and procedures, (as that term is defined in Rules 13a-15(e) and15d-15(e)) and internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f)) under the Securities and Exchange Act of 1934, asamended. Based on the evaluation, the principal executive officer and principalfinancial officer concluded that Bankshares’ disclosure controls and proceduresare effective. There were no significant changes in Bankshares’ internalcontrols over financial reporting during the last fiscal quarter.

 

# **PART II – OTHERINFORMATION**

 

# **Item 1. LegalProceedings**

# ** **

# **Item1.**Submission of Mattersto a Vote of Security Holders

# ** **

**Item 6.    Exhibits**

 

Exhibits

 

10 ZZ  Form of Mercantile Bankshares CorporationRestricted Stock Unit Award Agreement with Edward J. Kelly, III, dated March29, 2006.

 

10 AAA  Form of Restricted Stock Unit Award Agreementfor grants made under the Mercantile Bankshares Corporation Omnibus Stock Plan,2006 Long-Term Incentive Program.

 

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

 

31.2 Section 302 Certificationof Chief Financial Officer. Filed as an exhibit hereto and incorporated hereinby 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

 

44

----

 

**Signatures**

 

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

 
|        | **  Mercantile****Bankshares Corporation**   |
|-------------|--------------------------------------------------------|
|        | **  **(Registrant)                           |
|        |                                                   |
|        |                                                   |
| May 9, 2006 |                                                   | **  **/s/  Edward J. Kelly, III |   |
|        | Date                                                   | **  **By:  Edward J. Kelly, III |
|        | **  **Chairman  of the Board,                |
|        | **  **President  and Chief Executive Officer |
|        |                                                   |
|        |                                                   |
| May 9, 2006 |                                                   | **  **/s/  Terry L. Troupe |   |
|        | Date                                                   | **  **By:  Terry L. Troupe |
|        | **  **Executive  Vice President and          |
|        | **  **Chief  Financial Officer               |
|        |                                                   |
|        |                                                   |
| May 9, 2006 |                                                   | **  **/s/  William T. Skinner, Jr. |   |
|        | Date                                                   | **  **By:  William T. Skinner, Jr. |
|        | **  **Controller                             |
|             |                                                        |  |  |  |

 

45

----